Uncertain Waters: Navigating the Evolving Landscape of Private Equity with Associate Priscilla Liu

The private equity market remains a dynamic and influential sector in global finance, focusing on privately held companies to generate long-term returns. Despite occasional market fluctuations and regulatory hurdles, the private equity landscape continues to offer investors diverse avenues for creating value and realizing capital growth. According to Bain’s Global Private Equity 2024 report, the year 2023 for private equity was one of portent. Deal value fell by 37%. Exit value slid even more, by 44%. Fund-raising dropped across private capital, as 38% fewer buyout funds closed.

Hellman & Friedman (H&F) is a prominent global private equity firm founded in 1984 with $100+ billion asset under management and a distinctive investment approach. H&F focuses on large-scale equity investments in high-quality growth businesses, partnering with highly experienced  management teams to drive their success. Their deep sector expertise, long-term focus, and collaborative approach empower companies to flourish across sectors like software & technology, financial services, healthcare, consumer & retail, and business services.

CEOWORLD magazine recently had the opportunity to engage in an enlightening discussion with Priscilla Liu, an Associate at Hellman & Friedman’s San Francisco office. Ms. Liu offered invaluable insights into current market trends and their profound implications for the future of private equity investment.

How do you perceive the trends shaping the future of the private equity landscape? 

Priscilla Liu: There are a few trends that are worth highlighting that have been stalling Private Equity dealmaking activities in recent years and many of them interconnected. I would like to highlight high interest rate environment and sluggish M&A and IPO market.

High Interest Rate Environment 

Priscilla Liu: Since 2021, the Federal Reserve has embarked on a significant interest rate hike cycle to combat rising inflation. As of April 2024, the federal funds rate has increased from near zero percent to a target range of 5.25% to 5.50%, marking the fastest and most aggressive rate hike cycle in recent history. This substantial increase in borrowing costs has had a noticeable impact on various sectors of the economy.

Rising interest rates cast a long shadow over the private equity landscape. The cost of capital climbs, squeezing deal profitability and potentially limiting deal volume. Portfolio companies face a double whammy: higher interest expenses impacting cash flow and potentially lower valuations due to revised discount rates. Exits become more complex, as potential acquirers grapple with their own financing hurdles. Sector selection becomes a strategic imperative, as some industries (think high capex or interest-sensitive consumer demand) are more susceptible to rising rates.

Navigating this new environment demands a multifaceted approach. Private equity firms must possess not only financial acumen but also a keen understanding of sector dynamics. Agility in deal structuring and portfolio management becomes paramount. Firms that can effectively assess deal economics, valuations, and portfolio performance under these new conditions will be best positioned to not only mitigate risks but also identify and capitalize on hidden opportunities. Ultimately, their ability to adapt and innovate will determine their success in generating attractive returns for their investors.

Stagnant M&A and IPO Market Hinders Private Equity Exits 

U.S. private equity (PE) dealmaking experienced a significant correction in 2023, with deal value plunging 41.2% from the record-breaking $1.2 trillion witnessed in 2021, according to Pitchbook data. While replicating that peak activity seems unlikely in the near future, positive signs have emerged. Deal flow has exhibited tentative stabilization over the past several quarters.

As we head further into 2024, a key question remains: will the global M&A slowdown extend into a third year? Historically, such prolonged declines have only been seen during major financial crises like 2001-2002 and 2008-2009. While Q3 2023 may mark the bottom of this two-year downturn, with Pitchbook reporting a 35.5% drop in global M&A value from its 2021 peak, there are reasons to be cautiously optimistic. Unlike previous two-year downturns that saw steeper declines (60-70%), the current environment lacks the hallmarks of a crisis year. Macroeconomic uncertainties have abated somewhat, and liquidity is improving. These factors suggest a potential for a sustained rebound in dealmaking activity.

What is your take on the future? Do you predict a rebound in private equity dealmaking or are you more bearish for the near future? 

Priscilla Liu: I would say there are early signs of recovery, but patience is key. I personally am cautiously optimistic about a return to normalcy.  While dealmaking is expected to pick up after two years of muted activity due to rising interest rates and geopolitical tensions, a significant return of capital to investors will likely not.

Green Shoots, Not Instantaneous Growth: The current uptick in transactions represents early signs of recovery, not a sudden surge. Many sponsors are trying to exit investments held for the past two years, capitalizing on lower corporate borrowing costs and a pick-up in bond issuance that fuels buyouts. This trend suggests a potential for sustained recovery, especially considering the U.S. economy’s projected resilience despite a potentially slower-than-expected rate cut cycle.

Mixed Signals, Positive Outlook: While strong economic data and geopolitical tensions have delayed anticipated Federal Reserve rate cuts, other factors are fueling optimism. Rising stock prices in the public markets and increased lending by credit funds are creating a more favorable environment for exits and financing.  Valuations remain reasonably robust, and demand for private equity remains strong. According to Wall Street Journal’s article in March this year, the California Public Employees’ Retirement System (CalPERS) is signaling it wants to increase its investments into private equity and private debt, with the shift in assets coming mostly from its stock market positions.

The Bottom Line: The private equity landscape is evolving. Despite the positive indicators, LPs should expect a measured pace of capital return. The industry’s long-term prospects remain sound, and the current activity suggests a potential for a sustained, albeit gradual, recovery.

Last but not the least, can you discuss the importance of due diligence and risk management in private equity investing? How do you mitigate risks in your investment decisions? 

Priscilla Liu: A meticulous approach to due diligence and risk management is paramount to the investment strategy. It is important to prioritize a thorough understanding of the fundamental business and its growth drivers, fostering a unique perspective that allows us to create value and optimize operations. However, true risk management extends beyond simply evaluating asset prices. It requires a well-defined base case during underwriting that is supported by strong conviction, alongside a rigorous analysis of potential downsides. This provides comfort in navigating unforeseen challenges.

H&F pursues quality and growth at scale and often deploys billions of dollars into one single investment. Consistent with this strategy, durability of growth becomes a crucial factor, aiming to provide a margin of safety for these large investments during uncertain times. The investment philosophy is rooted in seeking high-quality assets with the potential for long-term, sustained compounding of returns. This extended investment horizon allows for strategic adjustments and course corrections as needed, ultimately aiming to build enduring franchise value and generate superior risk-adjusted returns over extended periods.