Overall, we continue to have a positive outlook for private equity (PE) despite an increasingly competitive market environment. Long-term trends, particularly in the area of technology and innovation, are creating opportunities for disciplined, experienced managers to generate attractive returns.

Deal activity, following a pandemic-induced standstill in Q2, rebounded strongly in Q3 and Q4, especially for durable businesses that proved resilient during an extremely difficult year. Debt financing continues to be available at attractive terms. Exits and distribution activity across both buyouts and venture capital have been strong.

Still, competition is high: Increased deal volume in the back half of 2020 helped absorb some of the industry’s dry powder, but substantial amounts of capital raised in recent years will remain a factor for the foreseeable future. As a result, valuations are elevated and deal processes can be highly competitive.

Robust valuation multiples bring great businesses to market that might not otherwise be for sale—but the same can be said for less desirable businesses at similarly elevated prices. Working with experienced managers that have navigated prior cycles and developed clear playbooks for value creation is more critical than ever. 

We offer three considerations for private equity investors as they search for opportunities in this environment:

1. Big deals produce headlines, but smaller deals can deliver differentiated results

While the largest buyout deals tend to grab headlines, we see the most attractive opportunities among firms with revenues of USD 10 million to USD 100 million. Despite increasingly competitive markets, these businesses can generally be purchased at lower valuation multiples with transaction structures less reliant on leverage. Smaller, undermanaged companies, even when fundamentally sound, can often benefit tremendously from collaboration with experienced general partners (GP) that have the deep sector expertise to drive transformational change. Once a growth plan has been successfully implemented, these businesses can be sold at premium valuations and drive differentiated returns for investors. 

We look for investment opportunities wherever they may arise rather than straining to fill prescribed allocation buckets. We believe this approach is particularly well-suited for a world experiencing varying degrees of pressure and recovery as a result of the coronavirus pandemic.

2. Co-investing can potentially help investors reach PE program objectives¹

Co-investments offer limited partners (LPs) the opportunity to invest directly in individual private companies alongside a GP that leads due diligence and is ultimately responsible for executing the deal.

Relative to other types of private investment opportunities, co-investments have the potential to provide:

• Return enhancement: Research shows that co-investment net returns to investors can enhance overall private equity portfolio performance (Exhibit 1). Selection, however, is critical as greater upside potential comes with a higher dispersion of outcomes.

• Attractive economics: For LPs, the majority of co-investments are made on a no-fee, no-carry basis.

• Increased visibility and discretion: Co-investments are offered as pre-identified opportunities, not on a blind pool basis, as is the case in PE commingled funds.

Today, a number of dynamics are supporting particularly attractive co-investment deal flow. Increased deal activity and transaction complexity have created a greater need for reliable co-investors—and investors are seeking these opportunities. Over time, sellers have become more confident in the ability of proven co-investors to execute deals. This is particularly notable in the small and middle market, where fund sizes had previously limited otherwise capable GPs from participating in desirable though somewhat larger transactions sourced within their networks. We expect this trend to continue to drive a greater opportunity set for the foreseeable future.

Participation in co-investments has the potential to enhance overall private equity portfolio returns  
EXHIBIT 1: PRIVATE EQUITY PORTFOLIO RETURNS WITH CO-INVESTMENT ALLOCATIONS

Source: Cambridge Associates LLC Private Investments Benchmark Index. To calculate the weighted projected portfolio return, the 25-year periodic return for U.S. private equity through 3Q 2018 was used, equal to a 13.4% net IRR, and co-investment returns were projected to be 500 bps higher. Weighted portfolio returns are calculated by applying the strategy weights to long-term returns. Data is based on availability as of November 30, 2020. For illustrative purposes only.

3. Technology and innovation continue to drive opportunities

Technology and innovation are transforming our lives, economies and businesses—and driving substantial return-enhancing opportunities in venture capital and private equity. In many cases, the COVID-19 environment has accelerated technology adoption and benefited technology-focused businesses.

Not all innovative ideas, however, translate into sustainable, profitable businesses. Identifying the likely winners, ensuring that a detailed value-creation plan is in place and executed—and that downside risks are understood—requires a seasoned GP with deep sector knowledge and specialized skills. We highlight opportunities in two areas as examples in today’s market:

Software-as-a-service (SaaS) refers to web- or cloud-based software for which a customer pays a recurring subscription fee for access. SaaS solutions can be expediently installed, cost-effective alternatives to customized installations on in-house servers. They allow enterprises to rapidly adopt a wider range of software tools that can have a significant impact on productivity and efficiency. These flexible solutions can grow with business and production needs to quickly become a vital part of a company’s day-to-day operations. This accelerated innovation and end-user demand are fueling high levels of growth at earlier stages, making these SaaS providers attractive to venture capital firms, while more mature businesses are appealing targets for buyout firms.

Health care demand is growing, driven largely by long-term demographic shifts. At the same time, the sector is catching up in its adoption of software applications. Attractive investment opportunities take many forms, including online platforms designed to connect independent medical practices and provide economies of scale, and services supporting patient adherence to medication and therapy programs. We see increasing opportunities for technology-based solutions that can help providers deliver better care to patients, with better outcomes and at lower costs.

In short, while the private equity market continues to be competitive, we believe significant opportunity remains for disciplined, experienced investors.

¹ For further discussion see: "Private equity co-investments: Investment characteristics and considerations" J.P. Morgan Asset Management, October 2020.