PE: the unseen takeover

As the stock market grabs the headlines of the business pages with billion-dollar valuations, investment scandals and failed IPOs, away from the spotlight – and the volatility – private equity is recording ground-breaking results

Some of the figures around private equity (PE) activity are pretty eye-watering. Investments in global PE reached a record $1.1trn last year, according to Bain & Company, and exit value reached $960bn.  

To put that into context, the $1.1trn in buyouts doubled 2020’s total of $577bn and smashed the previous record of $804bn set in 2006. Furthermore, the average deal size for major PE funds broke the $1bn mark in 2021 for the first time.

Encouraged by strong returns and new investment vehicles, investors are increasingly deciding to put their money into private companies.

Alex Dean, Head of Private Wealth for the UK at IQ-EQ, says the growth of PE stems from the 2008 global financial crisis. Between 2010 and 2020, private market assets under management increased by $4trn and the number of active PE firms more than doubled.

Much like the pandemic-related stimulus that has supported PE’s expansion over the past year, billions of dollars were pumped into the financial system after the crash, creating a lasting source of accessible and low-cost funds. 

The financial crisis also brought about increased regulation over public companies, which drove investors towards privately owned firms.

What most attracts investors to PE, Dean says, are control, flexibility and returns. “PE investors can have a seat on the board of a company, influence and make decisions,” he explains. 

“There’s no distraction of daily stock market instability. And as private companies are not as heavily scrutinised or researched, PE offers investors the chance to spot an opportunity including combining a business with another business or transforming a business in ways that others can’t execute.”

Private firms also avoid some of the administrative burden of regular reporting, public annual general meetings and shareholder agreements. 

However, PE investments can be complex. While stocks are traded daily through public market exchanges, PE investments are long term, with capital typically tied up for at least 10 years. It can also be difficult to liquidate or transfer direct PE investment holdings.

Yet impressive risk-adjusted returns, Dean says, compensate investors for the fact that their money is less liquid and tied up for a longer period of time.

In the US, PE achieved average annual net returns of more than 10% between 2000 and 2020, according to Cambridge Associates, while the Standard and Poor’s 500 produced returns of less than 6%.

Vehicles for investment

With private companies less subject to regulation, critics accuse PE firms of a lack of transparency. According to its harshest portrayals, PE is about stripping assets, loading debt and laying off staff to generate quick returns.

James Fox, a Jersey-based corporate lawyer and Partner in the private equity team at Ogier, says these notions are tired and misleading.

“The whole point of PE is high growth and high return – and the best way to give investors a return on their money is to grow a business. That asset-stripping perception is completely wrong,” he says.

“You’ll also hear that if a company is private, there’s no regulation. But there is regulation at fund or fund manager level. Major PE fund managers, with billions under management, are often regulated in at least one jurisdiction.

“PE investors demand a level of reporting on assets equivalent to any investment. Plus, if PE firms are buying into a regulated business, they need to comply with all the same regulatory approvals as any other buyer would do.”

While major PE firms dominate the market, large family offices are also contributing to its growth. 

According to UBS, 80% of family offices are making PE investments in 2022, up from 77% in 2021 and 75% in 2020. And family offices are now allocating 21% of their portfolios to PE – an increase of 16% on 2019.

Many of these investments are made via regulated funds or managers, which means groups of investors can take comfort from regulatory oversight at fund level while benefiting from a private company regime at asset level.

Dean also points to hybrid funds, which enable investment in both public and private securities and companies. 

“Investors may look for stability in bonds or property investments, but at the same time have the flexibility to invest in listed stocks,” he says.

Meanwhile, club deals, where PE investors jointly acquire a company, are on the increase. Blackstone, The Carlyle Group and Hellman & Friedman acquired healthcare company Medline in a deal worth around $34bn in 2021, although club deals can also involve smaller-scale, individual investors.

Fox sees the PE market as a “barbell model”, with large PE funds raising billions at one end and family offices making smaller deals at the other. 

There’s a market opportunity in the middle, he says, where family offices could form their own quasi-PE funds.

Future trends

Despite the eye-watering numbers around the growth of PE, the impact of inflation and rising interest rates means the coming years may be more challenging. 

Amid the uncertainty of the pandemic last year, as many business owners looked to exit, PE firms raised investment, made deals and leveraged buyouts, acquiring companies using borrowed money. Interest rates were still low and debt cheap.

Now, in order to control soaring inflation across the eurozone, central banks are raising interest rates for the first time in more than a decade. 

These interest rate rises, Fox predicts, will mean less leverage in the future as debt becomes more expensive.

Still, by historical standards, interest rates are relatively low. Fox says PE houses have sophisticated financial models that allow an optimum ratio of equity and debt to be applied to any particular business so that it achieves its full potential.

Industries ripe for PE investment include technology, media, telecoms and life sciences, says Fox, where companies are looking to grow as quickly as possible. Elsewhere, an expanding global population is increasing demand for investment in infrastructure. 

New technologies are allowing PE businesses to manage ever more complex investments. Artificial intelligence is making financial data easier to understand and expediting the deal-making process, and reporting is becoming more automated and information more easily accessible for investors. 

Family offices now have investments spread across the globe, investing in companies in countries where it wouldn’t have been possible just a few years ago.

Further, a focus on environmental, social and governance (ESG) factors is central to PE investment. Some 70% of limited partners have investment policies that include an ESG approach, according to a survey by Bain and the Institutional Limited Partner Association. 

And 85% of those have an ESG policy for PE investments, while 93% would walk away from an investment if it posed an ESG concern.

PE investment in healthcare more than doubled to a record $151bn in 2021, with medtech attracting attention as investors look for ways to relieve pressures on health services.

The storm clouds may be gathering over the global economy, but Dean believes PE firms and investors have long proved their ability to thrive in difficult circumstances.

“PE has a history of investor activism; of people trying to make an impact in companies,” he says. “Investors are excited by the opportunity of finding the next global winner.”