This article is part of Bain’s 2023 Global Private Equity Report

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As extraordinary and resilient as the post-Covid rally in global private equity proved to be, it was ultimately no match for the Fed.

For the first six months of 2022, the industry extended 2021’s record-shattering burst of deal activity, despite persistent inflation, the invasion of Ukraine, and growing tensions with China. Then, in June, when US central bankers issued the first in a series of three-quarter-point interest rate hikes—and their colleagues around the world followed suit—banks pulled back from funding leveraged transactions and dealmaking fell off a cliff, pulling exit and fund-raising totals down with it (see Figure 1).

Given the heights from which they fell, buyout deal value ($654 billion), exits ($565 billion), and fund-raising ($347 billion) all finished 2022 with respectable totals in a historical context (see Figure 2). But the sudden reversal marked the end of an up cycle that has endured (with a brief Covid brake tap) since 2010, when the industry emerged from the global financial crisis and produced a 12-year run of stunning performance.

Figure 1

Figure 2

It remains to be seen whether the abrupt shift from accommodation to tightening will trigger what could be called the most anticipated recession in history that hasn’t happened yet—at least not in the US. A tight labor market and lingering Covid-related stimulus have so far kept the economy limping along. (The fleeting two-quarter dip in 2022 wasn’t officially deemed a recession.)

Yet there’s no denying the impact of the unprecedented mix of macro forces in play (see Figure 3). The resulting rise in rates has already shut off the spigot of cheap, obtainable debt financing. And deep ambiguity about the future course of global economic activity is likely to cast a shadow over the private equity value chain through 2023’s first half, if not beyond.

Figure 3

What makes the current economic slowdown different from the one brought on by the global financial crisis is the lack of clarity about what’s happening. There’s no Lehman collapse, no housing meltdown, no sharp falloff in economic activity to signal a definitive sea change. Instead, the global economy is presenting investors with conditions few among them have ever seen before. As if war in Europe, energy shocks, and supply chain issues weren’t enough, inflation hasn’t been this high or persistent in 40 years (see Figure 4). The resulting rise in interest rates has reversed a downward trend that has defined investment markets for as long as anyone can remember.

Figure 4

The net result is the dreaded “U word”—uncertainty, a deal killer if there ever was one. As buyers, sellers, and lenders all wait for clarity around the economic forces that could affect cash flows, uncertainty will continue to act as a cap on deal activity, especially for the largest transactions that require the most leverage. Dealmakers are still finding ways to finance smaller transactions with private credit and larger equity infusions. But the overall decline in new deals and exits will likely persist, creating a knock-on effect for fund-raising.

Limited partners (LPs) will need time to work through imbalances in their portfolios brought on by market swings and a slowdown in cash back from previous commitments. The short-term cash squeeze will make it difficult for them to extend new commitments, especially after several years of record-breaking allocations to private equity. Raising new capital will be particularly hard for midsize generalist funds as LPs continue to favor specialists and large funds with top-tier performance. The same could be said for general partners (GPs) challenged to generate distributions because their exit volume is dependent on the (now-moribund) market for initial public offerings.

How long these conditions will last is impossible to predict with any accuracy. But amid the short-term gloom, there is nothing to suggest the long-term outlook for private capital is any less positive than it was in 2021. Indeed, after attracting an astonishing $10.7 trillion in capital over the last decade, the industry may be getting even more appealing as investors continue to chafe at the limitations of the public markets.

The number of US public companies has declined by about a third over the last 25 years, and the remaining pool is dominated by a handful of large tech firms that hold disproportionate sway over the indexes. That makes it increasingly difficult to find adequate diversification in the public markets. Private market returns, meanwhile, are outpacing public returns over every time horizon, while alternative funds provide access to the broad global economy and the fullest range of asset classes. These advantages explain why private markets continue to grow relative to the public markets.  

GPs are stoking that growth through ongoing product innovation. They have steadily developed new types of fund structures across asset classes, helping the industry become increasingly attractive to LPs with highly specific allocation requirements. While buyout remains the industry’s largest asset class, a variety of others have been growing at double-digit rates (see Figure 5). GPs are also diversifying their sources of growth by structuring products for massive, but relatively less penetrated, pools of capital like sovereign wealth funds and wealthy individual investors.

Figure 5

History suggests that clear sight lines—not ideal economic conditions—are what will bring the energy back to dealmaking. If interest rates remain higher, GPs can work with that; if uncertainty persists, so will the hesitancy to commit. The industry ended 2022 with a record $3.7 trillion in dry powder, so GPs will be eager to put it to work as soon as possible. But buyers, sellers, and lenders are all looking for clearer signals about where GDP is headed and how much further the rates hikes have to go.

The lessons from the last downturn are particularly useful in plotting a course through this time of uncertainty and turbulence. Put succinctly, the winners didn’t panic last time around. They properly assessed their risk scenarios, created mitigation plans, and set themselves up to accelerate out of the downturn. This has implications for both dealmaking and portfolio management.

Mitigating risk. Confidence boils down to learning how to underwrite risk in a time of great macro uncertainty. This confidence flows from a different set of muscles than most GPs are used to exercising. Deal teams have become increasingly specialized over the past cycle and may have a keen understanding of how to evaluate the micro forces impacting a target company. But once every 10 years, macro matters—a lot—as the danger increases that the world will shift under your feet.

The due diligence challenge is to analyze with specificity how these shifts might impact your company and its industry. There may be 10 macro factors out there disrupting global activity, but chances are, only 2 or 3 of them really matter for your deal. The question then becomes, what is the range of scenarios or possible outcomes relative to those critical few macro factors, and what is your mitigation plan for each scenario? This process is about considering a fan of possible outcomes (not just the one or two most likely) and thinking through whether the fan is asymmetrically good or bad.

The winners last time around used this kind of insight to get back in the game as quickly as possible. The data is clear: Deals done through a downturn generate superior returns over time (see Figure 6). Leaders keep finding deals that they like and can underwrite confidently by making sure the macro factors are accounted for. They also stay aggressive and aren’t deterred by lingering adverse capital conditions. If a deal targets a good asset at a good price, it may be worth getting it done with more equity or a higher price on the debt than you’d like. You can always fix the balance sheet when conditions improve, but waiting risks losing a valuable opportunity to profit from the rebound.

Figure 6

Preparing companies to win. Within the portfolio, overreaction is deadly. When the cycle turns, the impulse is to start selling the furniture at portfolio companies and slashing costs to the bone. That may shield the balance sheet for a while, but it will inevitably cripple performance. While it makes practical sense to conserve cash, draw down lines of credit, and otherwise build a war chest for surviving a recession, it’s also important to look for opportunities to stay on offense.

Accelerating out of recession starts with taking a fresh look at a portfolio company’s competitive position and plotting how to use the downturn to take market share from competitors. This always depends on subsector dynamics and the strength of the competition. But the companies that are prudently aggressive—vs. conservative and reactive—are the ones that shift profit pools during recessions. Discerning opportunity, while mustering the wherewithal and courage to go after it, ends up generating superior performance over time. 

Now for a more detailed look at what happened in 2022.

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Investments

While alternative investments overall trended downward in 2022, the buyout and growth categories took the brunt of the macro headwinds.

Buyout blues. Global buyout value (excluding add-ons) totaled $654 billion for the year, a 35% decline from 2021. Overall deal count, meanwhile, fell 10% to 2,318 transactions (see Figure 7). In terms of value, 2022’s was still the second-best performance historically. But that’s because of the extraordinary momentum in the year’s first half.

Figure 7

Coming off 2021, when the industry completed deals worth $1 trillion, dealmakers charged into the first few months of 2022 seemingly intent on generating another trillion-dollar year. But when central bankers around the world began tightening down to combat persistently high inflation, second-half activity fell off precipitously in every major region (see Figure 8). The especially sharp drop-off in Asia-Pacific dealmaking reflects repeated market shutdowns due to Covid restrictions. Buyout count fell or growth was muted across all sectors, although technology retained its nearly 30% share of all buyout deals globally (see Figure 9).

Figure 8

Figure 9

The banking industry’s reluctance to lend to large leveraged transactions starting in midsummer dictated how the year in dealmaking ultimately unfolded. As yields rose sharply, the number of syndicated loans for leveraged buyouts dropped like a rock. Across the US and Europe, leveraged loans fell 50% to $203 billion as volume plummeted in the year’s second half (see Figure 10). The result was a decline in the sort of large, high-leverage transactions that have buoyed deal value for years. Average deal size fell 23% to $964 million after climbing steadily every year since 2014 to a record high in 2021 of $1.2 billion (see Figure 11).

Figure 10

Figure 11

With the banks essentially closed for business, smaller transactions requiring less debt picked up share in the overall totals. GPs turned to direct lenders such as Sixth Street Partners and Ares Credit Group to finance 80% of all middle-market loans during the year (see Figure 12).

Figure 12

The appeal and feasibility of smaller deals can be seen in the growth of add-ons, deals that are financed from the balance sheet of a portfolio company, usually to expand its footprint or add an adjacency. Add-ons made up 72% of all North American buyouts in 2022 by deal count, and a growing share of them were used to further buy-and-build strategies—multiple arbitrage plays where a GP buys smaller companies at lower multiples to build them into a larger one that will command a higher valuation (see Figures 13 and 14).  

Figure 13

Figure 14

While GPs have gravitated to add-on and buy-and-build strategies in ever greater numbers, it remains to be seen whether these moves will pan out for all of them. In our experience in over 30 years of doing coinvestment deals, buyers tend to underestimate the due diligence and integration challenges. The commercial logic of rolling up small companies in a fragmented industry is no doubt compelling. Yet it is critical to be rigorous about how the pieces fit together.

The GPs and portfolio companies getting it right start every acquisition process with a clear, testable thesis for how the deal will make the platform company more valuable over time. They’re also careful not to let the commercial appeal obscure issues like organizational and cultural fit. Identifying synergies is essential, but so is defining how and when they will be achieved and how much risk there is that the savings might not materialize. Mitigating that risk involves drawing up a detailed integration plan to bring execution risks to the surface early.

Growth on pause. A year ago, the growth equity and late-stage venture segments were on fire. But, like buyout, these funds saw a large decline in activity in the second half of 2022. Overall, deal value dropped 28% to a rounded $644 billion (see Figure 15).

Figure 15

Growth deals don’t rely as much on bank debt as buyouts do. But growth and venture funds faced a number of their own challenges. The first is math: Rising interest rates reduce the value of future earnings, which has a disproportionate effect on the value of fast-growing companies for which the expected cash flow bonanza is somewhere in the future.

This math challenge was exacerbated by a second factor: investor recalibration. Much of the technology segment’s momentum in 2021 and early 2022 stemmed from a Covid effect—the notion that demand within areas like e-commerce, work-from-home, and cybersecurity had been pulled forward, accelerating the penetration curves of many companies. As the pandemic waned, these predictions often began to appear overly optimistic, especially in a world where the cheap capital being used to inflect growth was going away. That and growing concern about an economic downturn chipped away at animal spirits.

A third factor has been GP conservatism. As the availability of fresh growth capital suddenly became suspect, many GPs have asked management teams to ease off the throttle—even if just a bit—to conserve precious cash. That’s a recipe for more resilient balance sheets, but, like the other factors, it called into question future growth prospects, eroding valuations that relied on those expectations. The end result was fewer companies taking on new funding at attractive multiples.

Lower valuations have put growth and venture funds in a holding pattern. Not only have the companies they acquired in recent years come down in value, making buyers and sellers reluctant to transact, but the IPO markets are virtually shut down, dramatically slowing the growth of the market’s favorite exit channel. Deal activity is unlikely to recover until valuations return to previous levels or enough time passes that assets are able to grow into their earlier valuations by generating higher earnings at lower multiples.

What’s clear is that the falloff in deal activity across alternative asset classes has done nothing to help the industry whittle away at its mountain of unspent capital. Dry powder continued its decade-long growth streak and rose to a new record of $3.7 trillion in 2022 (see Figure 16). Buyout dry power finished 2022 at $1.1 trillion. Growth fund dry powder was just under $350 billion.

Figure 16

Although growth valuations have been moving lower, buyout multiples, at least in the US, have held steady (see Figure 17). Taking a cue from Europe, they are starting to ease off in the current environment, but several factors are giving US multiples more support than the deal numbers would suggest.

Figure 17

First, because dry powder is so plentiful, any high-quality deal remains competitive. A full 65% of North American buyouts in 2022 attracted multiple bidders or involved a formal auction process. Second, owners in this environment are only offering up companies that will command a premium.

For their part, buyers are still willing to pay up for a deal if they have real conviction. We’re seeing more transactions financed with 70% equity and 30% debt instead of the usual 50-50 structure. Funding that debt can be expensive, but to get quality deals done, GPs are kicking these debt issues down the road, confident that, when the conditions improve, they can restructure. As we discuss elsewhere in this report, the logic of present value suggests that multiples aren’t likely to remain this high over the long term if interest rates continue to climb. As they trend downward, it will pay to be ready to pounce.

Exits

If investments fell precipitously in the second half of 2022, exits fell even harder. With every channel in decline, buyout-backed exits dropped 42% to $565 billion and showed weakness in regions across the globe (see Figures 18 and 19). Growth equity exits, meanwhile, plummeted by 64% to $312 billion (see Figure 20).

Figure 18

Figure 19

Figure 20

Amid the sharp declines in public equities, the IPO market shut down almost completely in 2022, which was especially hard on the growth equity segment. Sponsor-to-sponsor deals dropped by 58% as lenders cut off financing for big transactions and PE buyers shied away from the still-high asking prices coming from other firms. Sales to strategic buyers were higher than the five-year average, largely because corporate earnings proved to be relatively resilient throughout the year. But as macro uncertainty cast a gloom over the market in the second half, the strategic channel slowed and finished down 21% from 2021.

Some of the slowdown in 2022 can probably be attributed to GPs pulling exits forward into 2021 to take advantage of surging deal activity and multiples. But faced with less-than-favorable market conditions in 2022, many GPs were simply unwilling to part with promising assets that were coming under short-term pressure.

A good example is a fund that invests in companies that are particularly reliant on human capital. With labor costs on an inflationary spiral upward, margins across the portfolio were compressed by about 300 basis points. That meant fund managers were going to have to play catch-up—raising prices, boosting revenue, or taking market share to get EBITDA back to where they had projected it would be in the deal model. All of that would take time.

They did consider whether to sell some companies on the original time clock and take the hit on returns. But it made more sense to get with LPs and agree to delay those exits until conditions improved. That mindset is an important vestige of the last downturn. GPs say the mistakes they made after the global financial crisis can usually be traced to letting go of assets too quickly rather than doing what they could to hang on and ride out the storm. If it’s a decent company, they found, it will recover and the fund will make a return.  

Given this kind of thinking, it’s likely that hold periods for exited companies will stretch in 2023 if the economy stalls out. That may protect returns over the longer term, but for now, extended hold periods will inevitably make it harder for LPs to fund new commitments from exit-driven liquidity. That means tools like GP-led secondaries and continuation funds will remain an important way for investors to find liquidity when they need it. But as with private markets generally, strong allocations to secondary funds in recent years are already limiting new commitments to these vehicles.

Fund-raising

While the long-term outlook for fund-raising remains exceedingly bullish, the environment for attracting new capital in 2023 will be considerably less so. For a variety of reasons, LPs are tapped out, and the cash squeeze they are facing will make it difficult to ramp up commitments in the coming months.

Largely on the back of a strong-ish first half, alternative managers around the globe raised $1.3 trillion in private capital during 2022, down 10% from 2021 but still the second-highest total ever. That brought the five-year total to a staggering $6.4 trillion, dwarfing any five-year period in the industry’s history (see Figure 21).

Figure 21

The slowdown reflects a couple of dynamics. The total number of buyout funds closed in 2022 skidded 43% from 2021 as most firms found it increasingly difficult to raise new capital. The total value of buyout capital raised, however, dropped a less-onerous 16% because macro jitters forced LPs further into the arms of the largest, most experienced funds, which raised more money than ever (see Figure 22). Activity slid across all major regions (see Figure 23). Growth equity and real estate funds also had a significant drop-off. But infrastructure funds, which investors view as less cyclical, saw a 22% increase.

Figure 22

Figure 23

The pressure LPs are feeling has several components, most notably the unprecedented flood of capital devoted to private equity in recent years. Not only has the amount been monumental, but the velocity of commitment has been accelerating steadily. For buyout funds, the average period between successive funds (first to second generation, third to fourth, etc.) has dropped 35% over the last decade as GPs circle back every three years instead of five. They are also asking for more money each time—50% more in 2022 than for predecessor funds (see Figure 24).

Figure 24

All of that was fine as long as GPs could recycle a steady amount of capital by maintaining high levels of distributed to paid-in capital (DPI). But as exits—and the outlook for exits—slowed sharply in 2022, GPs had to pare back distributions. LPs were already stretched, and the slowdown in DPI created new liquidity issues. That precluded making further commitments until cash flows improved.

Judging by the past downturn, LPs will likely see buyout funds hang onto many companies for an incremental year or two. But that’s hard to gauge given that it’s not even clear what the shape of a downturn would be. Add to all of these factors the “denominator effect,” where declines in public equity valuations make the size of private equity allocations in LP portfolios look out of whack, and it is unlikely the pace of fund-raising will pick up any time soon.

As in any downturn, the scarcity of capital will mean roughly a quarter of funds now in the market won’t raise again. But for GPs generally, the pace and volume of fund-raising over the past several years has left funds flush with fresh capital: A full 86% of large buyout firms have closed a flagship fund or held an interim close over the past three years, and almost half have closed in the past two (see Figure 25). Growth flagships are similarly flush.

Figure 25

Those that have raised recently can wait, earn fees, and choose their targets carefully as the economy works through this down cycle. LPs, too, have learned that extra patience is a virtue during these periods. Fund vintages invested in the year or two after a downturn have outperformed historically, generating strong distributions over time.  

As LPs cut back, established funds at the top of the market will inevitably continue to claim the largest share of the reduced pie. The trend toward specialization and away from generalist funds is also sure to continue. The vehicles getting funded in this environment are those that can help LPs meet specific objectives through true expertise in a narrow slice of the market—not just software, say, but a clearly defined set of three software subsectors that sell only mission-critical applications to fast-growing service companies. Funds that can demonstrate they are the smartest player in a given space by finding high-quality deals and delivering them to investors are the ones standing out in a crowded field.

One thing is becoming ever more apparent: The long-term opportunity private equity presents may be bigger than the traditional sources of capital can support. That explains why the industry has been so assiduously expanding relationships with the massive sovereign wealth funds in capitals around the world and seeking to tap the legions of individual investors who control half of all wealth globally.

It's also clear that there are plenty of places to put the money. As technology continues to transform sectors like healthcare and finance; as innovation builds in areas like artificial intelligence, web3, and big data; and as the energy transition accelerates, the demand for private investment capital stands to grow exponentially over the next 20 years. The coming year will likely turn out to be a pause in the action, but private equity’s long-term appeal to investors is secure.

Returns

In the decade leading up to 2022, surging values of US public equities had closed the historical gap with private equity returns. But that trend ended abruptly last year when public markets tanked globally and private valuations held up—at least through the third quarter, the latest industrywide data available by the time of publication (see Figure 26).

Figure 26

While the S&P 500 closed 2022 down 19% and the MSCI Europe Index finished the year with a 17% decline, valuations for the private equity holdings of the largest public alternative asset managers—Blackstone, KKR, Apollo, and Carlyle—all held up better (see Figure 27). In fact, two of the four posted gains over the year. Buyout funds more broadly posted some write-downs in the second and third quarters, but nothing to match the downturn in public equities.

Figure 27

The question these results raise is whether private equity valuations will follow the public markets south when fourth-quarter marks are eventually tallied this spring or later in the year if the economy tumbles into recession. Trend lines for public and private valuations have generally shadowed each other since the Financial Accounting Standards Board issued its 157 ruling in 2006. And that has set the expectation that bad news regarding the valuation of private holdings is only a matter of time. Many LPs are bracing for the worst. Those surveyed by Preqin in 2022 said overwhelmingly that private equity had met or exceeded their performance expectations during the year. But 60% were expecting performance to deteriorate in 2023 amid the signs of an economic slowdown (see Figure 28).

Figure 28

It’s true that the fourth quarter is typically when the most pronounced adjustments to portfolio company valuations occur. There is one audited appraisal required annually, and that typically happens as funds wrap up their year. These should be the most reliable estimations of value that investors see in any 12-month period.

Data from Burgiss, a private capital data and analytics provider, confirms that if changes are on the way, they are most likely to show up in the fourth quarter. But the analysis also shows that the magnitude of change is typically not that dramatic. Close to 60% of the time over the past decade, the fourth-quarter adjustment has been less than 10% one way or the other (see Figure 29). Change greater than 20% occurs only 21% of the time.

Figure 29

Burgiss analysis also calls into question the notion that 2022 represents a sudden break in the historical relationship between public and private valuations. In fact, a gap may have been developing for years. If you chart quarterly changes in buyout fund valuations against movement in public indexes (indexing them to the fourth quarter of 2019, right before Covid-19 hit), a divergence shows up right away. Private valuations over that period, especially for hot sectors like healthcare and technology, have consistently outpaced those set by public markets in the US and Europe (see Figure 30).

Figure 30

The conclusion one might draw from this data is that GPs are simply overvaluing their assets. But, if anything, new analysis shows that GPs skew toward the conservative. Over the past decade, buyout funds have exited assets at valuations exceeding their last quarterly mark nearly 70% of the time (see Figure 31). If fund managers err, in other words, it is on the side of promising less and delivering more, not the other way around.

Figure 31

Of course, fourth-quarter marks may yet bear out industry concerns. But it’s just as plausible that private equity performance may continue to hold up better than expected—especially given the Q4 performance we’ve seen from the large public firms.

One important reason for optimism is the composition of private equity portfolios (see Figure 32). More than two-thirds of the 2022 decline in public equities was attributable to the plunging values of tech-related stocks, most notably Microsoft, Apple, Alphabet, Meta, and Amazon, which together lost 43% in 2022. Private portfolios are also heavily invested in the technology sector, but it is a different kind of tech.

Figure 32

A full 88% of the technology investments in buyout funds are software, which is significantly less volatile. These are mostly mature SaaS enterprise businesses with stable cash flows. They tend to be more resilient in a downturn because their products are “sticky”—either mission critical or deeply embedded in a company’s operations. Private portfolios are also balanced by healthcare companies, which tend to hold up well in a recession.

This period will test whether private equity’s experience weathering the global financial crisis has taught fund managers the value of constructing portfolios that are resilient in a downturn. It will also challenge them to maintain superior returns without relying on the multiple expansion that has carried the industry for years. As the full impact of inflation and rising interest rates unfolds across the global economy, the coming months and years will likely see downward pressure on multiples. The top-tier firms will be those that can generate alpha from the inside out with value-creation strategies that boost margins and spur revenue growth.

What remains clear, however, is that the industry overall is well positioned for long-term growth and prosperity. Despite the recent drop-off in deal, exit, and fund-raising activity, 2022 was still the second-best year in history, and the underlying fundamentals remain sound. This slowdown and the macro factors contributing to it will present real challenges. But, unlike the 2007–08 period, when the global banking system nearly collapsed, nothing appears fundamentally broken this time around. While all signs point to a shift in the economic tide, the magnitude will be nothing the private equity industry hasn’t dealt with before.

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