According to BDO’s inaugural U.S. Private Capital Outlook, preparations for a downturn are underway for the private equity and venture capital sectors, as more than half of fund managers say they are being more selective when evaluating highly valued transactions.
Ten-plus years into a bull market, 72% of private equity funds expect an economic downturn within two years. The venture capital industry is slightly more optimistic on timing, with just over half (56%) anticipating a downturn to hit within the next two years. However, that a bear market is coming is a foregone conclusion: 92% of private equity and 87% of venture capital respondents expect a downturn to occur within four years.
The survey also found that 30% of private equity respondents and 20% of venture capital respondents are looking to exit current investments. That percentage rises to 36% of private equity respondents and 21% of venture capital respondents among those anticipating a downturn to hit within two years.
“Expecting economic contraction has sent private equity and venture capital to the markets in droves as they look for liquidity to strengthen their stockpiles during a down economy,” said Scott Hendon, National Private Equity Industry Group Leader at BDO. “With funds chasing the same types of downturn-proof investments, competition has been unbridled, sending valuations to historic levels. Though we expect this trend to continue, we are seeing private capital funds deploying more creative ways to put their capital to use.”
Retreating to defensive strongholds and downturn-proof sectors
With downturn-proofing underpinning their strategies, both private equity and venture capital firms are on the lookout for investments with secular trends behind them and are relatively aligned on where the best opportunities can be found – technology, financial services, and natural resources.
But technology clearly reigns as the hottest sector, with 54% of private equity and 51% of venture capital managers identifying it as most likely to experience increasing transaction activity. Within technology, the areas of greatest interest for investment are 5G, artificial intelligence (AI), and the Internet of Things (IoT).
The BDO survey shows that the biggest drivers of deal flow are anticipated to be private company sales and capital raises (52% of private equity respondents and 42% of venture capital), public-to-private transactions (47% of private equity respondents and 39% of venture capital), and distressed businesses (40% of private equity respondents and 39% of venture capital).
Increasing competition from an evolving competitor set
Both private equity and venture capital respondents rank increased competition from other buyers as the most significant challenge to closing new deals (27% and 24%, respectively), followed by gaps between buyer and seller valuation expectations (21% and 23%, respectively).
Private equity respondents anticipate most of the competition over the next 12 months will come from strategic buyers (41%), with peer private equity firms ranking third (26%) behind hedge or mutual funds (36%). Meanwhile, venture capital professionals cite hedge or mutual funds (43%), strategic buyers (34%), and other venture capital firms (28%) as their top competition for deals.
Challenges and opportunities in geopolitical uncertainty
Amid ongoing trade turbulence, trade issues top the list of geopolitical concerns for both private equity (30%) and venture capital (21%), followed by concerns about the U.S. presidential administration (24% and 18%, respectively).
But trade tensions may be creating opportunity: For both private equity (30%) and venture capital (29%), Asia is the geographic region, aside from North America, that presents the greatest opportunity for new investment. The region replaces Continental Europe (16% for private equity, and 22% for venture capital), which had been first choice for private equity for the past two years at 45% in the prior survey, and 37% the year before that.
“Right now, Southeast Asia is one of the largest growing middle-class economies in the world. India, Indonesia, and the Philippines, though experiencing political struggles, represent strong opportunities to diversify away from China, and are attracting global investment,” said Lee Duran, Assurance Partner and a leader in BDO’s Private Equity and Venture Capital practice. “Greater interest in other emerging economies is becoming a reality given the U.S.-China trade war.”
Looking ahead to the U.S. presidential election, 51% of private equity professionals and 30% of venture capital executives surveyed say investor interest in private capital would increase under the policies of a Republican president. By contrast, 46% of private equity professionals and 37% of venture capital professionals surveyed indicate investor interest in private capital would increase under a Democrat president. However, both private equity and venture see greater returns under a Democrat in office: 34% of private equity and 29% of venture capital professionals surveyed expect exit multiples and the deal environment to improve under a Democrat, compared to 30% and 28%, respectively, under a Republican.
A rising baseline of digital expectation
Digital potential – the estimated bottom-line and top-line growth that can be achieved through digitization and digitalization strategies – has become increasingly critical investment criteria. All private equity firms surveyed classify long-term digital potential as “very important” or “moderately important” when making investment decisions, in contrast to the prior year’s survey when it was cited by only three-out-of-five firms.
Private equity respondents see the greatest opportunity for technology to accelerate value at the portfolio company level through cash flow management (20%), employee productivity (19%), and product/service innovation (17%).
To digitize their portfolio companies, more than half (52%) of private equity funds are adding leaders with digital expertise to the board or senior management. Another 39% are building digitization into value creation plans, slightly below that of their venture capital peers (42%). Just over a quarter (27%) of private equity respondents are pursuing complementary add-on investments, compared to 41% of venture capital respondents.
A cyberattack or data breach is still perceived as the greatest digital threat to portfolio companies by both private equity funds and venture capital funds (40% and 31%, respectively). In addition, 30% of private equity respondents and 36% of venture capital respondents report running into cybersecurity problems during the due diligence process more than half of the time.
Additional findings include
Top Regulatory Concerns: Private equity respondents cite the Tax Cuts and Jobs Act of 2017 as the greatest regulatory concern to their business, while venture capital respondents cite the Foreign Corrupt Practices Act as their greatest regulatory concern.
Top Challenges in the Sale Investment Process: Private equity fund managers rank credible budgeting and forecasting as their top challenge in a sale/investment process (21%). Venture capital fund managers, meanwhile, rank margin trends as their top challenge (22%).
The Rise of Co-investment: Limited partners have turned to co-investments and direct investments to increase their private market exposure, thereby reducing or eliminating management fees. In response to growing demand, 43% of private equity funds report offering co-investments to their limited partners, this year’s survey found.
BDO’s private equity practice assists private equity funds, portfolios, venture capital, mezzanine, and buyout firms throughout the fund cycle with all aspects of fund services, portfolio management and compliance, transaction advisory services and exit services.
BDO is a professional services firm providing assurance, tax, financial advisory and consulting services to a range of publicly traded and privately held companies. The firm serves clients through more 60 offices and more than 550 independent alliance firm locations nationwide.
The BDO US Private Capital Outlook (download the full survey findings HERE) is a survey of 200 fund managers at private equity and venture capital firms in the U.S. The survey was conducted by Rabin Research Company, a Chicago-based market research firm, in October 2019.
© 2019 Private Equity Professional | December 16, 2019