Mark Hauser, Co-Managing Partner of Hauser Private Equity, breaks down the unique challenges facing the private equity industry throughout the pandemic.

As global economic sectors continue to rebound from the COVID-19 pandemic slowdowns, the private equity market experienced a landmark year in 2021. Collectively, the industry saw exceptional fundraising numbers, larger limited partner (or LP) distributions, and higher returns than those provided by other asset classes. Evidence of these impressive trends was still present in 2022 Q1. However, private equity company principal Mark Hauser says private equity investors will likely be faced with several significant challenges in 2022.

Private Equity Markets Saw Impressive Growth in 2021

In March 2022, Bain & Company provided market analyses based on its Bain 2022 Global Private Equity Report. Globally, the company reported that even with ongoing pandemic-related question marks, aggregate private equity volumes achieved new records in 2021.

To illustrate, general partners (or GPs) collectively experienced their second-highest fundraising volumes in the industry’s history. Limited partner distributions also trended higher during 2021.

These positive outcomes were one result of a surprisingly fast economic recovery. Pent-up demand, attractive interest rates, and a collective desire to get deals wrapped up before taxes increased also contributed to deal-making’s accelerated pace.

How the Pandemic Affected Private Equity in 2021

Except for the pandemic-related economic shutdowns in early 2020, the COVID-19 pandemic did not materially affect private equity transactions. In fact, teams reported increased efficiencies that resulted from less travel and more virtual transactions.

In addition, central banks’ trillions in monetary stimulus funds provided private and public investors with extra capital to channel into investment vehicles. This financial windfall helped investors to obtain inexpensive capital to fund their leveraged buyouts. Concurrently, the substantial cash influx helped portfolio businesses to better handle ongoing supply chain problems.

With virtually unlimited amounts of available capital, the largest private equity funds continued to maximize their deal sizes and obtain the most funding. In fact, the average 2021 deal size surpassed the $1 billion mark for the first time in the industry’s history.

Emerging Private Equity Trends for 2022

During 2022 Q1, private equity investors continued to evaluate the post-pandemic financial landscape. Mark Hauser notes that certain factors remained unchanged while new influences became increasingly significant.

Private Equity Investment Infrastructure Evolves

Two private equity investment infrastructure changes will affect the way investors do business in 2022. These factors will likely apply to firms in varied industries.

Technology-driven Innovation

As with many other industries, the private equity market has traditionally focused on cost and efficiency optimization. In the 21^st century, however, the use of digital technology and other disruptive methodologies is becoming the norm rather than the exception. The pandemic-driven switch to a digitalized global economy drastically accelerated this trend.

Investors have embraced this move to digitalization, funneling virtually unlimited amounts of capital to insurgent companies driving this trend. Concurrently, the investors have provided support to old-guard firms seeking to become more competitive in the now-global marketplace.

In both scenarios, investors are finding new ways to build growth into their investment selections and allocations. Highly focused companies, and those with proven expertise in their industries, have an advantage in this increasingly competitive arena. Investor Mark Hauser emphasizes the importance of adopting this laser-focused (and timely) approach.

Higher Number of Newer Fund Managers 

More newly minted fund managers have recently come on the global private equity scene. With three or fewer funds under their belts, these newer managers may be more receptive to innovative investment proposals. Many astute Limited Partners have tasked special teams with courting and building relationships with these newer managers.

Specifically, Limited Partners can offer valuable market and industry expertise to up-and-coming managers. This increased knowledge base enables the managers to improve their credibility in a highly competitive marketplace.

More Regulatory and Standardization Emphases

In 2022, investors and regulators alike are looking for more transparency relative to fundraising activities. The United States Securities and Exchange Commission (or SEC) has also proposed changes to the fundraising process. On a related note, multiple demands for quality data are spurring a move to more widespread standardization.

Emergence of Desirable Investment Targets

Economic trends and technological innovations help to drive private equity investors’ targeted selections. In 2022, some investments have become more desirable while others are falling out of favor. Private equity principal Mark Hauser recommends ongoing due diligence to identify the most promising investment targets.

Increased Interest in Technology Funds

In 2021, private equity investors backed a record number of technology-based deals. This trend is likely to continue at least through 2022.

Investors often choose technology business investments because of their decreased capital needs and reduced fixed operating expenses. In addition, the industry functions with a recurring revenue model and historically reliable returns. Software-as-a-service (or SaaS) companies aptly demonstrate this business model in action.

In the buyout arena, technology-driven industries have also become desirable investment targets. Examples include the growing health technology (or health tech) and financial technology (or fintech) sectors.

More Emphasis on ESG Investments

Private equity firms have consistently faced public criticism for the firms’ support of fossil fuel ventures. To illustrate, only 12% of energy sector investments have focused on renewable energy projects. The industry is also under pressure to tell their businesses about climate-related hazards and show how investments support the transition to a less-harmful future.

In response, private equity LPs are increasingly integrating environmental, social, and governance (or ESG) factors into the investment selection process. This focus mirrors the global economy’s pursuit of carbon reduction strategies and increased reliance on electric vehicles.

In addition to ethics considerations, investors and funds have seen how sustainable business practices minimize risk and enhance performance while helping each firm to positively impact its communities. Mark Hauser says companies that highlight ESG factors are better primed for success in the increasingly sustainable global economy.

However, the process is not as cut-and-dried as it appears. One private firm’s ESG fund criteria may differ from another company’s requirements. In addition, no uniform ESG reporting standard currently exists. This makes it difficult to highlight each investment’s level of success (or lack thereof) in regard to returns.

Reduced SPAC Utilizations

Throughout 2020 and 2021, Special Purpose Acquisition Companies (or SPACs) became an increasingly popular investment option. Promoted as an Initial Public Offering (or IPO) alternative, these investment vehicles are structured to enable lower marketing costs and faster deal completion.

During the second half of 2021, however, the SPAC fervor began to abate. Although SPACs still figure in some private equity investment strategies, their popularity appears to have peaked and is now on the decline.

Private Equity Industry Challenges for 2022

Although private equity market investors have a reason for optimism in 2022, several emerging issues deserve investors’ attention. Economic, geopolitical, and national security concerns will likely influence fund managers’ decisions throughout the year.

Bain & Company Report Highlights Large-scale Global Issues

The Bain 2022 Global Private Equity Report discusses several issues that could affect private equity’s near-term desirability as an asset class. The report said rising energy and food prices, along with more expensive capital costs, were significant concerns.

The Bain & Company Report noted that Russia’s invasion of Ukraine was a major factor in the still-unfolding economic turmoil. “While the macro impacts of the war are impossible to gauge, it is likely the disruption will maintain upward pressure on prices, while creating a massive humanitarian crisis that is shaking Europe and (the) world,” the Bain Report states.

Other private equity market influences include changing global demographic trends and a gradual shift away from globalization. “There are plenty of signs that geopolitics and national security concerns may become impediments to global capital inflows…These issues may make it ‘significantly more challenging’ for private equity firms to continue to deliver investor-pleasing higher returns,” the report advises.

In summary, the Bain Report says that maximum investment returns will result from a portfolio company’s ability to bring more money through the door. “In an era of inflation, top-tier returns will inevitably depend on nuts-and-bolts value creation, helping improve a portfolio company’s ability to generate more revenue,” the Bain Report concludes.

Persistent Supply Chain and Inflation Concerns

As frustrating supply chain issues drag on, the global economy continues to be affected in two ways. First, retail stores of all types have fewer goods to sell to customers. Products that are available have drastically higher prices.

In a similar vein, electronic chip shortages have idled numerous manufacturers’ assembly lines. Products that reach the vehicle dealership, or make it to the store shelves, display considerably higher price tags compared to items produced prior to the supply chain issues’ onset. In both cases, price inflation continues to affect virtually all global economic sectors.

Higher Federal Reserve Interest Rates 

Leveraged buyouts reached record levels in 2021 and are expected to achieve good results in 2022. The abundance of dry powder, or available capital, has led many industry experts to this conclusion.

However, the Federal Reserve (or the Fed) has indicated that it will increase interest rates three times in 2022 and again in 2023. Higher interest rates mean leveraged loans will also become more expensive. Although this move will help to lessen inflation, investors could likely see decreased returns.

Potential SEC Regulatory Requirements

Private equity fund managers should closely monitor possible SEC regulatory changes. In February 2021, the agency passed a proposal to require private equity fund managers to tell investors about the respective fund’s past performance. Managers must also disclose details of the fund’s fees, expenses, and compensation.

In addition, SEC Chairman Gary Gensler wants to mandate additional Form PF filing disclosures. If the regulations come to pass, funds would have to report significant losses within one business day. Fund managers should take all necessary steps to ensure compliance with evolving SEC regulations.

Evolution of the Private Equity Industry

As 2022 continues to unfold, private equity principal Mark Hauser and other private equity investors will monitor economic, technological, and geopolitical factors that could affect their investment selections. With these insights, they are better equipped to make decisions that will optimize their investments’ returns.