Private credit, or lending to companies by institutions other than banks, has grown rapidly in recent years as stricter regulations have made it more expensive for traditional lenders to finance riskier loans. According to Preqin data, the asset class is expected to grow from $1.5 trillion at the end of 2023 to $2.6 trillion by 2029.
There is also a concerning trend that has recently emerged in the private equity (PE) industry. After years of remarkable growth during which the sector significantly contributed to funding businesses, the rise in interest rates and increasing regulatory concerns have reportedly hindered its progress.
The private equity sector’s current health
Having achieved exponential growth over the past two decades, the private equity industry is now floundering. Up until two years ago, the PE market had thrived by relying on a model built on cheap financing and leverage. However, the confluence of higher borrowing costs, market volatility, and economic uncertainty has created considerable challenges for the PE ecosystem. These challenges have raised alarm bells among regulators.
“Clearly, debt markets have impacted returns,” says Mike Donaldson, CEO of South Africa-based RMB Corvest, a pioneer in private equity that focuses 100% on equity investing, with PE being its primary asset class.
Mike Donaldson added that while the PE sector has encountered headwinds recently, the undeniable fact is that the sector has matured into a multi-trillion-dollar industry that is critical in driving business growth and job creation.
Data indicates that globally, assets under management in the private equity sector have increased significantly over the past decade, from $2 trillion in 2013 to $8 trillion in 2023. The industry, however, remains relatively small compared to the public equity market, which stands at $100 trillion, and banking sector balance sheets, which total $98 trillion.
In the United States, private equity firms have created 12 million jobs and contributed 6.5% to the GDP, amounting to $1.4 trillion. In the United Kingdom, the sector plays a crucial role in funding businesses, with around $313 billion actively invested in companies. Data from the British Private Equity and Venture Capital Association shows that in 2023, British businesses backed by PE and venture capital (VC) employed 2.2 million workers (1.9 million of whom were PE-backed), collectively earning $94 billion. Additionally, suppliers to these businesses employ another 1.3 million workers.
In other regions, Asia-Pacific’s PE investments have been on a growth trajectory, hitting a five-year high of $244 billion in 2021, according to KPMG. However, investments have recently plunged to $84.7 billion. In Africa, the PE industry has emerged as a lifeline, providing alternative routes to growth for companies that might otherwise struggle to achieve the requisite scale. PE and VC investments in Africa soared 66% in 2022 to $7.7 billion, according to S&P Global Market Intelligence data.
In an interview with World Finance, Paras Shah, Managing Partner at Bowmans’ Kenyan office, said, “The flow of PE investments has been healthy in Africa and continues to facilitate growth for many businesses for which bank credit was not easily accessible.”
He further added that the majority of deals on the continent are relatively small, ranging between $15 million and $25 million, as the market itself is also small.
Companies across all major industries are attracting massive investments worldwide due to the transformative power of PEs, which have become a kind of financial war chest, offering handsome returns within the shortest period possible. As the private equity industry continues to grow, it is also leading to the migration of highly qualified professionals from industries like banking and insurance to PE ventures.
Banks, especially, are grappling with the impact of the exodus, as former employees are now emerging as direct competitors or clients. Even more concerning is the rise in default rates on leveraged loans. While the full extent of the issue remains unclear, for banks with significant exposure, the risks could raise serious alarms.
The crisis is very much there
In some ways, things have started to crash since 2022. The root cause is the United States Federal Reserve’s rapid increases in interest rates, the sharpest since the 1980s. The Fed’s aggressive approach to controlling stubborn inflationary pressures has had contagion effects, instigating hikes across the globe.
Nathanael Benjamin, the Bank of England’s (BoE) Executive Director for Financial Stability Strategy and Risk, said, “The strong growth and attractive returns of the private equity asset class over the last 10 years occurred during a period of low interest rates. However, since the start of 2022, interest rates have increased substantially.”
He added that markets are not expecting a return to the low levels seen in the recent past for the foreseeable future.
High borrowing costs have inevitably revealed the vulnerabilities within the private equity industry. In addition to eroding investor confidence, it has created significant challenges. Clearly, this has been a period of downturn for PE across all metrics, including fundraising, dealmaking, and exits. The consequences are rippling throughout the entire ecosystem, with struggling companies—many of them small and medium-sized enterprises (SMEs)—unable to secure the growth capital they need.
The modern private equity industry began in 1981 in the world’s largest economy, when former Treasury Secretary Bill Simon acquired the card company Gibson Greetings for $80 million. In the same year, the great American bond bull market commenced. Since then, private equity has bounced back from several market downturns, buoyed by ever-cheaper financing.
After the Federal Reserve lowered interest rates to zero following the collapse of Lehman Brothers in 2008, buyout financing became more attractive than ever.
According to Reuters, “Investors snapped up leveraged loans, which were stripped of their traditional protective covenants, and acquired junk bonds at the lowest yields in history. Ultralow interest rates also inflated stock market valuations, further boosting returns for investors in leveraged buyouts.”
In the decade after 2012, the industry’s assets under management increased by nearly $10 trillion. During the COVID market frenzy, the value of global private equity deals topped $1 trillion for the first time. Companies controlled by buyout firms borrowed billions of dollars at low cost to finance dividend payments to investors. Private equity funds also raised more money than ever, leaving the industry with around $3.7 trillion in so-called dry powder.
However, things changed in mid-2022 after the Fed started raising interest rates, and banks became more reluctant to lend. The value of US buyout deals in the last quarter of the 2021/22 financial year fell to half the level of a year earlier and has remained depressed since.
In May 2023, Reuters columnist Edward Chancellor wrote, “The current market downturn will likely produce bargains. But this time around, there’s a lot more private equity money chasing a limited number of opportunities. Furthermore, it’s unlikely that financing conditions will ever be as easy as in recent years. Bond bear markets usually last for decades, so private equity funds could face the prospect of a prolonged period of higher borrowing costs, lower valuations, and depressed investment returns.”
As 2024 came to an end, the Federal Reserve started cutting interest rates. Still, the PE industry is not overjoyed by the development, as the market is still grappling with a string of issues, including weakening corporate performance, political uncertainties, and a sluggish fundraising climate.
Even though the rate-cut cycle began in September 2024, dealmakers said the development had already been priced into transactions for several months. Term sheets circulating among advisers have incorporated the lower borrowing costs, with both private credit lenders and banks lowering spreads to factor in the widely anticipated rate reduction.
In an interview with PitchBook, Beau Thomas, co-founder and managing partner at Agellus Capital, a lower-middle-market private equity firm, said, “The credit markets—particularly private credit—have been supportive of leveraged buyouts (LBOs) over the last several months: spreads tightened very meaningfully.”
According to PitchBook LCD data, “The average all-in yield for LBO loans rated BB+ and below tightened to 9.4% in Q3 2024, 31 basis points lower than Q1 2024, and the lowest quarterly level since Q2 2022.”
“One of the challenges facing PE firms is the difficulty of exiting larger companies with $100 million in EBITDA (earnings before interest, taxes, depreciation, and amortisation) or more, because the sellers either deem the IPO market unfavourable or can’t find buyers willing to meet their valuation expectations,” Beau Thomas added.
General Partners (GPs) who manage funds are feeling the squeeze, as management fees and carried interest are drying up. Limited Partners (LPs), the investors in private equity funds—including sovereign wealth funds, insurers, pension funds, foundations, and wealthy individuals—are in a state of despair, with funds returning the lowest amounts of cash since the financial crisis 15 years ago.
“The majority of PE firms have not realised their core investments during these cycles and have chosen to hold for longer,” explains Mike Donaldson, CEO at South Africa-based RMB Corvest.
Global consultancy firm Bain & Company’s 15th Annual Global Private Equity Report captures the reality of the PE industry in recent times. The report contends that echoes of the 2008 global financial crisis have reverberated loudly. However, the industry has never seen anything quite like what has happened over the last 24 months.
Hugh MacArthur, global private equity practice chairman at Bain & Company, said, “The sheer scale and speed of rate rises last year, and the uncertainty around that, was a shock for the industry in 2023.”
In 2023, buyout investment value dropped to $438 billion, a 37% drop from 2022 and the worst total since 2016. When compared to 2021’s peak, it was 60% down. Overall, the deal count dropped by 20% to around 2,500 transactions. Compared to 2021 highs, deal count was down 35%. The malaise infected regions across the world, with North America, Europe, and Asia-Pacific experiencing significant declines.
While dealmaking was severely impacted, exit activity fared even worse, as rising interest rates and macroeconomic uncertainty caused a disconnect between buyers and sellers over valuations. In fact, exits have become the most pressing challenge for the PE industry. Beyond halting the return of capital to Limited Partners (LPs), exits have left General Partners (GPs) holding onto $3.2 trillion worth of unsold assets, comprising an astonishing 28,000 companies that PE firms cannot exit.
The median holding period for a buyout has notably risen to 5.6 years, significantly higher than the industry average of around four years. In 2023, 46% of businesses were held for four years or longer, the highest proportion since 2012. The decline in exit activity led to a 44% drop in buyout-based exits, which fell to $345 billion globally. The number of exit transactions also decreased by 24%, reaching 1,067 for the year. This decline in exits was observed across all regions.
Is there a way out?
The inability of PE funds to exit and return capital to LPs had a detrimental effect on fundraising during the high-interest rate regime. However, new fundraising contributed an impressive $1.2 trillion to the stunning $7.2 trillion in fresh capital the industry has accumulated since 2019, thanks to the amount raised in 2023, which was, in fact, the least the industry has pulled in annually since 2018. It was down 20% from 2022 totals and almost 30% off the all-time high in 2021.
“The biggest contributing factor to the fundraising plunge is that low returns have prompted LPs to become overly selective about new redistributions. In essence, LPs are opting to carry out thorough due diligence, seeking to zero in on GPs that have demonstrated resilience in returning capital over the years. Assuming patient capital, returns should materialise once markets re-rate,” Mike Donaldson explained.
The private equity industry finds itself at a crossroads, facing challenges in investments, exits, and fundraising. This situation has been worsened by an excess of dry powder that remains uninvested due to the slowdown in dealmaking.
According to S&P, global private equity dry powder reached an all-time high of $2.5 trillion in 2023, up from $2.3 trillion in 2022, marking an 8% increase. Notably, 25 PE firms controlled 21.8% of the dry powder, with 19 of them based in the US. Apollo Global Management topped the list, holding $55 billion in uncommitted capital for its private equity strategies. Other firms sitting on record levels of dry powder include Blackstone, KKR, Carlyle Group, CVC Capital, Warburg Pincus, Brookfield, Bain Capital, and Advent International, among others.
Additionally, due to ongoing geopolitical scenarios across the world, resultant economic uncertainties have created a situation in which investors are becoming more restrained and selective. The dynamics have also been complicated by the valuation gap, which has been one of the primary impediments to dealmaking in recent months. Due to high interest rates, vintage PE assets have faced the risk of valuation mismatches at exit. To a large extent, this explains the increase in the median holding period for a buyout.
The valuation dilemma has pushed both GPs and LPs to turn to the secondary market in search of liquidity. However, even here, increased supply has put downward pressure on prices and valuations. Research by US-based financial services firm Jefferies reveals that secondary market volumes reached $112 billion in 2023, up from $108 billion in 2022, marking a 4% increase. Strong buyer demand, a significant supply of both LP portfolios and GP-led opportunities, and stabilising market conditions contributed to the rise in secondary volume. Notably, while pricing overall improved due to rising public valuations, only 1% of LP interests were priced above the net asset value (NAV) of the company portfolio.
A report by Jefferies revealed that the “sustained high interest rates in 2023 altered investors’ required return on capital and limited their use of leverage, resulting in just 1% of funds pricing above NAV, with many older, tail-end interests trading below 75% of NAV.”
According to PitchBook, despite 2023 being a turbulent period for the PE industry, it did not stop the execution of some earth-shaking deals. A majority of the top deals closed were valued at below $1 billion. Only about a quarter were valued at more than $1 billion.
The $13.5 billion acquisition of Japanese conglomerate Toshiba by PE firm Japan Industrial Partners stood out among the top deals. It marked the end of a 74-year era for Toshiba as a listed company, while also giving the struggling conglomerate a new lease on life.
Other notable deals included Silver Lake, with the participation of Canada-based CPP Investments, paying $12.5 billion to acquire Qualtrics, an experience management company, and American investment firm Stonepeak paying $7.4 billion to acquire Textainer, one of the world’s largest lessors of intermodal containers. Additional noteworthy deals included Roark Capital paying $9.5 billion to acquire Subway, one of the world’s largest quick-service restaurant brands, and Apollo agreeing to buy out the shareholders of Univar Solutions, a commodity and speciality chemical distributor, for $8.1 billion.
Globally, the vibrancy of capital markets is facing real threats from PE firms. A survey conducted by US-based multinational law firm Dechert in 2023 paints a clear picture. In the survey of 100 senior PE executives in the United States, Europe, and Asia, 94% said they had plans to pursue take-private deals. In 2022, only 13% had take-private ambitions.
What’s next?
The private equity portfolio company bankruptcies have emerged as an area of grave concern. The devastation of high interest rates has extended to portfolio companies. In the United States, S&P data show that bankruptcy filings by PE and VC-backed companies surged to 104 in 2023. This was the highest annual total on record, representing a 174% growth over the 38 filings in 2022, and accounted for over 16% of all US bankruptcy filings. Bankruptcies in the healthcare sector were among the highest, totalling 17.
The industry, however, is starting to see some light at the end of the tunnel. Easing borrowing costs and renewed interest from lenders have resulted in a rebound in activity. The trend is projected to gain pace in the coming months, providing a greater sense of stability. However, expect cautious optimism to remain among industry stakeholders in the coming months.
The first quarter of 2024 offers a glimpse. S&P data show that PE and VC deal value stood at $130.6 billion during the period, compared to $124.3 billion for the same period in 2023, representing a 5.1% increase. With 60% of GPs expressing optimism about 2024 prospects compared to 34% last year, the industry believes the worst is behind it.
According to a Financial Times report, published in August 2024, America’s private equity giants have reportedly invested $162 billion in anticipation of a revival in activities like deal-making, mergers, and buyouts. Figures from data provider Preqin show that private equity firms are holding upwards of $2 trillion in dry powder—money that has been committed but not yet invested. That number is down from the $3 trillion-plus figure the FT cited in May 2024.
However, the report also showed that due to the “18-month slowdown” in dealmaking triggered by the Federal Reserve’s aggressive interest rate hikes, companies have struggled to sell existing investments and return money to their backers.
Meanwhile, PYMNTS Intelligence reported earlier in 2024 about private equity’s push into the fintech landscape, an area where “arguably, valuations don’t reflect the potential of changes in payments processing, and especially payments acceptance.”
Now that the rate-cut cycle has started, at least in the United States, will the private equity sector get back to its glory days? To get the answer, we will need to wait for a few months into 2025.