Adapting to a Changing Environment: US Private Equity Companies Navigate Difficulties

The landscape of US private equity has undergone a significant shift since 2021, as evident from the data provided by PitchBook. Deal volumes have plummeted, prompting buyout organizations to explore innovative strategies to maintain investments and secure funding from backers. Amidst a 67% decline in investor cash from asset sales since the second quarter of 2021, firms are grappling with the need to find alternative avenues to bolster returns and capital.

One notable development is the emergence of a robust secondary market for private equity assets, along with the rise of non bank financing options. These avenues have provided middle-market private equity firms with potential escape routes in the face of challenges. Oxford University's Ludovic Phalippou points out that firms have numerous strategies at their disposal before admitting defeat to investors.

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Yet these strategies aren't without complexities. Initiatives like continuation funds, designed to extend asset ownership, have struggled to gain traction among investors due to perceived conflicts of interest. Similarly, US insurance authorities are closely scrutinizing collateralized fund obligations that package private equity stakes. Additionally, using company portfolios as collateral for loans comes with high interest rates.

To address liquidity challenges, some firms have turned to selling partial holdings in companies. This approach generates immediate cash for investors while retaining an ownership stake. However, it might hinder the potential for a full company sale down the line.

The urgency to explore these new methods stems from the aftermath of last year's market volatility. With pensions and institutions heavily invested in private equity, firms are finding it challenging to raise cash. According to PitchBook, private equity funding in the first half of 2023 was significantly lower, indicating a pressing need for adaptive strategies.

Geopolitical instability, recession fears, and rising borrowing costs for portfolio companies have cast a shadow over an asset class that seemed invincible just a couple of years ago. Limited partners are now focusing on metrics like "distributed to paid-in capital," reflecting their concern about returns.

Private equity firms are employing tactics like continuation funds, minority sales, net asset value loans, and collateralized fund commitments to navigate these demands. Continuation funds, though met with skepticism due to potential conflicts of interest, offer a lifeline for firms to extend ownership of less sellable assets. Minority sales allow returns while maintaining control, although governance and pricing issues persist.

Net asset value loans have gained popularity as they provide liquidity without immediate selling pressure. However, the high cost of such loans can burden debt-laden borrowers. Meanwhile, fund securitization is on the rise as private equity embraces risk and adds debt in turbulent markets. Collateralized fund obligations offer unique investment opportunities but face regulatory challenges.

In this dynamic landscape, private equity firms are confronted with the need to adapt and innovate. As traditional strategies face headwinds, these new methods, though challenging, provide potential avenues to weather the storm. The industry's resilience and ability to embrace change will likely shape its future success.