I have spent virtually all of my career in the private equity industry, and I have never seen the likes of the series of challenges confronting the industry and the economy as a whole.
No one needs to be reminded of all that we have already been through, starting in early 2020 with the onset of the pandemic, the country’s ever-increasing divisiveness in politics, civil unrest and government intervention. More recently, we have been confronted with skyrocketing inflation, a war in Ukraine, higher interest rates and a growing consensus that the U.S. economy is headed into a recession.
Private equity has stayed on top as an asset class because it is transformational, and events like those that the country is experiencing should help the industry and the investments it oversees stand out in a positive way. Private equity is not measured publicly on a daily basis and it is not subject to the whims of the market or to investors’ needs for quick cash to cover margin calls.
Other private businesses are not as rigorously managed as the ones owned by private equity funds. Private equity Type A personalities and the KPIs they wield measure everything imaginable in an effort to achieve success to impress their investors in order to raise the next hundreds of millions of dollars or $1 billion fund.
It is this last part that could finally cause private equity as an asset class to revert to the mean of investment strategies. There is currently more than $1 trillion of capital in the collective private equity piggybank that is considered “dry powder,” or those funds seeking an investment. Not since the 1980s, when the private equity industry was just beginning, have we experienced the levels of inflation we are experiencing today.
In all of 1980, the industry raised approximately $2.4 billion. According to various sources, in just Q1 2022, the private equity industry raised approximately $125 billion. This constant pressure to put money to work in investments is being exacerbated by the high inflation that eats away at the purchasing power of idle cash in investor coffers.
The combination of the two factors will further exacerbate the factors that drive up valuations that private equity funds are willing to value businesses they invest in, just to get the capital deployed in investments that can stay ahead of inflation. All other things being equal, buying assets at a high valuation would drive down investment returns. The higher cost of debt and the likely reduced earnings that come from recessions reduce the ability to leverage investments that have historically been private equities’ go-to solution to drive higher investment returns.
Valuations do remain high for good investments. In turbulent times like these, it makes the strong and differentiated companies even easier to find compared to the tail end of a historic economic expansion. But in the end, what is considered a high investment return is a relative term.
The question is whether the tens of thousands of motivated, intelligent professionals in the private equity industry and the trillion of dollars in their war chests can continue to generate the higher returns that their investors have become accustomed to. ●
Jeffrey Kadlic is Founding Partner of Evolution Capital Partners