Denice R. Preston
The global situation for private equity by 2020 has become complicated and mainly due to a recession in the economy during the first quarter. Numerous businesses are on the edge of collapse. What are the most pressing issues for private equity funds in these turbulent times?
The global state of private equity for 2020 has become complicated primarily because of the economic contraction that has been accelerating since the last quarter. The experts predict a prolonged recession that will see the economies slowly rebounding between 2021-2022. The consumer’s income has been dramatically affected, and many companies are in danger of destruction. What are the most significant issues private equity funds face in these challenging times?
Private Equity Has Evolved Since the 2008 Financial Crisis
In the recession of 2008 following the financial crisis, Private equity funds were in no position to benefit from buying opportunities because the value of assets fell. The situation today is fundamentally different. In 2007-09 the real economy was impacted by a tightening in credit due to excessive risk-taking in the financial industry. However, in 2020, consumer demand has diminished, which has caused a demand-driven recession that has impacted the economy. The impact of private equity funds is due to their portfolios rather than the excessive leverage causing the well-known “refi-cliff.”
Since the last recession, the market has changed. Funds have grown and attracted new sophisticated investors, who have enhanced their capacity to weather the effects of a recession. However, several years of monetary policy expansion and, consequently, the desire for yields have given the sector unprecedented quantities of capital available, known as “dry powder,” which is, in turn, pushing upwards the demand for targeted companies. The increased demand for money has led to valuations to a high level which has led to the necessity of efficient management of portfolios and efficiency within the fund as well as in the portfolio businesses. In addition, the whole sector has grown and diversified in sophistication, thanks to the rise of private credit funds, venture capital funds, and distressed funds that can help companies at different stages and with other financial circumstances. The increased sophistication has led many traditional PE investors to a greater degree of discipline, efficiency, and sector specification. In light of this massive change in the industry, greater regulatory oversight, macroeconomic uncertainty, and years of depressed yields and interest rates, What is the outlook for the private equity industry expected to do?
One thing is sure – funds that can achieve the highest level of financial and operational excellence and are well-positioned to undergo rapid change can overcome headwinds and profit from the opportunities that arise naturally from a crisis. Flexibility and rigor are the key factors to success in private equity. This is why we will be looking more closely at macro trends rather than an analysis of numbers – forecasting from a single outlier isn’t reliable for predicting future trends.
What Did the Industry Expect Before COVID-19?
Before COVID-19, specific apparent trends were emerging in PE. Funds were getting more prominent as they grew, and the rise of so-called “mega-funds” – the average fund has reached $1 billion. Exits decreased, particularly those made through IPOs or secondaries (sales of Private equity funds into another). Another trend in the direction of consolidation. Smaller companies can attract a significant portion of the capital pumped into LPs. The winners include firms such as Apollo, KKR, Platinum Equity, and Warburg Pincus. The amount of money raised was close to all-time highs, which has put more pressure on funds to use their dry powder promptly.
A Recession Was Already on the Cards
As 2020 loomed and the financial world was looking forward to a recession caused by geopolitical tensions around the world, the impact of Brexit, and the slowdown in Chinese growth. But, not many were prepared for the scale COVID-19 brought. Private equity investors were beginning to change their behavior in line with COVID-19, and the number of deals was reduced in 2019. But the decrease was partially offset by increasing pressure to invest due to the massive amount of capital raised in previous years. Ultimately, the circumstances stress performance, requiring the funds to focus on operational and financial excellence to maintain returns.
Deal Multiples Kept Increasing and Were on Track for All-time Highs
The high deal-valued multiples can be hazardous in the world of private equity. On the bright side, they can have an effect that improves the value of companies that are already part of the portfolio while sustaining mark-to-market valuations and creating a favorable atmosphere for profitable exits. According to data compiled by Bain, Multiple expansion is responsible for a significant portion of the value private equity funds made for their investors over the past ten years.
Pooled Enterprise Value for US and Western European Buyouts 2010-2019
The flip side is that transactions with higher valuations (and therefore more multiples) are likely to have less likelihood of ever-increasing at the same rate as their initial value. The funds are left with two potential sources of return growing revenue and EBITDA margin growth (in other words, improved efficiency in operation and cost reduction). Since recessions can hinder sales growth and margin expansion, revenue and efficiency improvement are brought to the top of management teams’ priorities. Deal multiples were expected to be at a post-crisis peak during the 2nd quarter of 2019.
Share of US Leveraged Buyout Market, by Leverage Level
As deal multiples grew, so did the leverage applied to each transaction. It has now surpassed levels before the financial crisis. At the time, there was a fear of what is known as the refi-cliff as the massive volume of leveraged Buyout (LBO) debt that was coming to maturity as banks faced huge deficits in their balance sheets and the syndicated lending market ended. A new trend in the private market, such as the development of debt-based private funds, has eased the pressures in this sector, providing LBO patrons with new ways of accessing credit. This market gained prominence when banks were compelled to eliminate risk from the balance sheet. The private market investors joined the market with credit-based vehicles, often in the same category as private equity funds. The market has seen rapid growth since it reached over $800 billion of total assets managed in 2019.
What Happens Now for Private Equity?
Private equity funds can operate flexibly and efficiently to help the portfolio company, strategically pick the sectors they are invested in and take advantage of fiscal and monetary ease. The reduction in multiples will position them for success or, at the very least, increase their capacity to withstand.
Is the Pandemic a Supply or Demand Shock?
Supply and demand shocks are distinct. The term “supply shock” refers to an unanticipated event that alters the availability of a good or commodity in any direction, like an interruption to the distribution and supply chain. In contrast, demand shock refers to an unexpected change in the demand aspect (a natural catastrophe or terrorist attack is a good example).
COVID-19 is unique in that it has created a supply and demand shock at the same time. The restrictions on the movement of factories and goods working at lower capacity have impacted the supply side Lockdowns and widespread unemployment have affected the demand side. As per the economists David Baqaee of UCLA and Emmanuel Farhi of Harvard, “Both cuts in demand and supply lower real GDP. But distinguishing the supply and demand issues is crucial for policymakers because both require different strategies.”
The options for each aspect could cause problems for the other. For instance, lowering interest rates to boost demand can cause problems with supply due to shortages and high inflation.
