Private Equity Firms See Opportunity in Upheaval and ESG in 2022

Private equity deal value in 2021 dwarfed that of 2020, nearly doubling to $1 trillion from $565 billion in 2020. Experts suggest that the elevated deal value is the result of so-called “dry powder” in the hands of private equity firms. In other words, private equity firms that held back on deal-making in 2020 due to pandemic uncertainty or for other reasons made up for lost time last year.

Some experts also speculate that the pace of private equity deals in 2021, up 35 percent from 2020, was driven in part by the looming specter of proposed Biden administration changes to capital gains and corporate taxes.

With a record-breaking year in the books and the high deal-making levels expected to continue, private companies looking to either sell to or compete against private equity firms should pay close attention to their next moves.

Areas for Opportunistic Investment

Dry powder is a double-edged sword. While it is partly responsible for the enormous surge in deal value over the past year, dry powder also leads to greater competition and higher prices of entry into investments. In fact, 35 percent of global private equity executives surveyed by Dechert and Mergermarket said the quantity of dry powder combined with the ability to put capital to work would be a top-two challenge for the private equity industry in the months ahead.

Nonetheless, Rafael Pastor, an advisor to the private equity firm Partners Group, and a director of multiple private companies, including KinderCare Education and Rosetta Books, predicts that private equity firms will take advantage of opportunistic investments in three areas this year: credit, real estate, and infrastructure. Pastor said in a conversation with NACD that private credit and real estate are well positioned now as interest rates rise—and even more private equity real-estate investment will happen as inflation continues to soar because real estate is traditionally viewed as a solid hedge against inflation. Meanwhile, last year’s $1.2 trillion Infrastructure Investment and Jobs Act will likely push many private equity firms to invest in infrastructure across the country, according to Pastor.

In addition, a third of respondents to Dechert’s survey named region-specific factors, including macroeconomic and geopolitical issues, as a top-two challenge for the industry. Indeed, private equity firms are pivoting to invest where they see opportunity in the wake of the pandemic, the war in Ukraine, US-China tensions, and other geopolitical uncertainty.

“Historically, uncertainty and even instability always create opportunity,” Pastor said. “Private equity firms are really good at spotting those opportunities.”

Military spending and energy (both traditional carbon-based fuel and alternative energy) will be two hot spots for private equity firms in this regard, Pastor said. In addition, life science and pharmaceutical companies will get even more private equity attention post-COVID.

“You have to remember that private equity firms don’t just jump into an opportunity because it pops up,” Pastor said. “They tend to track different sectors and different companies for up to a year or two and see how they’re doing so that they can identify companies that are targets for them when the opportunity arises. They don’t just show up in the eleventh hour—they’ve been there all day.”

A Greater Focus on ESG

Although private equity portfolio companies are not subject to as much US Securities and Exchange Commission scrutiny as public companies are, private equity firms are also increasingly paying attention to environmental, social, and governance (ESG) matters. How could they not, when major institutional investors such as BlackRock and State Street have pushed businesses to focus on ESG over the past few years?

A significant portion of private equity firms’ investment in portfolio companies comes from pension and union funds, and these funds want the companies they invest in to be doing the right thing for their stakeholders. In fact, 96 percent of North American respondents to the Dechert survey said that they expect an increase in limited-partner or third-party private equity fund investor scrutiny of ESG issues and reporting in deals over the next three years.

Twenty-nine percent of all respondents ranked climate change as their most important ESG consideration when making investment decisions, followed by sustainability at 14 percent, which aligns with regulatory initiatives’ focus on environmental issues and the fact that these issues are more easily measurable than social and governance matters. Privacy and data security received the largest share of responses (69 percent) for general ESG considerations that may not be the most important but are still top of mind. All in all, 76 percent of North American respondents said their firms were considering raising an ESG-focused fund over the coming year.

ESG won’t just be a consideration in the decision-making process. While 76 percent of all respondents said ESG’s importance at the time of investment would generally increase over the next three years, 72 percent said ESG would become increasingly important at exit and 70 percent said ESG would become increasingly important during the lifespan of the investment—with 46 percent of respondents saying that there would be a significant increase in its importance during this period.

Private equity firms are among the largest employers in the United States when you add up all the people they employ through their portfolio businesses. With this in mind, Ownership Works offers a recent example of private equity firms’ ESG consciousness. The nonprofit launched in early April, backed by a coalition of more than 60 investors, banks, and pension funds; that included 19 private equity firms, such as Apollo Global Management, KKR & Co., and Warburg Pincus.

In partnership with the founding firms, the nonprofit aims to help companies develop and implement employee ownership programs. The founding private equity partners have committed to supporting and implementing shared ownership models within their portfolio companies, demonstrating that they indeed intend to elevate their focus on ESG issues during the lifespan of their investments.

What This Means for Boards

For private equity-backed portfolio company boards, Pastor sees the following types of directors as vital in the months ahead:

• Vertically Aligned Directors: If a private equity firm plans to invest in infrastructure, for instance, it will want to have portfolio-company board members who have a background in infrastructure.

• Functional Members: For example, when a private equity firm is looking to take its portfolio company public, it will keep an eye out for someone with expertise in digital marketing or finance. If the company is focused on diversity, equity, and inclusion, it will want a board member with a human resources background.

• Generalists: While less dominant than in the past, this type of director still has the attention of private equity firms looking for “horizontal experience,” as Pastor calls it—experience running a company as a CEO or on the board of a complex organization where they had to handle instability, inflation, and other environmental pressures.

In this environment of high valuations and increasing competition among private funds, potential sellers and their boards would be wise to consider all of these trends in seeking out any offers. Beyond those companies looking to sell, however, private companies and their boards should be aware of how private equity firms influence the competitive landscape.

Private equity firms bring to their portfolio companies sound governance processes, operational expertise, strategy oversight, and technology investment. Broadridge Financial Solutions predicts, for example, that private equity firms will increasingly deploy distributed ledger technology, artificial intelligence, and robotic process automation in deal-making, reporting, and recordkeeping to create cutting-edge efficiencies.

To compete, non-private equity–backed companies should seek to elevate their oversight and other business practices, particularly if they exist in the sectors noted above, such as real estate, infrastructure, or energy—especially when it comes to ESG.