2023 has been one of the most challenging years for private equity over the recent past. After the Covid-era boom in dealmaking, there has been a noticeable slowdown, partly driven by rising interest rates and geopolitical uncertainty.
In this article, DealRoom draws on its experience to advise optimizing private equity portfolios against this backdrop.
The Current State of the Private Equity Market
2023 has been a year in which private equity managers have had to navigate more challenges. With fundraising essentially stalling since mid-2022, the industry faces its most challenging period in over a decade. Prequin measures the difficulty in fundraising by looking at funds raised against funds being sought. 2023 will close out with around $1 trillion in funds raised against a total of $3.3 trillion being sought. It’s not easy out there for funds seeking capital.
We’ve noted an interesting trend that underpins these numbers. The largest private equity firms – most publicly listed – may be finding it even easier to fundraise than before. For example, according to Private Equity International, the 10 largest funds brought in over 35% of all funds raised in H1 2023. Our thesis is that investors see the extra points they pay at the more prominent PE firms as worth it, as they’re more likely to deliver during a challenging macroeconomic environment.
In September 2023, the US added an impressive 336,000 new jobs – just short of double what economists predicted for the month. Having more than one market onlooker reach for the word ‘resilient.’ This thinking may ease private equity’s funding woes in the mid-term as consumer confidence rallies. It’s also likely that the big players mentioned in Private Equity International’s report will be doing large deals in the next 12 months.
The opportunities in this market are where they’ve always been – companies with recurring revenue, the ability to adapt, and bold business models. The uncertainty created by growing geopolitical stability will also dampen values, enabling the brave to capitalize. Keep an eye out for more US- and Europe-based deals, as US private equity companies redirect their focus away from opportunities in China.
Key Strategies for Portfolio Optimization
- Diversification across sectors and geographies: The call for diversification takes on even more importance in times of uncertainty. Just ask those companies that have lost billions on investments in Russia and Ukraine. A winning strategy here could be to seek opportunities in emerging markets, whose sales primarily consist of exports to developed markets.
- Active management and regular portfolio reviews: Slower fundraising offers an ideal window to take a more hands-on role with portfolio assets and conduct regular progress reviews. Pay particular attention to how each asset has performed as interest rates have risen compared to before, and build insights into your overall portfolio strategy.
- Separate secular from cyclical trends: Again, this is a fundamental not unique to 2023, but one which takes on more significance in a year like this (and safe to say, 2024). With so much geopolitical strife, rising interest rates, and even US budget gridlock, separating the secular from the cyclical is essential.
- Leverage technology: Using data-driven decision-making is what ties our recommendations together. Looking at what will happen and why and building confident investment hypotheses is core to private equity. It is also core to what Deal Room’s end-to-end solution for private equity dealmaking is all about. The platform’s private equity offering has been built to address portfolio optimization.
Navigating Challenges in Portfolio Optimization
Your private equity company faces risks on several fronts, some of which you cannot easily forecast confidently. Where portfolio optimization is concerned, it’s essential to understand the nature of the risk and how it affects the portfolio’s performance. For example, interest rate rises will likely weigh heavier on a private debt fund than a private equity fund focusing on technology. Cyber risks play much heavier in the latter than in the former.
Whatever assets your company manages, consider the following for mitigation of its risks:
- Continuous risk assessment: Build as many scenarios as possible for events that may not seem likely but could feasibly happen. Rick Santelli of CNBC News, famous for predicting market moves, thinks interest rates will rise significantly in 2024. Whatever you’re feeling about the likelihood of this, understand what it could do to your fund’s portfolio and how you would respond.
- Hire for Risk: It’s remarkable how many companies don’t have an individual within their company directly responsible for monitoring risk. This is an oversight. Now more than ever, it’s essential that private equity companies have someone who knows risk management and can advise on adapting according to the environment. This hire represents a small investment that could pay off in millions of dollars.
Future Trends in Private Equity Portfolio Management
When looking at future trends in private equity portfolio management, we can revert to Bill Gates’ aphorism, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” With that in mind, we suggest overlooking geopolitical tension and interest rate rises (as much as possible) and focusing on issues like America’s aging population, the great retirement, and even employee shortages.
These are the issues that are happening. And grasping this reality and making the right investments, given the circumstances, could yield considerable returns in some instances. Of course, the other dominant trend now and over the coming years is, and will continue to be, the emergence of artificial intelligence. Our advice for private equity managers optimizing their portfolio is to seek to build it only and wherever it adds value. If it doesn’t add value, it’s just a buzzword.
Conclusion and Next Steps
The good news is that you don’t have to have one big investment thesis – a popular idea in private equity, which only sometimes holds water. Instead, it’s essential to continue to be curious and understand how to separate value from price, insight from noise, and secular from cyclical.
The best way to do this is to embrace technology and continuous learning for portfolio optimization. Explore how this can be achieved with DealRoom’s platform for comprehensive private equity workflow solutions.
