The private equity industry had an interesting 2023, to say the least. The industry saw a tremendous number of regulatory reforms and heightened scrutiny within a difficult global environment. Unsurprisingly, private fund managers expertly navigated the geopolitical tensions, threat of recession, and higher interest rates — all of which continue to impact fundraising, deal competition, and exit timelines.
As the industry kicks off 2024, the challenges facing private equity are a combination of new and ongoing factors. For private equity firms, in particular, their digital transformation will be key to continue growing and generating value through tumultuous years.
1. New private fund regulations & increased scrutiny
Private funds in the U.S. were preparing for a slew of U.S. Securities and Exchange Commission (SEC) private fund adviser reforms to go into effect in 2024 or 2025 until the Fifth Circuit vacated the Private Fund Adviser Rules in June 2024.
That said, the SEC continues to closely scrutinize funds’ environmental, social, and governance (ESG) efforts, fee and expense allocations, and investor disclosures. The impact of this intense oversight is a push toward proactive compliance programs that enable more rigorous internal compliance efforts, new reporting requirements, and an efficient SEC exam response.
In an effort to help private fund advisers, the SEC took the unprecedented step of publishing a risk alert explaining how it chooses firms for examination, scopes those exams, and handles document requests. Private fund managers may now have more insight into SEC exams, but this doesn’t lighten the work ahead to prepare for the SEC reforms and strengthen their compliance programs.
Navigate your countdown to compliance with Ontra
2. A shifting macroeconomic landscape
Many of the economic elements heading into 2024 are a continuation of 2023’s challenges. With two major conflicts overseas, the U.S. is experiencing increased political tension. Inflation and interest rates remain high, and economic experts are offering varied forecasts of whether the Federal Reserve will manage a hard or soft landing this year.
Slow economic growth, labor issues, high interest rates, inflation, geopolitical tensions, potential recessionary pressures, and instability could all dampen fundraising and exit opportunities. Despite the slowdown in 2023, private equity firms remain optimistic. They’re developing new paths for value creation, including adjusting investment strategies and portfolio management approaches and implementing AI and automation at both the firm and portfolio company levels. The challenge will be to end 2024 on a good note whether or not the U.S. experiences a recession.
3. Fundraising continues to slow down
As a result of 2023’s market uncertainty and economic slowdown, private fund managers experienced fundraising setbacks. In H1 2023, total private capital fundraising fell 30.9% year over year, according to Pitchbook. Through September, Pitchbook reported a 14% decline in total private capital fundraising compared to the year before.
Not only has fundraising fallen, but the time to close has increased, too. For all private capital, the median number of months to close was 14.5 as of Q3. Pitchbook also reported some megafunds, including from The Carlyle Group and TPG, lowered their fund targets.
Consequently, private fund managers are focused on investor relations more than ever before. Much of fundraising comes down to relationships, and right now, firms have to overcome investors’ chance to shop around.
4. Digital transformation & AI is reshaping the industry
Leading private equity firms have been riding the wave of digital transformation for some time. However, leveraging AI is still relatively new. Only in 2023 has generative AI advanced significantly enough to handle more complex language and tasks.
Given AI’s latest capabilities, strategies for leveraging AI, data analytics, and automation tools have become business-critical and could transform private equity in 2024. Generative AI has the potential to optimize back-office practices, enhance operations at private equity firms and portfolio companies, support value generation, and give managers a competitive edge over firms slow to adopt the latest tools.
At the firm level, choosing the right AI technology is only the first step. The more significant challenges will be integrating new tools into existing tech stacks and managing the change for firms’ internal users. At the employee level, private market professionals will likely need to champion industry-specific AI solutions for their lines of business, take advantage of training, and adopt new skills.
Everybody wants to talk about how AI is affecting their portfolio companies. Obviously, efficiency, automation, and working with firms like Ontra have created a lot of opportunities for us to speed up how we work. Frankly, outsource more, but get a better overall product, service, or impact.
Russ Roenick
Managing Partner, Transom Capital Group
5. Growing cybersecurity & data privacy risks
Data security and cybersecurity concerns are closely connected to the private equity industry’s rapid pace of digital transformation. Protecting sensitive data and preventing and responding to cyberattacks are paramount as private market firms adopt various AI tools and other legal tech to enhance efficiency and collaboration during remote work.
While firms focus on their own cybersecurity measures, they’ll need to do the same with their portfolio companies. Cybersecurity is a growing priority during due diligence as well as post-close, yet there are often significant gaps in portfolio companies’ security procedures and enforcement measures. In 2024, firms will need to find ways to close these gaps.
6. Growing focus on retail investors
Leading firms, including KKR, Blackstone, Apollo, and Ares, are increasing their focus on retail investors, Forbes reported, with an emphasis on high-net-worth (HNW) individuals with $1 to $5 million in assets. Not only is this population growing, but HNW individuals are having a harder time diversifying their portfolios based on the public market alone. They’re turning to the private markets for a better chance at diversification and higher returns.
Blackstone sees potential to expand retail capital from $200 billion to $500 billion, KKR expects between 30% and 50% of new capital raised over the next few years to come from the private wealth channel, and Apollo seeks to raise $50 billion in retail capital cumulatively from 2022 through 2026.
Bain & Company
“Why Private Equity Is Targeting Individual Investors”
As top-tier alternative asset managers focus on retail capital, they’ll have to adapt to new expectations and prepare for the regulatory scrutiny that comes with the SEC seeking to protect less sophisticated players. While the retail segment is a strong opportunity, it’ll require new strategies, a proactive compliance program, and new investor relationships.
7. The struggle to hire the industry’s best talent
Competition for skilled professionals is an ongoing challenge for private equity firms, and many are now focused on retaining their best players. While hiring may have slowed at the largest firms, smaller firms are still on the hunt for top talent. Professionals who aren’t receiving the benefits or experiencing the work-life balance they’d hoped for could shift to smaller firms where they might enjoy more hands-on experience, ownership, and professional growth. In an attempt to keep top talent happy, some private equity firms were already turning to non-salary benefits before the end of 2023.
8. Rising operational costs
Private equity firms have been dealing with rising operational costs for some time now, and 2024 won’t be an exception. Firms are still facing inflation and a high-interest rate environment. They’ll need to double down on their efforts to reduce expenses that they can’t pass through to their funds, including their outside counsel fee and internal time spent on repetitive tasks (which costs firms more than they realize). Digitization, automation, and outsourcing will be key to minimizing unnecessary expenses.
For private equity firms’ portfolio companies, the key is effective financial management strategies. In this era of more expensive and less abundant capital, private equity firms have to focus on company performance and spend management. Cost-savings are critical at every level, from the back to front office.
9. Demand for ESG & sustainable practices
Investors continue to demand transparency into private fund managers’ ESG principles and actions, as well as measurable progress on any ESG factors the firm implements. While ESG or sustainability initiatives won’t become a requirement for every private fund, transparent communications and reporting are critical. If a fund manager incorporates ESG principles into its investment strategy and portfolio management, it has to be clear with its investors and the SEC.
ESG investing, however, will remain out of reach for private fund managers behind in their digital transformation. Firms must be capable of quickly and efficiently handling complex due diligence on investment opportunities when ESG factors are in play. They’ll also need reliable access to accurate data to track and report on ESG initiatives. Firms that overcome these challenges have the opportunity to create long-term value.
The legal operating system for private equity
Private fund managers can’t easily solve all the private equity industry’s challenges. However, there’s a clear path forward with industry-specific legal technology.
Ontra continues to expand its Legal Operating System, now also powered by OpenAI’s GPT-4, to support, accelerate, and automate private fund managers’ legal workflows. With AI purpose-built for private equity, private fund managers can decrease the time spent on repetitive tasks and turn their focus toward more complex problems.
