Is private equity becoming riskier?

A burst of financial innovation is designed to boost distributions. But private equity investors don’t need to take undue risks to access liquidity

Some private equity investors are scratching their heads over recent data emanating from the industry. Liquidity has become scarcer, average leverage levels have risen and portfolio company valuations are advancing more sluggishly.

In response, private equity managers have introduced a raft of innovations, including NAV-lending, continuation funds, retail-focused funds and greater use of secondary market transactions.

It is possible, then, to believe that this is an industry where risks are rising and returns are falling. But is this an accurate reflection of the current state of private equity?

“You can’t paint the whole of private equity industry with the same brush,” says Nitin Gupta, US Managing Partner at Flexstone Partners, an affiliate of Natixis Investment Managers. “It is definitely not the case that the industry as a whole is riskier.”

It is the case though, he argues, that investors really have to do their homework, in particular around manager selection, if they want to avoid managers that are engaging in riskier practices. “In that respect, nothing has changed,” Nitin adds. He believes that more value-add levers and ability to generate potential higher returns can be found in smaller companies and in smaller funds.

Rising competition, rising leverage, falling liquidity

Private equity is being challenged by higher inflation and interest rates (while they are lower than a couple of years ago), in tandem with macro and geopolitical uncertainty. Portfolio growth has slowed and leverage levels have risen as private equity managers seek to boost returns.

At the same time, managers are holding onto portfolio companies longer in the hope of getting a higher valuation at exit through multiple expansion or if that’s not possible then hoping the company at least grows into the valuation that they are carrying on their books. This acts as a squeeze on liquidity with mostly A assets (or best assets) trading, and limiting distributions to investors.

This squeeze on liquidity is, to an extent, a hidden issue. After all, exit volumes in dollar terms were up 40% in 2025. But those volumes, healthy as they appear, were actually underpinned by a small number of very large transactions. The predominance of very large transactions is almost inevitable in an environment where supersize funds now attract nearly half of all capital into private equity vehicles.¹

The number of exits, however, has actually fallen and distributions to the average investor have declined. Historically, investors receive 20%–25% of Net Asset Value (NAV) back every year. In 2021, post-COVID, that number spiked to around 34%. But since then, distributions have fallen to 12%–14%, which is less than half the historical norm.²

A further challenge to the health of the private equity industry is the proliferation of funds aimed at wholesale and retail channels. These funds add to available cash piles and serve to bid up prices.

“Evergreen” (or open-ended) wholesale and retail funds also need to deploy faster than closed-ended funds to avoid cash drag. This leads to a greater velocity of deal activity, particularly in the secondaries space, which has increased competition and prices in secondaries markets.

The proliferation of financial innovation

Private equity managers have responded to the challenges with financial innovation, chiefly designed to boost distributions and thereby facilitate follow-on fundraising.

Continuation funds, for one, are now a well-established option. Continuation funds consist in new funds in which selected assets are being transferred from an existing fund approaching maturity. These funds can offer liquidity to investors who decide to cash out from the first fund, while allowing managers (and investors too, if they choose to roll) to maintain ownership of trophy assets they know and like.

Continuation vehicles currently represent some 50% of exits or $116 bn across the industry — a dramatic rise from approximately $30 bn just five years ago.³

“There is no particular issue with using continuation funds, but if continuation fund exits represent the vast majority of your divestments, then it does become an issue because these are typically done at a discount to current NAV,” says Nitin. “If you are adding value to your portfolio companies and they are generating good margins and cash flows, then traditional exits to strategic buyers or outright private equity buyers should occur at or above NAV.”

Other widely-employed tools include dividend recaps, whereby high-performing portfolio companies take out loans to fund a special dividend payment to the manager and its investors. This allows the manager to realise some return from its investment before full divestment, and to provide liquidity to investors without them having to sell their stakes in high-performing assets.

This has been a successful strategy because lending markets have been buoyant amid Fed rates coming down and the growth of private credit. So credit spreads are relatively low.

“Dividend recaps are not a bad tool on the whole,” says Nitin. “But it depends how much leverage is put onto the individual company. If leverage levels are benign then it’s fine, you are just taking risk off the table and that makes sense.”

NAV lending is a different story. NAV lending is more controversial given that managers borrow capital secured against the collective value of their portfolios.

“NAV lending is not the best innovation in our opinion,” says Nitin. “It is a form of cross-collateralisation and is riskier than other financial innovations. If managers are aggressively using NAV financing then they are adding a lot of unnecessary risk to their portfolio and investors should evaluate whether that’s someone they want to back next time they are fundraising.”

The mid market: lower competition, lower risks

While risks across the industry may be rising, it is not necessary for investors to assume any risks they are not comfortable with in order to generate liquidity. “We are careful as allocators to pick and choose those funds that we believe can be strong performers without taking on unnecessary risk,” says Nitin. Flexstone applies the same logic when committing to co-investments, ie investing not into funds, but directly into companies alongside another manager.

Flexstone avoids excessive leverage and over-competition/higher valuations for assets by allocating solely to lower mid-market funds.

“We invest in funds or co-investments that take stakes in smaller everyday businesses,” Nitin says. “We don’t play in the large-cap space where there is a lot more capital chasing fewer opportunities and high leverage and which is more exposed to the technology sector. We are more conservative in how we underwrite our funds and deals.  We are very focused on creating diversified portfolios across various end markets and the tech sector has always been a very small exposure for us”

At the lower end of the size spectrum, entry valuations are lower and there is more opportunity to add value through operational improvements.

There is also a broader exit opportunity because smaller growth companies make attractive acquisition candidates for both strategic buyers and larger private equity funds.

This means smaller- and mid-cap managers don't rely on scarce Initial Public Offerings (IPOs, companies becoming listed on exchanges) or best liquid credit markets to exit dealflow.

Know your managers and access opportunities

Flexstone has leveraged its long-held expertise in the lower mid-cap space by creating an emerging managers programme, where it allocates to newly-formed managers that have raised no more than one, two or three funds.

Based on Flexstone’s analysis of 25-30 years of data, emerging private equity managers tend to outperform more established managers. This runs contrary to popular thought that the biggest funds have superior performance over time.

Emerging managers outperform, Flexstone believes, because the managers have more “skin in the game”. That is, they manage smaller funds and aren’t making bulk of their economics on annual management fees. Their compensation is therefore more correlated to the performance of portfolio companies upon a sale.

The deals tend to be smaller in this segment of the market and, as a result, valuations are better and operating inefficiencies higher.  Nitin says: “There are many ways to improve these companies”. Areas ripe for improvement include operating expenses, procurement, human resources and access to financial markets.

In addition, private equity owners can make capital injections to upgrade technology infrastructure across their portfolio companies, installing Enterprise Resource Planning systems and AI tools to make companies more competitive.

The small size of portfolio companies in emerging managers funds also allows for a greater proportion of strategic sales (ie sales to another market player, typically a larger competitor looking to consolidate), or sale to larger private equity funds, which shortens the hold period before an exit and meets the requirements of investors looking for regular distributions.

Keep calm and carry on

Overall, while innovation in private equity is generally to be welcomed, investors must exercise caution. More than ever, relying on an expert manager with close and established relations with other fund managers across the globe, is of great help to navigate the ever evolving and highly technical private equity landscape.  There continues to be a wide performance gap between top and bottom quartile managers, so manager selection remains key.

“Innovation is important to meet new challenges,” says Nitin. “But if managers rely wholly on innovative financial techniques, then we consider that a red flag.”

Most investors allocate to private equity for the same reasons now as in the past – gaining exposure to a diversified portfolio of growing companies with great products and low levels of debt. “Those kinds of companies will always find buyers, so there is no reason to take additional risk,” Nitin adds.