Executive summary:
- Deal activity in private equity has slowed significantly from 2021 due to high interest rates and economic uncertainty.
- Amid the slowdown, we believe that smaller, sector-specialist managers may be able to outperform larger, generalist managers. We also anticipate strong buying opportunities for venture capital investors.
- We see additional opportunities today in allocating more heavily to secondary managers. We also believe that investors can take advantage of longer fundraising cycles by gaining more visibility into fund performance.
Given the long-term, illiquid nature of private market investment strategies, it is critical for investors to avoid placing too much weight on transient market events when allocating capital. Private equity funds invest over a four- to five-year period, meaning that a substantial portion of a fund’s capital may be invested at a time when current market trends are no longer relevant. Since it can be difficult, if not impossible, to predict what the market will look like several years down the road, investors should focus on adhering to long-term strategic allocations and investment themes in private markets.
That said, Russell Investments does look to lean into certain market opportunities that we believe can lead to long-term outperformance for particular strategies. In today’s uncertain environment, several intriguing market dynamics are shaping how we allocate capital.
What’s behind the slowdown in transactions?
The most prominent factor distinguishing our current environment from past cycles is the relative slowdown in transactions. Deal activity remains down significantly from the peaks that we saw in 2021, with merger and acquisition (M&A) activity at a standstill and IPO (initial public offering) markets largely frozen. In 2023, deal activity for leveraged buyouts fell by 37% year-over-year, while exit activity for private equity funds declined by 44%.1
The main drivers of this downturn have been higher interest rates, which make it more difficult to finance new deals, and general economic uncertainty creating a rift in pricing expectations between buyers and sellers. This has led to a slight pullback in valuations, as price/EBITDA multiples for recent deals has declined slightly in recent years after seeing relatively steady growth for decades.
4 areas of opportunity we see in private equity
We believe that these market trends will lead to several actionable long-term opportunities. In this article, we’ve identified four areas of the private equity space to watch.
1. Smaller, sector-specialist managers
One expectation is that smaller, sector-specialist managers with deep operational expertise will deliver more favorable risk-adjusted returns than larger generalist, managers who tend to rely more heavily on leverage. Leveraged buyouts that require significant levels of debt financing may see downward pressure on their return profiles driven by higher financing costs. In this environment, it will be crucial for managers to create value by working directly with portfolio companies to drive top-line growth and enact operational efficiencies. This has always been Russell Investments’ core investment thesis in private markets and should ring even more true in a higher-rate environment.
2. Venture capital
Venture capital is another area where we expect to be overweight in the coming years. Venture strategies tend to operate in long cycles of 10-15+ years as new technologies emerge and drive innovation. The recent reset in valuations for tech companies, which became incredibly frothy in the late 2010s before peaking in 2021, could lead to a strong buying opportunity for venture capital investors. Paired with notable long-term opportunities driven by AI adoption, we could be looking at the start of the next venture capital cycle. Getting in early at the seed stage of the next cycle will reward investors who have the patience for this investment risk.
3. Secondary transactions
Next, while transaction volumes have been down across the market for the last two years, one area of the market where this has not been the case has been in private equity secondary transactions. The recent slowdown in deal activity has led to fewer distributions from private equity funds, leaving cash-strapped investors searching for liquidity. As a result, secondary purchasers have been able to buy interests in existing private equity portfolios at a much higher discount to NAV (net asset value) than we’ve seen historically. While the window for this opportunity may be closing when deal activity starts to normalize, Russell Investments has been using this time to allocate more heavily to secondaries managers, helping to significantly mitigate the J-curve effect that we normally see from private equity funds.
4. Extended fundraising cycles
Finally, the lack of liquidity from private equity in recent years has caused many investors to reduce their commitments to newer vintages. One of the consequences of this trend has been extended fundraising cycles, where high-quality managers who would normally raise capital very quickly end up staying in market for 12-18 months or more. This can work in the favor of astute investors, using this opportunity to gain visibility into seeded portfolios of funds that are nearing their final close. Since private equity funds typically allow investors to come in at cost plus a small interest charge, portfolios with investments that have already shown meaningful traction can present attractive arbitrage opportunities. As these situations have become more frequent, Russell Investments has taken advantage by topping up our commitments to high-conviction managers that have demonstrated strong early performance prior to a final close.
The bottom line
Each of these four areas represents an opportunity that we believe will benefit the long-term performance of our portfolios, regardless of how the market evolves in the coming years. While private markets require a long-term focus to achieve the best outcomes, being on the lookout for such opportunities is a key factor in generating outperformance.
1 Sources: Bain Global Private Equity Report 2024. Dealogic. Preqin.
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