Private equity: rise or fall?
October 06, 2025
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3 min
There has been a lot of press lately about diminishing returns in private equity and too much money flooding in. How do you combat these risks?
Most of the capital continues to flow to the larger funds and then those funds keep getting bigger. So, the problem is you have much more capital on the larger end of private equity, but the investment opportunity set for the number of companies on the larger end continues to be fairly limited. So, you naturally have a situation where these larger funds are bidding up entry, valuation multiples and putting on more leverage. And this impacts the overall returns, but also makes these companies more susceptible to industry downturns because of the higher leverage.
And that's why at Flexstone Partners, we've always focused on the lower middle market where the amount of capital raised is lower, and the opportunity set of number of small companies to invest in is very vast. And in addition, you have three things going for you on the lower end.
- One: you have lower entry valuations.
- Two: you have a better opportunity to add value post-investment because these are smaller companies and less sophisticated than their larger counterparts.
- Three: you have a much broader exit opportunity set because as these companies grow, they make great acquisition candidates for either strategic buyers or larger private equity funds, and you don't have to rely on the public markets or the most liquid credit markets to exit as you do on the larger end.
Exits seem to be tougher in private equity. What is your strategy to find successful exits to your investments at Flexstone? Has it changed over the years?
So overall, the exit activity is down, and especially if you compare it to the 2021 and 2022 levels. But those years, I would say were a bit of an anomaly coming out of COVID. Now in the last few years, there's been higher interest rates, higher inflation, macro and geopolitical uncertainty. So, all of that's led to investors being more cautious in deploying capital, which has led to lower valuation multiples than what we had back in the 2021 and 2022 timeframe. And in turn, this has led to private equity funds holding onto their portfolio companies longer in hopes of getting the same higher multiple on exit as what they paid a few years ago.
At Flexstone, we've had good exit activity this year, and I would say that's a function of:
- One: investing in the lower middle market where deal volume has been a lot less impacted relative to the larger end.
- Two: is our investment selection, which continues to be highly, highly selective.
- Three: is that we build portfolios that are highly diversified by vintage, by number of investments and by industry sector. So, this helps to mitigate the overall macro noise that you see in the market and that may impact certain industries more so than others.
- And four: as I mentioned, these smaller companies have more exit alternatives relative to their larger ones, given their smaller size and ability for an acquirer to pull off a transaction even when markets might be tight because it doesn't require that much debt. And there are many more eligible buyers and exit routes that they have relative to the larger end of private equity.
Why are continuation funds gaining in popularity and are there any drawbacks or risks investors should be aware of?
I think continuation funds are here to stay. This isn't a temporary phenomenon. There's been significant capital raised by secondary funds for the continuation fund strategy, and we're now seeing even primary funds raise capital for this same strategy.
Now, this continuation fund strategy gives sellers an additional avenue to generate liquidity when it may not be possible to sell a company. They're gaining in popularity because initially, GPs were only putting their best investments into these vehicles because they were rolling a lot of their carry or GP profits and investing from their new fund into these same vehicles. So, they needed to have high conviction on the future success of these investments. And also, the private equity funds already know these companies and management teams really well. They've been existing investments, so the risk is a lot lower.
On the other hand, the drawback here is that continuation vehicles don't always maximise exit valuation in the sense that if these companies are trophy assets for the private equity fund, then why not just hold onto them for a bit longer and then go through a robust auction process where you would potentially have strategics or other private equity funds interested in buying the business.
Now, we've seen plenty of continuation funds marked up within a very short period of time after they were created. So, you really question whether you get the best value if you're the selling LP, but you do get the liquidity though.
There is an increasing push to allow retail investors to access private equity, but also criticisms that returns and quality of investments are suffering in this move. How do you combat this?
I think the quality can be maintained for retail investors, but for that, they have to have the capacity or an advisor to do the homework when investing in private equity funds because while median returns and private equity have been strong, there is a bigger delta between top quartile and bottom quartile in private equity versus in other asset classes. So retail investors and their advisors have to look at a private equity fund's prior track record, the team's expertise, investing in the same strategy that they say they're focusing on now, make sure it's the same team investing today as the one that generated the prior track record and make sure the private equity fund that they're investing in builds a diversified portfolio that can weather different market cycles.
What new developments in the private equity industry are you particularly excited about?
In terms of new investments, AI is obviously the one that has been front and center of discussions.
And here I'm not talking about investing in AI companies or VC and growth companies because we don't do that. I'll leave that to the VC funds. But across middle market companies, I believe we've barely scratched the surface of AI implementation. What's very exciting is as AI use cases evolve and companies begin to implement AI into their operation, there's a potential to unlock significant amount of productivity that could really drive top line growth and margins across small and middle market companies. This can drive a lot of value for all stakeholders. At the same time, these small and middle market business owners will look to partner with private equity funds to help them navigate this complexity.