Parting of the ways?

The article on private equity in this issue may lead people to conclude that the asset class is in poor shape. The figures are there after all. But it’s a situation that’s actually long overdue. An asset class can’t keep growing forever without reaching a correction at some point. That’s probably where private equity is now, and there is likely no need to have any fears for its long-term future.

Private equity arguably owed its turbocharged growth over the past couple of decades to external conditions as much as to its own attractions. One was the hunt for yield, where poor returns from traditional bonds combined with chronic underfinancing of US public pension plans led to a flight to what was supposed to be an outperforming asset class. Whether that will do much to fix the US public pension mess is an interesting question, since the law of diminishing returns has led to lower returns. There certainly seemed to be less outperformance even before current conditions took hold.

Then there are inflation and interest rates. Some may question whether the broader macroeconomy really has transitioned to a secular medium-term higher interest rate norm, but these conditions have persisted at least since the Covid-19 pandemic and appear to be moderating, but not disappearing.

Private equity naturally benefited from conditions where its favourite tipple of leverage was available at low to zero interest rates. Now that the era of cheap money is over, it’s going to have to adjust operations and expectations to an environment where leverage is no longer readily available or cheap.

What that does to returns remains to be seen, but the much-publicised bottleneck in exits probably reflects the reluctance of general partners to accept lower valuations as much as structural impediments to trade sales or IPOs. GPs might also look to live up to their own rhetoric about value enhancement and business improvement.

Ironically, this might be a good time for institutional investors to raise exposure to the asset class, with fund management fees reaching new lows and negotiating clout on the side of limited partners for the first time in ages. This is with the caveat that such exposure should be sought slowly, soberly, selectively, and with a clear eye to actual current returns instead of GP hype.