Since the beginning of 2022, the private equity market has gone through a transition. With the dramatic rise in interest rates, private equity firms, which typically borrow significant amounts of capital, had to reevaluate not only what were the best businesses to purchase but, importantly, how they were going to sell their current underlying portfolio companies. For private equity investors, the exits/sales are paramount, because investors ultimately receive their return on invested capital through these transactions. This process is performed through distributions of paid-in-capital or, simply, distributions.

In the last few years, however, these distributions have suddenly halted. Sales of private companies generated by capital market activity, such as initial public offerings (IPOs) and mergers and acquisitions, are integral to generating the liquidity needed for investors. However, capital markets stalled, and these exits experienced dramatic drops in activity. In 2023, global private equity buyout-backed exit volume was down 66% from 2021(Source: Bain & Company Global Private Equity Outlook 2024). By the end of 2023, a record $3.2 trillion dollars was stored in aging, closely held companies (Source: Bloomberg: Private Equity Scrambles to Find an Alternative to IPOs to Unlock $3 trillion ).

Private equity is an asset class that can add meaningful value to portfolios. Over the long term, it can provide a return premium relative to public equities. Looking forward, it is crucial to monitor the potential headwinds and tailwinds of the current lack of distributions, especially if private equity is part of a greater asset allocation.   

Headwinds:
1.Liquidity Concerns
While there are many benefits to private equity firms being thoughtful when extracting value from their holdings, these decisions can stress the cash or liquidity needs of their investors. Investors may have to sell their investments at significant discounts (i.e., 15-20%) to potential buyers through the secondary market to generate this necessary liquidity. Ultimately, these decisions can suppress returns significantly.

2.Fundraising
2023 saw the slowest fundraising cycle for the industry since 2018 (Source: Bain & Company Global Private Equity Report 2024). Fundraising has been suppressed by two factors. Firstly, cash-constrained investors are waiting on much needed distributions before entering new private allocations. Secondly, competition for new deals has left many private equity firms with large amounts of uninvested cash. This may lead to investors being under-diversified across numerous years.

3.Overall Capital Allocation
Investors allocate capital to various asset classes, including private equity, based on expected returns, risk profiles, and liquidity needs. If distributions from private equity are delayed, investors may need to reassess their allocation decisions and reallocate capital to more liquid asset classes to meet their investment objectives.

Tailwinds:
1.Private Equity Firms Are Being Thoughtful About Exits

While exit activity has dried up, private equity firms and general partners are operating strategically. Unwilling to compromise on value, only the highest-quality assets have been brought to the market in the past two years. Instead, private equity firms are looking for alternative avenues to create value. These opportunities come in many forms – extending the lives of their funds, creating continuation vehicles where they hold their best and sell their less attractive assets, or utilizing the secondary market. These strategies ultimately benefit investors as private equity firms have more flexibility to strategically sell their underlying businesses.  

2.Opportunities in the Private Equity Secondary Market
Secondary sales accounted for 26% of PE exits in the first quarter of 2024 (Source: Ernst & Young Private Equity Pulse ). As current investors seek liquidity, new private equity investors can capitalize on market opportunities where they could potentially purchase robust private businesses at reasonable prices. With continued deal flow entering the secondary markets, the opportunity grows for investors to capitalize on this dynamic.

3.Potential Additional Compounding
Some investors argue that you will not experience the true benefits of compounding until an investment has matured for 15 or more years. With many funds extending their lives, investors can expect to potentially benefit from additional compounding on their assets as portfolio companies continue to grow. This process will involve patience and continued conversations with the private equity firms, especially if you are eventually expecting an exit and distribution.

Private equity markets have experienced massive changes since the Federal Reserve started raising interest rates in 2022. In many ways, the current cycle shares characteristics with the global financial crisis—record liquidity and distributions, in 2021, before a huge pullback in subsequent years. However, over time, private equity has proven to be a resilient asset class that has continued to benefit portfolios, through enhancing private businesses, exiting at attractive valuations, and providing strong absolute returns to investors. Overall, it is important for investors to evaluate the benefits and drawbacks of their current private equity positions and how they should manage any future allocations.

Sloan Smith, CAIA, MBA, CPWA, is a principal and director at Innovest and a member of the Investment Committee, which drives the firm’s investment related research and due diligence. Natalie Miller, CFA, M.S., is a senior analyst on the research and retirement plan teams at Innovest.