Why Private Equity Is Still Dogging It | Chief Investment Officer

When, oh when, will U.S. private equity exits turn around?

For limited partners, the most important job of PE funds is to sell portfolio companies—which translates into higher investment returns. PE has disappointed the LPs lately, big time.

Still, according to research firm PitchBook Data, the buyout sector is poised to rebound, under the theory that things couldn’t get any worse. No doubt, the situation looks gloomy now. “Dealmaking has clearly yet to find a bottom,” the PitchBook report concluded.

In the year’s third quarter, a total of 275 PE-backed companies had exits, with value of $44.1 billion, according to the report, written by lead PE analyst Tim Clarke and his team. Compared with the second quarter, that marked a drop of 6.9% in exit count and 41% in value, respectively. Other than the pandemic-panic-stricken Q2 2020, that made Q3 2023 the lowest recorded figure in more than 10 years, in both count and dollars.

For the year through September 30, the picture is equally dispiriting, even matched against a lousy year like 2022, when the stock market tumbled. This year, the S&P 500 is actually up, by 10%, but PE has not followed: “Exit value hit an air pocket in Q3,” the PitchBook report summarized. In both number and proceeds, 2023’s first three quarters (85 exits, $183 billion generated) lag behind 2022’s comparable period.

There’s not a chance that 2023 as a whole will come close to the bonanza year of 2021, which featured 1,849 exits and $891 billion, PitchBook analysts asserted. Let alone 2022’s sad showing, of 1,344 and $330 billion. “Exit activity is arguably the most important link in the PE chain of capital formation and a lead indicator of industry growth,” the firm’s report noted.

To blame for the sorry plight are macro problems: higher interest rates, which inhibit borrowing and throw off deal metrics, the lifeblood of mergers and acquisitions; inflation, no friend of the stock market; and international turmoil, signaling potential problems for trade.

How has this all turned out for limited partners in PE funds? Unexciting, in light of the first-half showing (the third quarter is still being tabulated). In the first quarter, the funds collectively delivered a 4.1% return; in the second, 3.1%. “However, it’s important to note that these returns pale in comparison to the 16.9% return of the S&P 500 during the first half of 2023,” the report observed. What’s more, investors today can earn more from U.S. Treasury bonds (the 10-year note is yielding almost 5.0%) and with a lot less risk.

Until recently, PE has been popular with pension funds. But some allocators are re-thinking that. The Maryland State Retirement and Pension System is cutting back on its commitment to PE, seeking to bring its 21% allocation closer to a 16% target. The Alaska Permanent Fund Corp. has opted to do the same thing. Nonetheless, others are still building out their PE commitments. California Public Employees’ Retirement System is expanding its private-equity portfolio to 13% from 8%.

Despite the cooling of PE returns, a case can be made that down and mediocre years in private equity are good ones to invest there. “Years that feel stressful end up being the best-performing vintages,” said Brian McDonnell, head of global pension practices at Cambridge Associates, in a video interview with finance site FundFire.

He is aptly summing up the current climate in PE. Initial public offerings, a common way for PE partnerships to exit, are anemic this year, per stockanalysis.com: As of Monday, 131 IPOs have been launched on the U.S. stock market in 2023, less than at the same time in 2022, 168.

The front end of the PE pipeline, buyout activity, has also flagged in 2023. PitchBook found that, in the third quarter, “deal value broke below the $200 billion level for the first time since the COVID-19- pandemic-induced lockdown of 2020.” Meanwhile, PE fundraising also has not been robust: For the year’s first three quarters, the amount was down 13% from the comparable period last year.

No one knows, of course, when PE will get its mojo back. The PitchBook paper declared that PE shops are holding onto a large number of portfolio companies, awaiting more propitious times to do exits. Other reports have indicated some PE managers are selling companies to themselves, or to so-called continuation funds, to offload investments.

There are some glimmerings of better days ahead, though. Banks are starting to lend for deals, PitchBook indicated. Even better, PE firms are sitting on a mountain of “dry powder,” meaning cash on hand, available to do deals, whether to take over companies or to buy them from other PE firms: an estimated $956 billion in total.

That is why, PitchBook opined, investors remain “hopeful” PE firms “will put it to work.”