‘Waiting and hoping isn’t a strategy’: PE needs exits

It’s a race for distributions in private equity.

Some advice from consultancy Bain & Co, in its mid-year private equity report: “Waiting and hoping isn’t a strategy. It’s time to get moving.”

Challenges abound in the financial markets, but it could be that things are looking up. Public markets have been on the rise, inflation appears to be stabilizing and a consensus seems to be building that the economy is not heading for a deep recession. If IPO markets – one of the major exit channels for private equity – reopen, and inflation stays under control, deal activity should start to re-energize.

A resurgence of deal activity means, to some extent, exits will pick up. And that is the vital essence so desperately missing right now from private equity’s natural cycle.

As one GP told me recently, it’s hard to predict exactly what the world will look like in December. But some signals are pointing in the right direction. The S&P 500 jumped 16 percent in the first half and the Nasdaq soared by 32 percent, the report said. As well, lenders unloaded more than half of the “hung” leveraged buyout debt they committed to before the economy went sideways, Bain & Co said.

Until exits pick up, private equity is going to be sluggish. Dry powder is building up, with around $1.1 trillion in uncalled capital in buyout funds, as GPs wait for their pipelines of quality assets to build back up. GPs are much pickier these days on what they’re chasing, not to mention sellers of quality assets are reluctant to come to market with the potential for low bids.

Fundraising, meanwhile, has continued to slow while LPs wait for money to come back from their portfolios.

But exit activity is crawling – buyout-backed exits fell to $131 billion over the first half, a 65 percent decline from the same period a year ago, according to Bain & Co’s report. Exit value is tracking down 54 percent and the count is off 30 percent compared with 2022, the report said.

The unrealized value sitting in buyout funds has set an all-time record, at around $2.8 trillion, Bain & Co found. More than half of that has been held for more than four years, and nearly one-quarter longer than six years.

“Weak cumulative distributions over the past five years have left LPs cashflow negative on private equity allocations that represent a significantly larger slice of their overall portfolios than at the beginning of the current cycle,” the report said.

“LPs private equity programs are also more mature today, and many are closing in on long-term target allocations, leaving them more heavily reliant on distributions to fund capital calls. No surprise, then, that investors are intent on getting money back from GPs before considering any new commitments.”

As faithful readers of LP Weekly are well familiar, slower distributions and overexposure issues have been plaguing LPs, leading to many institutions to simply slow their pace of new commitments. The desire for access and exposure is there, but right now the market has essentially turned against LPs who want to build their programs.

The natural cycle of PE is – raise money, invest, harvest, return capital, raise new money. That cycle has been disrupted, and until it gets back into balance, nothing is going to come easy. In this situation, some firms inevitably will not be able to raise a new fund. This current cycle, like others in the past, will lead to the extinction of some franchises – or at least, their shift from raising commingled funds to operating without a dedicated pool of capital.

As one LP recently told me, maybe that’s a good thing. Any market needs a proper periodic cleansing, and this cycle is sure to be a thorough one.