Navigating trade tensions and tax reform, heightened competition for new deals and preparations for an impending market correction are the top issues facing private equity fund managers, according to BDO’s Tenth Annual Private Equity PErspective Survey. In fact, 89 percent of private equity fund managers expect a prolonged downturn sometime in the next two years. Over one-fifth (22 percent) anticipate a market correction in the next 6-12 months. Meanwhile, more than two-thirds (67 percent) anticipate a market correction in the next 1-2 years.

Whether the next recession comes tomorrow or in two years, private equity firms are proactively taking steps to shore up their portfolios for potential economic headwinds. To prepare for a downturn, 70 percent of survey respondents are being more selective when evaluating highly valued deals, although strong deal activity indicates that investors are still eager to deploy capital. Concurrently, 14 percent are holding their current investments for longer periods, and just 8 percent are exiting current investments.

“Data suggests that there’s a shift underway in private equity, with valuations at historic highs and competition for a limited number of quality deals driving up purchase prices,” said Scott Hendon, National Private Equity Industry Group Leader at BDO. “A confluence of economic factors leads us to believe a market correction may be coming and to expect valuations to be tested as buyers get less aggressive on cyclical assets.”

In a competitive environment, dependable sources of deal flow are more vital than ever before. Private company sales/capital raises are the most cited drivers of deal flow in the next 12 months, noted by almost two-thirds of respondents (61 percent)—a seven percentage point decrease from last year but up substantially from the year prior. PE exits are the second-most-cited at 21 percent, relatively consistent with projections from the past two years.

Competition for new deals in middle market private equity is getting significantly tougher. Over the next 12 months, survey respondents said the most competition for middle market deals will come from other private equity firms (83 percent), followed by strategics (11 percent), surprisingly lower than expected. While strategic buyers continue to bid up prices, middle market PE peers are multiplying and, at the same time, bulge-bracket PE firms are moving downward.

Over the next 12 months, the overwhelming majority (89 percent) of firms will direct the most capital toward new deals, putting on the backburner add-on acquisitions and de-leveraging portfolio company balance sheets. Funding portfolio working capital needs is also not a top priority compared to the hunt for new deals.

Additional findings from the Tenth Annual Private Equity PErspective Survey include:

• Views on the Trump Administration’s Policies: Forty-five percent of survey respondents say the policies of the Trump administration are likely to increase investor interest in private capital. Twenty-two percent expect exit multiples and the environment to decline due to the Trump administration’s policies, compared to 18 percent anticipating the opposite. 
• Trade Tensions Are the Biggest Political Concern: Reflecting the major impact of tariffs and the proposed agreement to replace NAFTA, trade is overwhelmingly (50 percent) the biggest concern among global political issues for private equity fund managers. Trailing far behind is the U.S. presidential administration (18 percent) and Brexit uncertainty (12 percent). 
• Top Regulatory Concerns: This year, tax reform is private equity firms’ chief regulatory concern, cited by 21 percent of survey respondents. The Affordable Care Act also ranks high on the list of regulatory concerns, selected by 20 percent of the PE fund managers surveyed. The pressure to retain talent with competitive healthcare programs and the political uncertainty around mandatory benefits coverage by employers are also dominating the regulatory landscape for PE executives. 
• Industry Outlook: Healthcare & biotech (22 percent) and tech (24 percent) are the middle-market sectors most likely to experience increasing deal activity during the next 12 months, according to survey respondents. Retail & distribution (20 percent) and real estate (19 percent) are the middle-market sectors most likely to experience decreasingly deal activity during the next 12 months. 
• Uses of Proceeds from Debt: Other than to fund acquisitions, nearly a third of survey respondents said they're using proceeds from debt towards dividend recaps (30 percent). However, fewer are opting to improve the balance sheet by refinancing debt (14 percent) or investing in operational improvements (17 percent). Fifteen percent are not planning to increase any of their portfolio's leverage. Just under one-quarter of survey respondents (23 percent) say they're using proceeds from debt to fund add-on acquisitions. 
• Understanding Evolving GP/LP Dynamics: To improve their relationships with LPs, most respondents report taking steps to improve reporting transparency and fee disclosures (44 percent) or offering alternative investment structures such as co-investments or separate managed accounts (40 percent). Fund managers believe the management team (20 percent) and track record (29 percent) are the most important factors for LPs when evaluating GPs in today's environment. Operating experience (13 percent) and investment focus (11 percent) are also believed to be important, but slightly less so. 
• International Investment Remains Strong: Outside of North America, continental Europe is considered the most attractive region for investment (45 percent) in the next 12 months, with Asia coming in second (27 percent). South and Central America follows at 14 percent, with Eastern Europe (9 percent) and the Middle East and Africa (5 percent) trailing behind as key regions for investment in the next year.

The BDO Tenth Annual Private Equity PErspective Survey is an international survey of more than 75 senior executives at private equity firms in the U.S. and internationally. The survey is administered by PitchBook, an independent and impartial research firm dedicated to providing premium data, news and analysis to the private equity industry.