After weeks of historic levels of value erosion in global capital markets, many asset managers are trying to mitigate emerging risks while finding new opportunities. Economic experts expect more capital market shocks for the rest of the year. Private equity, as one of the main alternative investment classes, finds itself in an interesting position in the face of such market volatility.
Private equity (PE) funds commit to a higher return profile than the open markets in the medium to long term. They are also characterised by 10-year terms, so fund managers sit tight in the face of market volatility and do not rush to make short-term decisions. These are redeeming qualities that are likely to give asset managers a better level of comfort in times of uncertainty.
However, the extent to which private equity can attract capital may be restricted by regulatory prescripts governing the asset classes that asset managers can invest in. Further, the private equity market is not immune to the impact of economic uncertainty.
The portfolio companies that generate the underlying value face the inflationary impact of increased import costs. Depending on the price elasticity of the goods or services that a portfolio company provides, this may have a significant impact on the sales of that business.
Where supply chains have been disrupted in their entirety, the portfolio company will need to seek alternative sources. In a world of ever-growing exclusion lists due to an investment ethos based on sustainability, sourcing alternative supply chains is not always a straightforward exercise.
A PE fund’s support team will be essential in assisting portfolio companies with these market changes. Fund managers who have not seriously invested in developing internal geopolitical analysis capabilities or retaining external advisers for this purpose should review this facet of their business.
There are many features of fund management documents that are aimed at putting PE funds in a better position to weather the storm. Fund documents usually provide for geographic and sector diversification. An investment mandate will also guard against concentration risk that arises when a fund invests a significant portion of its assets under management in a single company.
However, some of these protections may not be available to specialist funds that depend on sector concentration to build and leverage scale. These specialist funds will rely on their skills base and an ability to leverage existing and alternative supply chains to weather the storm.
One would also expect to see PE funds explore opportunities that enable the creation or control of vertically integrated supply chains that will give them better visibility and control of cost inputs (other than tariffs).
Economists predict that tariffs will have a general inflationary effect. Apart from the rising costs of goods that portfolio companies may need, inflation may also lead to increased borrowing costs. When debt is more expensive, PE funds that ordinarily use leveraged buyout strategies may be limited to smaller cheque sizes. This may lead to them seeking more co-investments, acquiring smaller businesses and then expanding them through bolt-on acquisitions and relying on deferred consideration structures (such as earn-outs) more regularly.
Foreign investors may seek to exit emerging markets in times of uncertainty. This may create new opportunities for PE funds to acquire local divisions of well-established international brands that have decent growth profiles
Market volatility can affect the ability of PE funds to exit investments by way of a public offering. One expects to see some funds deferring the timing of public offerings until market conditions are more favourable. Fund managers may choose to run private auction processes that involve other funds or trade buyers instead of waiting for market conditions to improve.
On the flip side, depressed capital markets do provide opportunistic investors with the ability to implement take-private transactions. However, this option will only be available to funds that have significant cash resources or co-investors that will enable them to make attractive offers to listed targets. For this reason, some PE funds may wish to pace the deployment of their funds under management as they assess emerging opportunities. This will ensure that they have sufficient resources to take advantage of a change in market conditions.
Foreign investors may seek to exit emerging markets in times of uncertainty. This may create new opportunities for PE funds to acquire local divisions of well-established international brands that have decent growth profiles.
Notwithstanding the current economic headwinds, fund managers will continue to find opportunities in sectors that have scaling prospects, such as digital infrastructure, consumer goods, manufacturing and financial services, to name a few.
Fund managers need to continue focusing on value creation and the risk management levers at their disposal to respond to market changes. However, the medium- to long-term focus of private equity makes it the perfect asset class in a world faced with increasing volatility.
• Bulose is a corporate and commercial lawyer at CMS South Africa
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