Why boring is beautiful amid private equity’s ‘exit crunch’

“If I need a medical procedure, I’m not sitting there saying, ‘gosh, let me wait until the Fed lowers the interest rates before I go in to see my doctor’,” he says. “Smaller, middle-market businesses are humming along because the Main Street economy in the US is relatively stable.”

That may change, of course, but Flexstone’s investment processes requires it to stress test any deal for a recession, giving Gupta comfort about what’s coming.

Private equity’s ‘exit crunch’

Flexstone has a little over $US10 billion ($16 billion) in funds under management and counts superannuation giants Hostplus and AV Super among its clients; Australia is its third-largest institutional market. The firm specialises in putting together portfolios of private equity managers for its clients, and also makes co-investments in individual assets.

But it steers clear of both the mega-private equity deals that have become popular, and the venture capital sector. Its portfolio is also underweight technology, a sector where Gupta says, “a lot of bad decisions were made” during the pandemic frenzy.

It is these parts of private equity that Gupta says are exposed to what he considers the worst of the “exit crunch” that has led to IPOs, trade sales and secondary sales falling sharply in the past two years.

Preqin Pro research shows there were 1294 global private equity exits from January to September, down 35 per cent from the boom year in 2021.

There were some signs that exits are becoming easier, with a smattering of IPOs in the US recently, and some thawing of the banking sector’s recent aversion to providing private equity credit. But whether the recent surge in geopolitical risks and another jump in bond yields slam the exit window shut again remains to be seen.

Gupta feels insulated from the worst of this. In his smaller, more boring part of the market, 90 per cent of portfolio companies are sold to trade buyers or larger private equity companies.

He says Australian super funds are sharpening their private equity focus in this difficult environment, and increasingly want access to newer managers with specialist skills.

A big part of the reasoning, Gupta says, is that research shows a private equity firm’s first few funds tend to have the greatest probability of delivering top quartile returns, which reflects their size (it’s harder to outperform with a larger fund), their ability to find off-the-radar and cheaper deals, and the fact the managers tend to have a lot of their own money at risk.

Flexstone’s emerging managers program has delivered a net return of more than 20 per cent since it launched in 2019.