If there’s one topic that has dominated the minds of private equity investors in recent months, it’s liquidity. It is so present that you can now even buy T-shirts on Amazon emblazoned with the phrase “DPI is the new IRR”. DPI, or Distributions to Paid-in Capital, measures how much capital a fund has returned to its investors relative to what has been called. Putting DPI ahead of the industry’s widely promoted performance metric IRR (Internal Rate of Return) sends a clear message to managers: stop focusing on returns and start selling stakes to generate liquidity.
The private equity industry is currently experiencing a severe downturn in deal activity. According to S&P Global Market Intelligence, global deal volume fell by 34.7% year-on-year in 2023, reaching its lowest level in five years. Economic uncertainty, public market volatility and geopolitical tensions have made General Partners (GPs) hesitant to sell their stakes, fearing they won’t achieve their desired outcomes. IPOs, in particular, have been almost nonexistent over the past 12 months. As a result, many LPs have received significantly less capital back than in previous years.
Sustained Interest in Private Equity
Distributions from successful exits are, in general, a meaningful source of capital for investors to meet calls on previous commitments. Pension funds, insurance companies and other large investors typically rely on this liquidity stream as they often adhere to allocation guidelines that limit their exposure to alternative investments. When GPs extend their holding periods beyond the typical timeframe, these LPs not only must seek alternative liquidity sources but also face a temporary reduction in their ability to make new commitments to the asset class.
To fully grasp investors’ growing impatience with private equity managers, it is worth looking at the current market phase we are in. Historical data shows that funds launched immediately following recessionary periods have consistently outperformed their peers. Bain & Company has compiled a comprehensive overview of the annual returns achieved by global buyout funds since 1993. For instance, after the dotcom bubble burst, the average IRR for buyout funds was 25% in 2001, 40% in 2002, and 48% in 2003. Similarly, following the global financial crisis, the IRR was 22% in 2009.
Investors Favor Lower Mid-Market Buyouts
Now, with inflation seemingly under control, the European Central Bank has recently initiated its first interest rate cut, setting the stage for an expected economic rebound. LPs also appear to be anticipating a turnaround, as interest in the asset class remains strong. A survey by Natixis of 500 institutional investors globally reveals that over a third plan to increase their private equity allocations in 2024.
However, today’s LPs are more discerning. Unlike in previous years, when money was cheap and almost all private equity segments were thriving, they are now carefully evaluating which sub-segments to include in their portfolios. Recent surveys shed light on the lessons they may have learned from recent market turmoil. Rede Partners, an advisory firm specializing in alternative investments, reports that 50% of institutional investors plan to increase their commitments to lower mid-market buyouts – funds focusing on majority stakes in small and medium-sized companies. A further 46% favor mid-market investments. Large-cap funds, by contrast, are less preferred, with only 10% planning to increase their allocations in 2024.
Stable Distributions Due to a Larger Buyer Pool
Smaller deal sizes naturally lead to a larger pool of potential buyers compared to the large-cap segment where IPOs are often one of the very few available exit channels. Lower mid-market managers typically sell their stakes to a wide range of financial or strategic investors, such as competitors; exit channels that have – for high quality assets – remained open despite the numerous macroeconomic challenges. As a result, distributions to LPs have been relatively stable in the lower mid-market.
That said, the rising appeal of the lower end of the market can also be attributed to additional structural advantages, which become particularly apparent in challenging times. By far the most important is the greater potential for value creation through operational and strategic measures. Medium-sized companies are typically more flexible than large corporations, allowing them to respond quickly to current challenges and seize short-term opportunities, particularly when working alongside an experienced private equity investor. In addition, entry prices and leverage ratios are typically lower, leading to an attractive risk-return profile.
Focus and access are key
Yet it is important to recognize the remarkable heterogeneity of the lower mid-market, characterized by a wide range of manager performance. And: Access is crucial. Managers with proven track record in navigating economic turmoil are in high demand, continuing to complete their fundraising in record time and with significant oversubscription. Given the ongoing economic complexities, we expect to see an even greater concentration on this group of exceptional managers. As a result, focus and access will become increasingly critical to investment success.