Insight: What’s next for PE?

Christopher Masek has been the CEO of IK Partners for more than a decade and has worked in the private equity industry (“PE”) for over 30 years. Despite persistent economic uncertainty and an inhospitable interest rate environment, Christopher believes that opportunities for growth remain, but only for firms with truly sustainable business models.

The invasion of Ukraine marked a clear moment of change for the world economy in general and PE in particular. Crises converged to create a perfect storm: supply chain bottlenecks, labour shortages, energy constraints and mounting inflation on the micro front; and a sharp shift in monetary policy, characterised by an end to quantitative easing and rising interest rates at the macro level. While this watershed had long been predicted, it made for a rude awakening.

PE handled the micro side of the equation pretty well. Price rises were passed on, strategic stocks were shored up, employee churn was overcome and energy needs were hedged. The macro side has, altogether, been more challenging — particularly the limited supply and rising cost of capital.

This environment has dramatically changed the PE landscape. General partners, limited partners and lenders are in a period of doubt, evidenced by a sharp slowdown in new deals, fewer exits and a reduction in funds available to make new investments. Successful navigation in this climate is not about managing the micro crises, it is about overcoming capital constraints.

Reality Check

The first consideration is what not to do, in particular, continuing to pay high multiples on non-cash generating metrics and thereby ignoring the present reality. Such investments are less prevalent today, not least because lenders are no longer willing to support them. Nonetheless, concerns persist around deals of this nature, particularly those completed between 2019 and 2022. With this vintage period under significant scrutiny, investors will not accept waffling or delusional valuations.

Instead, practitioners need to demonstrate a track record of consistently returning capital with a low loss ratio, coupled with a wariness for excessive financial creativity. Crucially too, firms need a well-articulated and meaningful raison d’être, positioning themselves beyond the habitual mishmash of: “We only do proprietary deals”, “We are top quartile” and “We create value,” too often fed to highly experienced investors. Finally, access to well-priced capital requires a large, well-organised and dedicated team of Investor Relations professionals, who are on a par (at least) with Investment teams. As one of my partners put it recently: “How many car manufacturers were there at the beginning of the last century? Hundreds. How many are there today? Closer to a dozen. Were these businesses the most creative in the industry? No. But they consistently adapted to market constraints and demands.”

A Robust Model

So how should IK adapt to and manage our activity in the current environment, which, we contend, is here to stay? Our belief is that we have long been equipped for it; in the way we invest, the way we monitor our investments and the way we communicate with stakeholders.

We have established a rigorous investment process to select high-quality, cash-generating assets with strategic logic, operational runway and talented management. We pioneered the development of a substantial and effective in-house Operations team to ‘beat’ the micro and generate alpha. And our work yields demonstrable results. Our loss ratio is among the lowest in the industry, we annually return more capital to our investors than we deploy and we produce consistent and predictable levels of exit proceeds.

Our investment formula is based on a time-proven model, which we continuously upgrade and enhance. We stick to the lower-mid market space and focus on traditional economy companies with a particular roadmap for strategic and operational improvement. We value investments fairly, based on properly baselined cash metrics. We avoid over-leverage and creative financial engineering. And we provide companies with the requisite support to grow, develop and achieve a successful exit.

Today, we are regarded as the institutional reference in the European lower-mid market space and this, coupled with our reputation as a trusted partner by opinion-leading investors, provides our firm with a hard-won ‘right to exist’.

But we also need to ensure that our path is aligned with the demands of our investors and other stakeholders. Their first ask is clear: to continue generating strong, predictable and consistent returns. Here, we have detected a real shift in how performance is measured, from self-promoting arbitrary valuation metrics to unadulterated cash-on-cash returned to investors. To ensure that we deliver against this expectation, we devote time and resource into building and developing our team of Investment Professionals and our Operations and Capital Markets teams. These individuals are widely considered to be at the top of their game.

Investing for Good

Our next priority relates to our values and our role in society. Just as the industry has set high standards for financial performance and accountability, the same is required when it comes to environmental and social progress; from initiatives to reduce emissions and work towards net zero, to the promotion of diversity and inclusion in our ranks, as well as support for health and wellbeing in the communities where we work. IK has been at the forefront of this responsible investment movement, rigorously incorporating ESG considerations into our investment process, actively managing our portfolio companies for good, supporting our local communities and undertaking standalone initiatives that reflect our ‘people-first’ agenda. Most importantly, while technological risks have traditionally been a key due diligence item in anticipating how a company may perform and be perceived by future buyers, possible future ESG trends and their potential impacts on an investment have become at least as critical.

Finally, our investors expect full transparency and genuine engagement. To that end, we have grown our Investor Relations team. We have also invested substantial resources into our team of 27 individuals responsible for reporting, compliance and interaction in Luxembourg, complemented by a range of IT tools to ensure that we offer our investors complete transparency and ongoing dialogue. We recognise that our relationship with investors is more critical than ever and we are committed to providing them with active and professional support.

We believe that deep-rooted, lasting change is underway across our market. That means the environment of tomorrow will be markedly different from what we once knew. Long prepared for this new era, we at IK expect to thrive in the future as positive outliers. Of course, true success takes time but we have certainly made a strong start and are excited to be at the forefront of change, seeking, like those top-rated carmakers, to be among the winners in an industry marked by challenge, evolution and rationalisation.