“I’m actually really worried about all the investments that were made in 2020 and 2021,” she said. “How are you going to earn the return that you told us about? You’ve got to work really, really hard, and that company’s probably going to have to do things that it didn’t think it had to do in order to earn that return for us.”
If portfolio companies don’t make those expected returns, private equity firms will have even less less cash on hand to make distributions to their investors or pursue new deals. That’s created an opportunity for providers of private credit, such as loans backed by the value of a fund’s portfolio, and preferred equity that pays a dividend and can offer protections similar to debt.
Churchill Asset Management has seen more interest from borrowers that want to structure payment-in-kind debt that doesn’t require interest to be paid in cash. Forgoing cash interest payments allows private equity firms to fund other obligations, such as distributions to their investors.
In this environment, private equity firms can also benefit from co-investment, which brings in limited partners to take a stake in a portfolio company rather than a fund. Firms might also pursue continuation funds, a secondary market option that has sponsors move an existing asset into a new fund—often bringing in new investors at the same time.
“The story of 2023 will be all of the continued evolution and growth within the secondary market,” said Drew Schardt, head of global investment strategy at Hamilton Lane.
Despite these creative funding strategies, the near-term outlook for private equity remains cloudy. Still, dealmaking could pick up in the second half of 2023 if the Federal Reserve halts its rate hikes and inflation decelerates.
If a recession does materialize next year, the downturn could yield better returns for funds that can scoop up potentially profitable companies at a discount.
“Great returns are made in recessionary periods,” Auerbach said.
This article was provided by Bloomberg News.