How private equity continues to outperform during economic downturns

Value of US buyouts compared to the S&P 500 from Q3 2007

COVID-19 has not disrupted the industry as much as the previous recessions did, with a 4% decrease in fundraising during H1 2020. In fact, 46% of general partners (GPs) in Europe believe that in the next 6-12 months investing opportunities will be stronger than in 2019 primarily due to corporate spin-offs. Whilst COVID-19 has limited returns for private equity firms, the impact has not been as significant as the recessions in 2000 and in 2007-2009. During H1 2020, private equity backed deals have dominated M&A, capturing the largest proportion of M&A activity in 13 years.

The outperformance of private equity during downturns is due to the fact they have other opportunities that are not available in public markets. Private markets are protected from the public and they can change and create value during these downturns, hence increasing returns. Moreover, recessions are considered to present new opportunities for various business sectors and private equity firms can capitalise on this by using their vast sums of dry powder and investing for long term goals without being hindered by the effects of recessions on market sentiment in public markets. Private equity’s illiquid structure can also provide benefits during downturns as it prevents investors from panic selling, stopping them from liquidating their holdings below market value. This strengthens the hypothesis that PE-backed firms can act as stabilisers during recessions.

Since the previous recession, the PE industry has expanded greatly with assets under management (AUM) expected to hit $5tn by 2023 (Preqin). But these changes are not only significant to what is currently happening in the industry, but also to how the industry will react to the next economic downturn. The first major difference is the abundance of capital which has accumulated as private equity has become more attractive; this attractiveness can be partially attributed to the rise in shadow capital. Lending to PE backed companies was generally underwritten by banks but today there is an increasing amount of debt being provided directly by private credit, in a process called “disintermediating the banking market”. The build-up in dry powder allows for capital to be invested far quicker and to a wider range of necessities. Moreover, there has been a shift in sector participation with PE firms turning to resilient, non-cyclical industries. These more resilient sectors include technology, which has seen $181bn invested into it by PE since the start of 2018 – more than double the ‘vulnerable’ sectors of retail and energy combined. Companies have also learned from previous downturns of the necessity for working capital and, therefore, are improving flexibility into their funding and working capital metrics (EY).

The Increasing Resilience of the PE Industry:

The PE industry is much more resilient now than it was going into the Global Financial Crisis. There are four main positive differences to note:

1. Stronger liquidity and deal activity: Fundraising and execution levels are far greater than they were a decade ago, illustrating that the PE industry environment is active and healthy. The top players in the industry have raised funds at consistent 1–2-year intervals since the financial crisis and the top five firms raised $100bn in 2017 and 2018 (BCG). Mega funds have contributed the most to this increase in fundraising activity, accounting for 40% of the total value in 2018 (BCG). Dry powder levels have risen simultaneously, reaching $1tn in 2018 (Preqin). The private equity industry is about selecting the right companies, and productive selection of companies is growing – from 2013-2018, investment deployment rose at an average compound annual rate of 10% (BCG). The increase in investment deployment and fundraising displays risks related to rising valuations and debt leverage levels. However, they are expected in a finance climate characterised by high fundraising and low interest rates.
2. Portfolio components are more recession-proof: Before the Global Financial Crisis, private equity performance was cyclical. Between 2005 and 2007, cyclical industries represented 25% of buyout deals in the top 10 PE firms. Nowadays, PE firms are much less exposed to cyclical swings as they have invested a greater share of their funds into technology related sectors – which are less sensitive to economic swings – almost halving their percentage of investments in cyclical industries. When reshuffling their portfolios, PE firms did not have cyclicality as their reasoning for doing so, however their efforts to take advantage of growing sectors and limit volatility reflects that they have tried to assess potential downturn impacts in their return expectations.