Private Equity Managers May Face Increasing Headwinds In 2023

Multiple studies have shown over the years that private equity has become increasingly popular among investors, and it’s easy to see why. Not only does private equity (PE) increase diversification within a portfolio, but the asset class’ returns have generally outperformed the public markets.

Looking into 2023, private equity could see increasing headwinds, but opportunities to generate alpha are expected to remain in place.

What to expect from near-term private equity returns

In its “2023 Long-Term Capital Markets Assumptions,” JPMorgan Asset Management said its return assumptions for private equity in 2023 are up significantly from 2022’s projections. The firm added that PE’s public market component is driving the entire increase, although cyclical valuation factors and ongoing trends will likely decrease returns on the margin.

The alpha generated by private equity firms had decreased modestly year over year. However, it’s still above the 15-year average for a median manager, reflecting its thesis of economic change. The firm pointed to near-term write-downs in cyclical valuations as significantly impacting its near-term outlook.

Meanwhile, secular factors like the rising cost of debt and robust competition for deal flow amid massive stockpiles of dry powder are expected to weigh on PE returns. To some extent, JPMorgan expects compression of exit multiples to weigh on private equity returns, although it noted that much of that impact is included in the write-down on valuations.

By the numbers: PE return projections

The firm believes the PE return premium versus the public markets will provide adequate compensation for the risks in illiquidity and leverage, especially at a time of increased volatility in assets. It reported that the historical premium of PE managers to U.S. mid-cap equities between 1993 and 2021 was 3.3%, while the 15-year average was 1.9%. In 2021, the premium was over 10%.

On a cap-weighted composite basis, the study projects that PE funds will generate a return of 9.9% in 2023, compared to its projection of 8.1% for 2022. The firm expects small-cap PE managers to return 9.5% versus the 2022 estimated return of 7.4%.

The report looks for mid-cap and large/ mega-cap PE managers to generate returns of 9.4% and 10.2%, respectively, versus the 7.6% and 8.4% returns projected in 2022. The firm projects a return of 8.5% for venture capital managers, although it did not provide an estimate for this subset of private equity in 2022.

Modeling financial sponsors as change agents that enhance efficiencies at their portfolio companies, JPMorgan sees significant investment potential amid the current economic transition. The firm expects PE managers to uncover opportunities in digitalization, housing, healthcare, ESG (environmental, social, and governance), and cybersecurity.

Factors driving the projections

However, JPMorgan also warned that private equity managers would also face challenges in the form of geopolitical risks and globalization, which the firm said is past its peak. The analysts expects private equity investing to increasingly involve growth capital, direct investing, subscription lines of credit, and commitment drawdown fee economics.

The firm based its core buyout/ growth capital return projections for private equity managers on public market beta, adding a slightly higher PE return premium than what it has utilized previously. JPMorgan boosted that premium because it expects growth sectors and the growth capital style of investing to play increasing roles in PE investing. The firm also cited the widespread use of operational tools like subscription lines of credit as playing a significant role in PE investing going forward.

PE managers now have access to record amounts of dry powder.

Performance dispersions

The firm added that performance dispersions among PE managers have been historically wide compared to the dispersion among public market managers, a trend it expects to continue. The top quartile of venture capital managers generated a historical return of 40%, while the bottom quartile managed returns of less than 10%.

Among small PE managers with less than $1 billion in assets and mid-size managers with $1 billion to $5 billion, the top quartile returns were around 25%, while the bottom quartile’s returns were less than 10%. Large or mega-cap PE managers with over $5 billion saw a top quartile return of 25% to 30% and a bottom quartile return of just over 10%.

Increasing headwinds for private equity

The environment for private equity has become increasingly problematic since last year amid rising discount rates, plummeting valuations, and high dry powder. Amid those shifts, the net asset values of PE-owned companies remain wide versus those of their publicly traded peers.

However, JPMorgan expects the net asset values to narrow, increasing the headwinds for its beta and alpha projections. The firm emphasized that the economy is now in a transitional period. However, it expects direct investing and modest fee accommodations to help offset the PE market’s hoard of dry powder and markdowns in net asset value.

Venture capital projections

This year, JPMorgan introduced projections for venture capital in 2023. The firm estimates that the asset class will return 8.5% annually over a 10-to-15-year investment horizon. However, it emphasized that the widespread assumption that venture capital has outperformed PE over time is a misconception.

Private equity had outperformed venture capital based on annualized returns since 1981, primarily due to the higher volatility typical of venture capital returns. In particular, VC took a massive hit from the collapse of the tech bubble in the early 2000s.

The firm warned that venture capital valuations might continue to fall in the near term. Its forecast implies valuations in line with the average across its forecast horizon. Venture capital valuations ended 2021 well above their long-term averages.

Other factors in venture capital returns

It added that a return to a low-interest-rate environment like what was observed in the post-financial-crisis expansion would support venture capital returns. This scenario is already implicit in JPMorgan’s macroeconomic forecast, although the firm noted that it would not happen overnight.

Additionally, the firm said the extreme dispersion of returns across venture capital managers suggests VC will continue to marginally underperform PE, as it has in the past due to significantly higher return volatility. The bank also warns that venture capital is a challenging asset class to navigate and might not deliver the returns that would normally be expected in higher-risk assets.