Private Equity (PE) involves investing into a privately-held company - typically one that have strong growth potential but require significant capital or operational improvements to achieve their full potential. Investments can be made in many forms including leveraged buyout, growth capital, Venture Capital (VC), etc. Often, PE and VC are used synonymously. In this article, we will thus discuss the differences between the two, as well as to provide a brief overview on the investment opportunity in this asset class given the current macroenvironment.
The primary difference between PE and VC would be the stage of investment, as well as the levels of capital injected. VC generally invest earlier in a firm's lifecycle with the following classifications:
PE firms may use a mix of instruments (debt and equity) to finance their investments and often take a controlling stake in the invested company. VC investments would be smaller in size and would usually seek developments in new products or services. The focus would be on high-growth industries that are disruptive, which can provide higher risk and returns.
In the current environment of inflation and rising interest rates, it can be challenging for the PE industry. However, PE has historically delivered stronger returns than public markets, particularly after economic recessions, and direct allocations with focused deal selection and portfolio building can benefit from market volatility. PE firms have relatively more flexibility to make long-term investments in companies, which can be crucial in times of economic uncertainty when public companies may be more focused on short-term gains. Additionally, private equity firms have more control over the companies in which they invest, which can allow them to adapt and implement changes that improve operations, thereby increasing value.
In 2020, private markets were briefly impacted by the COVID-19 pandemic, but quickly recovered in the second half of the year. In 2021, private markets continued to climb higher, with central-bank-induced liquidity driving activity. However, the first half of 2022 saw public market valuations drop and central banks raising interest rates to combat inflation, leading to increased opportunities for private equity investors. Private equity can take advantage of market volatility and execute on opportunities through direct selection, co-investments, secondaries, and traditional primary fund commitments.
Thus, patient capital and selectivity will be key for buyers to capitalize on changing market dynamics. PE buyers are adjusting how they calculate risk and structure transactions, building buffers into the capital stack and negotiating leverage. PE multiples remain attractive relative to public equity, and companies raising capital are offering investors concessions for downside protection. On the broader view, a focus on investing in sectors that are less vulnerable to inflation could present more resilient results. Apart from sector selection, implementing cost-cutting measures and operational movements in portfolio companies can also help to optimize operations and reduce expenses. Companies with resilient, recurring cashflows will be among the most attractive investments. Price discipline and deep sector expertise will be important when investing in both direct investments and fund managers across the primary and secondary markets.
Lastly, maintaining discipline in deal-making in terms of valuations and deal structures would be crucial since the industry is sensitive to rates movement. Investments generating attractive risk-adjusted returns should be considered first. In conclusion, the ability to focus on resilient sectors and implementing cost-cutting measures would be crucial. PE can still offer better returns in an inflationary environment with optimized investment strategies.