Private equity (PE) has demonstrated an ability to outperform public equities during recessions. The reason for this is relatively straightforward: For PE firms, a downturn represents opportunity. They can plan and invest over the long term, enabling them to deploy capital at more attractive terms, and make bold, calculated moves without being hamstrung by the short-termism that afflicts so many public companies. This ability to take a long view confers some important advantages.
Hands-on approach to managing portfolio companies
PE managers have an asymmetric information advantage over public market investors and, often, access to a deep bench of talent that enables them to pivot their approach during downturns to help their companies successfully weather the storm. In particular, they can use available dry powder to alleviate a company’s financing concerns, as well as help them renegotiate loan terms and debt obligations.
Similarly, PE firms can take a buy-and-build approach to consolidate a sector, using the same dry powder to make add-on acquisitions at a time when purchase price multiples are low. This can be particularly effective in down markets because public companies tend to retrench and avoid making investments during these periods, creating opportunities for private companies to gain the upper hand. PE managers are also often sector specialists, owning companies within a specific industry over multiple economic cycles. They are, therefore, well-equipped to identify difficulties early on as well as the best path forward.
A recent Harvard-backed study that focuses on the period around the Global Financial Crisis (GFC) confirmed that PE-backed companies are generally more resilient to downturns and can act as an economic stabilizer during a recession.1 In the study, PE-backed companies were found to be less likely to face financial constraints during the GFC, allowing them to grow and increase market share versus their peers. PE firms were also found to have been significantly more likely to assist portfolio companies with their operating problems and provide strategic guidance during the crisis. In fact, PE-backed companies invested 6% more and gained 8% market share versus their non-PE-backed peers during the GFC. As a result, PE-backed companies were 30% more likely to be acquired in the period post-crisis, with a greater potential for a profitable exit.
The same study also showed that, in the years immediately following the GFC, loans to PE-backed companies were about 50% more likely to be renegotiated than those to non- PE backed companies (Exhibit 1). This points to PE firms being able to leverage their existing banking relationships to access credit for their portfolio even when market liquidity is limited. It also demonstrates PE managers’ active approach to assisting their companies to raise debt financing, interacting with intermediaries on financial structure and, in some cases, even buying back the debt obligations of their portfolio companies.
Exhibit 1:
Ability to exploit the benefits of illiquidity
While it may seem paradoxical, private equity’s illiquid nature is an advantage in a recession, as it insulates investors from panic selling during the depths of a downturn. Panic selling almost always comes at a high cost, as investors often liquidate their holdings for below-market value (in fear of values declining even further). Meanwhile, PE managers have the benefit of a multi-year holding period, with the ability to patiently wait for more welcoming market conditions to exit their underlying portfolio companies. PE’s illiquid structure also renders PE’s correlation with the broader public markets of less importance, as the decision to exit an investment is put in the hands of professional managers who are closest to the underlying asset.
Given PE’s inherent attributes — a long-term investment philosophy, highly active involvement with portfolio companies, and fund structures that prevent fire sales — there is much for its investors to embrace across all market environments, but particularly in the face of market stress.
A previous blog examined PE’s performance versus public markets during recessions. For more information on this topic, download our white paper, Private Equity Offers Resilience in a Downturn.
1) Bernstein, Lerner, Mezzanotti, "Private Equity and Financial Fragility during the Crisis," January 2018. Study focuses on the UK market (largest PE market as share of GDP pre-crisis). Similar financial data is not publicly available in the U.S.
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