Private Equity managers may face increasing headwinds In 2023

Private Equity Managers May Face Increasing Headwinds In 2023 Multiple studies have shown over the years that private equity has become increasingly popular among investors, and it is easy to see why.

Not only does private equity (PE) increase diversification within a portfolio, but the asset class’s returns have outperformed the public markets.

Looking into 2023, private equity could see increasing headwinds, but opportunities to generate alpha are expected to remain in place.

The alpha generated by private equity firms had decreased modestly year on year.

However, it is still above the 15-year average for a median manager, reflecting its thesis of economic change.

Meanwhile, secular factors like the rising cost of debt and robust competition for deal flow amid massive stockpiles of dry powder are expected to weigh on PE returns.

To some extent, compression of exit multiples to weigh on private equity returns, although it can be noted that much of that impact is included in the write-down on valuations.

By the numbers: PE return projections It is widely believed that PE return premium versus the public markets will provide adequate compensation for the risks in illiquidity and leverage, especially at a time of increased volatility in assets.

It reported that the historical premium of PE managers to U.S. mid-cap equities between 1993 and 2021 was 3.3%, while the 15-year average was 1.9%.

In 2021, the premium was over 10%.

On a cap-weighted composite basis, a study projects that PE funds will generate a return of 9.9% in 2023, compared to its projection of 8.1% for 2022.

Modelling financial sponsors as change agents that enhance efficiencies at their portfolio companies.

Factors driving the projections However, there are signs that private equity managers would also face challenges in the form of geopolitical risks and globalization - analysts expect private equity investing to increasingly involve growth capital, direct investing, subscription lines of credit, and commitment drawdown fee economics.

PE managers now have access to record amounts of dry powder.

Performance dispersions The firm added that performance dispersions among PE managers have been historically wide compared to the dispersion among public market managers, a trend expected to continue.

The top quartile of venture capital managers generated a historical return of 40%, while the bottom quartile managed returns of less than 10%.

Among small PE managers with less than $1 billion in assets and mid-size managers with $1 billion to $5 billion, the top quartile returns were around 25%, while the bottom quartile's returns were less than 10%. Large or mega-cap PE managers with over $5 billion saw a top quartile return of 25% to 30% and a bottom quartile return of just over 10%.

Increasing headwinds for private equity The environment for private equity has become increasingly problematic since last year amid rising discount rates, plummeting valuations, and high dry powder.

Amid those shifts, the net asset values of PE-owned companies remain wide versus those of their publicly traded peers.

Venture capital (VC) projections It is estimated that the asset class will return 8.5% annually over a 10-to-15-year investment horizon.

However, it emphasized that the widespread assumption that venture capital has outperformed PE over time is a misconception.

Private equity had outperformed venture capital based on annualized returns since 1981, primarily due to the higher volatility typical of venture capital returns.

In particular, VC returns took a massive hit from the collapse of the tech bubble in the early 2000s.

Other factors in venture capital returns A return to a low-interest-rate environment like what was observed in the postfinancial-crisis expansion would support venture capital returns.

The venture capital market is a challenging asset class to navigate and might not deliver the returns that would normally be expected in higher-risk assets.

Time will tell.

(Source: Plutus internal research)

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