Bracing for a Bear Market, Private Capital Readies for Economic Impact

December 2019

Marisha Chinsky
Bliss Integrated Communication
(646) 386-2922
MChinsky@BlissIntegrated.com
 
  • To prepare for a downturn, private equity (PE) and venture capital (VC) firms are being more selective when evaluating highly valued targets and reallocating capital
  • Survey data points to investors retreating to defensive strongholds and secular growth areas
  • Increasing expectation for portfolio company digitization to accelerate value creation
 
Chicago,  IL – Preparations for a downturn are underway for the private equity and venture capital sectors, according to BDO’s inaugural U.S. Private Capital Outlook, which replaces and expands on BDO’s legacy Private Equity PErspective Survey. As they wait for the other shoe to drop, more than half of fund managers (50% of PE respondents and 54% of VC respondents) say they are being more selective when evaluating highly valued deals.
 
What comes up must come down: 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 PE and 87% of VC respondents expect a downturn to occur within four years—less than the length of most investment holding periods.
 
As they gear up for a potential slowdown, fund managers are shifting their capital allocation strategies. 28% of PE respondents will be directing the most capital toward funding portfolio working capital needs over the next 12 months. This is up from less than 1% a year ago, when the vast majority directed the most capital toward new deals. A greater percentage of VC fund managers—41%—will be dedicating the most capital toward portfolio working capital needs.
 
The survey also found that 30% of PE respondents and 20% of VC respondents are looking to exit current investments. That percentage rises to 36% of PE respondents and 21% of VC 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 PE and VC are on the lookout for investments with secular trends behind them and are relatively aligned on where the best opportunities lie. Fund managers anticipate the technology, financial services, and natural resources industries will see the greatest increase in deal activity.
 
But technology clearly reigns as the hottest sector, with 54% of PE and 51% of VC identifying it as most likely to experience increasing deal activity. Within tech, the areas of greatest interest for investment are 5G, artificial intelligence (AI), and the Internet of Things (IoT).

The biggest drivers of deal flow are anticipated to be private company sales and capital raises (52% of PE respondents and 42% of VC), public-to-private transactions (47% of PE respondents and 39% of VC), and distressed businesses (40% of PE respondents and 39% of VC).

Increasing competition from an evolving competitor set
Both PE and VC 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).  

PE respondents anticipate the majority of competition over the next 12 months will come from strategic buyers (41%), with peer PE 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 VC 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 PE (30%) and VC (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 PE, and 22% for VC), which had been first choice for PE for the past two years of BDO’s survey 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," stated 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 PE and VC see greater returns under a Democrat in office: 34% of PE and 29% of VC 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 PE firms (100%) 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.  

PE respondents see the greatest opportunity for technology to accelerate value at the portfolio company level as cash flow management (20%), employee productivity (19%), and product/service innovation (17%). VC respondents, on the other hand, see the greatest opportunity in improving operational efficiencies (20%).

To digitize their portfolio companies, more than half (52%) of PE 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 VC peers (42%). Just over a quarter (27%) of PE respondents are pursuing complementary add-on investments, compared to 41% of VC respondents.

A cyberattack or data breach is still perceived as the greatest digital threat to portfolio companies by both PE funds and VC funds (40% and 31%, respectively). In addition, 30% of PE respondents and 36% of VC respondents report running into cybersecurity problems during the due diligence process more than half of the time.

Beyond cybersecurity concerns, however, fears diverge. PE ranks more agile competitors as the second biggest digital threat to their investments (27%), compared to just 10% of VC respondents. For VC, the second-greatest digital threat to investments is a tie between disruptive business models and commoditization/automation (both 22%).   

Additional findings include:
  • Top Regulatory Concerns: PE respondents cite the Tax Cuts and Jobs Act of 2017 as the greatest regulatory concern to their business, while VC respondents cite the Foreign Corrupt Practices Act as their greatest regulatory concern.
  • Top Challenges in the Sale Investment Process: PE fund managers rank credible budgeting and forecasting as their top challenge in a sale/investment process (21%). VC fund managers, meanwhile, rank margin trends as their top challenge (22%).
  • The Rise of the Co-investment: Limited partners (LPs) 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 PE funds report offering co-investments to their LPs, this year’s survey found.

The BDO US Private Capital Outlook 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, an independent marketing research firm, in October 2019. Download the full survey findings here.

About BDO's Private Equity Practice
Strategically-focused and remarkably responsive, the experienced, multi-disciplinary partners and directors of BDO's Private Equity practice provide value-added assurance, tax and consulting services for all aspects of a fund's cycle, wherever private equity firms are investing.
 
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