Private equity will still outperform public markets in the next recession
In recent months, we have seen a reset in U.S. public markets on the back of inflationary pressures, rising rates, and geopolitical uncertainties. There is discussion of a looming recession, and markets seem to still be searching for the bottom.
This correction has given rise to concerns over private equity managers who acquired at lofty valuations. According to LCD data analyzed by Bain Capital, buyout multiples in the U.S. and Europe were around 12x. As rates and inflation continue to rise, PE firms invested at those levels could soon feel the pinch. In our mind, while economic uncertainty will have an impact, it also serves as a reminder of how important it is to pick good managers. Times like these further illustrate the importance of disciplined investing based on potential value creation programs and long-term value. The high-valuation environment over the last couple of years will likely impact PE managers who have deployed capital with looser selection criteria, focusing on the potential for multiple expansions and trading off the quality of underlying companies for short-term returns. But historically, it’s in times like these that private equity outperforms public markets the most.
Data from academics and various providers analyzing PE returns historically shows that PE outperforms public markets throughout business cycles, with the internal rate of return (IRR) picking up considerably following recessions. Our analysis shows that deals from top-quartile vintages raised around the global financial crisis generated a 61% IRR. By contrast, the S&P 500's annual return in 2008 was -38%. The overall outperformance of PE, when compared to public markets, is usually attributed to three drivers: Valuations Funds can invest in companies at lower valuations, leaving more room to expand multiples after recovery and generating more opportunities. Apart from room for multiple expansion, lower multiples allow for funds and their portfolio companies to acquire smaller competitors that complement existing platform investments at lower, sometimes distressed valuations. Capital PE has better access to capital and deploys it more flexibly, allowing portfolio companies to seize growth opportunities in a crisis while competitors may be rolling out austerity measures. Flexible access to capital in downturns can be essential to prevent bankruptcies. While defaults of individual businesses do go up during recessions, research by Hamilton Lane suggests that the risk of “catastrophic loss” (defined as a 70% or greater decline in peak value with minimal recovery) is less than half for PE-backed companies compared to public companies.
One study of almost 500 PE-backed companies in the U.K. during the 2008 financial crisis found that these companies recovered faster from the crisis and captured more market share relative to their comparable non-PE competitors. Active management Large funds’ active management approach and operational support give PE-backed businesses a competitive advantage as they respond to crises more quickly. While CEOs of public companies generally report to their board of directors only once a quarter, and owner-managers have to rely on their own resources, global top-tier PE funds actively support the management of their portfolio businesses in multiple ways. There is usually close contact between company management and the fund manager and advisors.
Some PE funds hold board meetings or management workshops monthly, and typically the CEO and GPs would have a weekly call to discuss affairs. In times of crisis, this frequency could increase. There is usually significant outside expertise that portfolio companies can take advantage of. The best funds retain senior advisors who join the boards of various portfolio companies. These advisors are typically experienced former CEOs and make their time, knowledge, and network available to the portfolio company. Most funds also offer a lot of operational support to portfolio companies.
This entails helping businesses develop new capabilities and manage transformation programs. Hard-to-access expertise in areas such as information technology, data and analytics, digital, and new market entry, is where funds’ operational teams provide particular value. This proved very efficient for PE-backed companies to navigate through the most recent COVID-19 crisis. A recent study by McKinsey found that operational teams have a significant impact on funds performance, particularly in post-recession era vintages. With multiples correcting, we expect to see managers adapting to the new environment. Growth funds, in our view, will place a higher investment focus on earlier-stage companies, while actively managing existing portfolios and performing add-on acquisitions.
Given the underlying growth of both the portfolio companies and the technology market as a whole, the growth strategies of PE funds are inherently resilient to market correction. In light of this, we believe the question is not if managers and funds can generate target returns, but when. Pavel Ermoline is an investment manager at Moonfare.
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