Creativity will be key to private equity's success in 2024

Necessity is the mother of invention, so goes the adage. And, while ingenuity and adaptability have always been in private equity's DNA, 2023 was a year when the paradigm shifted dramatically, and PE had little option but to change up its approach.

The coming year is likely to bring greater stability (heavy emphasis on likely), but there is little indication that dramatic changes in market conditions are in the offing.

In short, creative approaches will be just as important in 2024 as they were in 2023—perhaps even more.

So, which of 2023's nascent trends should we watch this year? Secondaries, NAV financing, growth investing and carveout deals are just a few things that I'll be keeping my eye on.

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All signs are that 2024 is going to be a huge year for secondaries transactions. Secondaries funds saw a surge in fundraising activity last year. As of the end of September, $68.1 billion had been raised globally—surpassing all annual totals on record except for 2020—according to PitchBook's Q3 2023 Global Private Market Fundraising Report. By the end of Q3, secondaries dry powder stood at an all-time high level of $202.7 billion.  
With few predicting an imminent pickup in IPOs and big-ticket acquisitions, traditional PE exit routes are likely to remain out of reach in many cases. Previous PitchBook analysis has also flagged that a large maturity wall is fast approaching of PE funds that need to return capital before terms end. This provides plenty of impetus for secondaries deals.

GP-led secondaries, particularly through continuation funds, looks set to continue its growth spurt. As we covered in our last Weekend Pitch of 2023, PitchBook lead PE analyst Tim Clarke expects 2024 to be a breakout year for exit transactions involving continuation funds.

But setting up continuation funds can be challenging, with clear potential for conflicting priorities between GPs and LPs. For instance, we have previously reported that election periods—the time given to LPs to decide whether to participate in a continuation vehicle or to liquidate their stake—can often be a source of tension. LPs sometimes feel they aren't given enough time to make decisions, while GPs often expect more urgency.

For me, one of the most intriguing things to watch over the next year will be how both sides adapt their processes as these vehicles become more commonplace—for instance, will clear industry standards emerge on time scales, information provision and communication?

Turning back to secondaries fundraising, strategies may also be evolving. Although the majority of secondaries funds continue to pursue generalist strategies, several big names have begun to raise more niche vehicles, such as Goldman Sachs' infrastructure secondaries fund.

PE firm Pantheon, which closed a $3.25 billion secondaries fund at the end of November—the fifth-largest last year and its largest-ever secondaries vehicle—attributes its fund's success to "significant inflows" from private wealth clients.

The idea of private equity firms targeting high net worth individuals to boost their fundraising has been discussed frequently in recent years, and it will be interesting to see if this trend takes any major leaps forward in 2024. NAV loan navigation Since traditional exit routes have been blocked, PE firms have also been turning to net asset value financing as a means of generating capital to fund distributions to LPs. Funds have also been using NAV loans, which are secured against the value of assets in their portfolios, as a way to finance value-add investments into portfolio companies—including those they are holding onto longer than originally planned—as well as to pay down existing portfolio company debt.

Buyout funds have shifted from rarely interacting with NAV loans to being some of their biggest users. But, as with continuation funds, the use of NAV loans can create tension between LPs and GPs if not managed properly. PitchBook's recent analyst note, NAVigating Considerations and Controversies Around NAV Loans, highlights some of these challenges while summarizing broader market developments.

PitchBook analyst Juliet Clemens says that some LPs have concerns that GPs aren't being sufficiently transparent about their use of NAV financing.

"This lack of transparency means that LPs may not be able to question the GP about crucial elements of these facilities, such as how many portfolio companies or assets are exposed to the facility, the terms agreed upon, or the total portfolio and asset-level leverage across a fund, making it impossible for LPs to implement risk management measures because the risks are hidden," Clemens said.

In particular, LPs have concerns about GPs using NAV loans to fund distributions. These loans aren't inexpensive, and a short-term gain may come at the expense of a better long-term return.

We are likely to see more of these tensions come to the surface this year. Jennifer Choi, CEO of the Institutional Limited Partners Association, recently told The Wall Street Journal she expects there to be "tough conversations" in 2024 about PE funds' use of debt, including NAV loans.

Choi said 85% of respondents in a recent ILPA member poll had a negative view of NAV facilities, adding that "it's going to be incumbent upon the industry to get more educated about what a well-structured facility looks like and what kind of disclosure GPs owe LPs." For GPs using NAV facilities, it may be wise to get ahead of the curve and engage fully with LPs about their intentions. Seeking the next golden age On capital deployment, 2023 was a year when leveraged buyouts seemed to be going out of fashion. The low-interest rate environment of the last decade and a half, which had made them so lucrative, is almost certainly gone for the foreseeable future.

As of the end of September, there had been $577.7 billion worth of LBOs compared to the $1.4 trillion and $1.1 trillion annual totals for 2021 and 2022, respectively, according to PitchBook data.

There was much talk last year about whether the so-called golden age for private equity was over, and that instead we may be entering a golden period for private credit.

But could we just be entering an era where a different type of private equity investment comes to the fore? For instance, in an October interview with Mathieu Chabran, co-founder of PE firm Tikehau Capital, he told me that while the LBO model may be under strain, a new golden age of PE growth investment focused on megatrends like decarbonization is still to come.

By deal count, growth equity deals accounted for about one in five US PE investments as of the end of Q3, according to PitchBook's Q3 2023 US PE Breakdown. And their share of the pie appears to be growing, outstripping platform LBOs as a percentage of PE deals for the first time in Q1 2023. In 2013, platform LBOs represented more than 30% of US PE deal activity. By 2023, that share had fallen to around 19%.  

Investing in younger, high-growth businesses clearly requires a different skill set than that of the traditional LBO playbook, and a totally different investing model. But could we see more PE firms focusing on this part of the market?

As PitchBook analysts observe in the US PE Breakdown, "Its main weapon is operating leverage, not financial leverage, and that is the name of the game in the current macro environment: unlocking EBITDA margin and EBITDA growth wherever and whenever possible."

Either way, this is a trend that still has a long way to run. Buyout funds continue to massively outstrip the firepower of PE growth funds. Carving out a deal And, of course, we will still see LBOs. For a clue as to where some of the most interesting deals may arise, we could turn to one of the biggest deals of last year—Fidelity National Information Services' divestiture of Worldpay to GTCR in a $12.7 billion LBO.

Corporate carveouts could be a key target in 2024 for PE firms hungry for big deals amid a high-interest rate environment. Divestitures of well-known business units by corporates can provide a solid base upon which PE firms can build value and, crucially, these types of transactions tend to attract finance more readily.

"As headwinds to dealmaking persist, GPs are active in pursuit of corporate carveouts and divestitures from larger entities, hoping to find a diamond in the rough," wrote PitchBook analysts. "GPs often find these transactions to be easier to finance and employ a range of plays to create value when acquiring carveouts."

I don't like making predictions, but one thing seems certain: 2024 is unlikely to be a textbook year for private equity.

Featured image by Joey Schaffer/PitchBook News

This article originally appeared on PitchBook News