The report shows that the bulk of managers expect a downturn in the next two years.

A new BDO report U.S. Private Capital Outlook explores the preparations of venture capital and private equity firms ahead of a projected downturn. The report replaces and expands on BDO’s report, Private Equity Perspective Survey.

More than half of fund managers (50% of PE respondents and 54% of VC respondents) say they are being more selective when evaluating highly valued deals. The reason: They’re waiting for the other shoe to drop on the economy.

Ten-plus years into a bull market, 72% of private equity funds expect an economic downturn within two years. The venture capital industry is slightly more optimistic about timing. Just over half (56%) anticipate a downturn to hit within the next two years. However, that a bear market is coming is a foregone conclusion: 92% of PE and 87% of VC respondents expect a downturn to occur within four years—less than the length of most investment holding periods.

How VC and PE Managers Have Prepared

As they gear up for a potential slowdown, fund managers are shifting their capital allocation strategies. The BDO report says 28% of PE respondents will be directing the most capital toward funding portfolio working capital needs over the next 12 months. This is up from less than 1% a year ag when the vast majority directed the most capital toward new deals. A greater percentage of VC fund managers—41%—will be dedicating the most capital toward portfolio working capital needs.

The survey also found that 30% of PE respondents and 20% of VC respondents are looking to exit current investments. That percentage rises to 36% of PE respondents and 21% of VC respondents among those anticipating a downturn to hit within two years.

“Expecting economic contraction has sent private equity and venture capital to the markets in droves as they look for liquidity to strengthen their stockpiles during a down economy,” said Scott Hendon, National Private Equity Industry Group Leader at BDO. “With funds chasing the same types of downturn-proof investments, competition has been unbridled, sending valuations to historic levels. Though we expect this trend to continue, we are seeing private capital funds deploying more creative ways to put their capital to use.”

BDO Report: Retreating to defensive strongholds and downturn-proof sectors 

With downturn-proofing underpinning their strategies, both PE and VC are on the lookout for investments with secular trends behind them and are relatively aligned on where the best opportunities lie. Fund managers anticipate the technology, financial services, and natural resources industries will see the greatest increase in deal activity.

But technology clearly reigns as the hottest sector, with 54% of PE and 51% of VC identifying it as most likely to experience increasing deal activity. Within tech, the areas of greatest interest for investment are 5G, artificial intelligence (AI), and the Internet of Things (IoT).

The biggest drivers of deal flow are anticipated to be private company sales and capital raises (52% of PE respondents and 42% of VC), public-to-private transactions (47% of PE respondents and 39% of VC), and distressed businesses (40% of PE respondents and 39% of VC).

Increasing competition from an evolving competitor set 

Both PE and VC respondents rank increased competition from other buyers as the most significant challenge to closing new deals (27% and 24%, respectively), followed by gaps between buyer and seller valuation expectations (21% and 23%, respectively).

PE respondents also anticipate the majority of competition over the next 12 months will come from strategic buyers (41%), with peer PE firms ranking third (26%) behind hedge or mutual funds (36%). Meanwhile, venture capital professionals cite hedge or mutual funds (43%), strategic buyers (34%), and other VC firms (28%) as their top competition for deals. 

Challenges and opportunities in geopolitical uncertainty 

Meanwhile, amid ongoing trade turbulence, trade issues top the list of geopolitical concerns for both private equity (30%) and venture capital (21%), followed by concerns about the U.S. presidential administration (24% and 18%, respectively).

But trade tensions may be creating opportunity: For both PE (30%) and VC (29%), Asia is the geographic region, aside from North America, that presents the greatest opportunity for new investment. The region replaces Continental Europe (16% for PE, and 22% for VC), which had been the first choice for PE for the past two years of BDO’s survey at 45% in the prior survey, and 37% the year before that.

“Right now, Southeast Asia is one of the largest growing middle-class economies in the world. India, Indonesia, and the Philippines, though experiencing political struggles, represent strong opportunities to diversify away from China, and are attracting global investment,” stated Lee Duran, Assurance Partner and a leader in BDO’s Private Equity and Venture Capital practice. “Greater interest in other emerging economies is becoming a reality given the U.S.-China trade war.”

BDO Report: Managers and the Election

Looking ahead to the U.S. presidential election, 51% of private equity professionals and 30% of venture capital executives surveyed say investor interest in private capital would increase under the policies of a Republican president. By contrast, 46% of private equity professionals and 37% of venture capital professionals surveyed indicate investor interest in private capital would increase under a Democrat president.

However, both PE and VC see greater returns under a Democrat in office: 34% of PE and 29% of VC professionals surveyed expect exit multiples and the deal environment to improve under a Democrat, compared to 30% and 28%, respectively, under a Republican.

Related: Goldman’s Private Equity Clients All Fear a Recession