We may be in "unprecedented times" due to the pandemic and current worldwide events, but it seems likely we'll soon find ourselves in a familiar situation: recession. Recessions pose considerable challenges for both private and public equity, but taking a look at lessons learned during previous economic downturns within the last 20 years can provide insight. To learn how to better navigate the choppy waters of private equity during a recession, let's first turn our attention to history.
Since the turn of the millennium, private equity has experienced two major recessions: the dot-combust in the early 2000s and the economic crisis of 2007 - 2009 (also known as the Great Recession). While public and private companies alike felt the squeeze of the downturn, the industries did not experience the recessions in the same way.
For instance, the largest point drop in history (previous to the COVID-19 pandemic) for the Dow Jones "777.68 points "occurred on September 29th, 2008. But, as we are able to see now, the private equity market didn't experience as drastic a crash. According to iCapital, fewer than 3 out of 100 private equity funds suffered a catastrophic loss (a 70%+ drop in equities from their peak values) compared to 40% of public stocks.
Further solidifying this trend, a study done by the Kellogg School of Management at Northwestern University found that "private-equity-backed [companies] actually fared better during the Great Recession than comparable companies not backed by private equity. "Meaning, private equity experienced less of a loss than the companies both in the public stock markets as well as those who had no funding at all.
It's important to call out here that private equity during the recessions didn't fare better than public only because of shareholders. The key seems to be two-fold: first, private equity firms typically have very diversified portfolios, and second, private equity firms have larger control over their portfolios "including what projects their companies undertake, where funds are used within the companies themselves, etc.
The diversification of portfolios in private equity firms reaches far beyond investing in companies indifferent industries; it means PE firms are investing in a wide swath of different private capital strategies. From real estate and infrastructure to offering lines of private credit, firms have myriad private equity opportunities and paths available to maneuver through a recession.
Greater Company Control
Additionally, PE firms can exact direct control over the companies in their portfolio "without being under the microscope of public markets. This allows for more experimentation and creativity when it comes to what projects the company undertakes since there's no worry of pleasing already-anxious investors during the next earnings call.
Across the board, a recession does mean negative cash flow, and it's important to call out that fact. While private equity did fare better vs. the public stock market, the fact remains that firms are likely looking at a reversal in growth and a decline in existing capital over the next few years. If we use the two recessions we've experienced so far in the 21st century as guides, it may take as many as 14 quarters to start seeing positive net cash flows again after the beginning of a market downturn.
If the beginning of 2022 showed anything, it's that change is coming. With securities falling consistently since Q4 of 2021, the bear market is officially here and heralding the next major recession. The key for firms, though, is to source private equity opportunities in the downturn to better weather the storm.
Part of firms' strategies must originate with how much dry powder "available capital to use to invest in new opportunities "they have. The 12-year bull market combined with the maturation of the private equity industry means firms have much more dry powder available than ever before. In 2019, EY estimated PE firms have $2.6 trillion in readily available capital available, with $1.4 trillion in immediately available funds. Given the market's growth "McKinsey estimates a total of $9.8 trillion in assets under management (AUM) as of June 30th, 2021 "PE firms are likely holding record levels of dry powder in 2022. This gives firms specific private equity opportunities during a recession that may not be otherwise available.
Perhaps the greatest opportunity a recession brings is the ability to "buy low, sell high." And for PE firms, this practice can take multiple forms.
As we detailed earlier,recessions mean negative net cash flow. For everyone. But, with the dry powder PE firms have stockpiled, this presents firms with a unique opportunity:buying down their portfolio multiples. Private companies, especially bootstrapped ones, often find recessions a time of particular strife: tighter budgets, layoffs, fewer new customers, more churned accounts, etc. Dealmakers can use this to their advantage to find investment opportunities at much lower multiples than what they paid for platform companies in their portfolio.
The analysis of previous recessions supports this theory, as well. In the aforementioned McKinsey study, they found the firms that "were more acquisitive during the recessions performed better" than those that did not complete as many acquisitions. Add-on acquisitions are not only a good way to take advantage of all the dry powder available and bolster existing platform investments, but also to diversify your portfolio "a key reason why private equity fared better than the public market in previous recessions.
Investing as a whole is not without its risks. Regardless of the global economic situation, the risk of a company failing is always there. And recessions compound that risk. That inherent private equity risk is one reason why many firms have become more involved in offering private credit lines to companies instead of the more traditional cash-for-ownership structure. In fact, law firm Dechert estimates the private credit market to reach $1.46 trillion in AUM by 2025.
Firms looking to further diversify their portfolio beyond the industries in which their organizations usually operate or through more traditional investment opportunities such as real estate and infrastructure must take notice of the private credit market. Especially with rising interest rates, private credit can provide huge opportunities to the firms willing to take advantage of it.
Even with the great opportunities a recession can offer firms, there are, of course, private equity risks.
Firms that try to take advantage of too many good opportunities risk overextending themselves. As much dry powder as there is available, it should not be used as your firm's"piggy bank" for securing new investments. Firms should also use this capital to support struggling companies in their portfolio. But perhaps the most important reason to have a stockpile of dry powder is as an emergency fund. Much as you should have 3 to 6 months' worth of savings for your own personal budget, PE firms should have enough liquid capital to successfully see them through at least half a year.
Maybe the greatest private equity risk in a recession is the urge to "stop the bleeding." Though perhaps more of a concern with private investors than private equity, panic selling should never be the first reaction. Every decision your firm makes must be measured and cautious to ensure you are using all the information available to you to make the right decision for your long-term strategy.
Being in private equity during a recession doesn't have to spell disaster. By understanding what opportunities are available and what risks to avoid, it's possible to weather the storm better than your peers.
Utilizing data to make better decisions about which add-on acquisitions are the right move, what companies may better diversify your portfolio, and more is possible with a private company intelligence platform like Sourcescrub. We'd love to show you why firms like LFM, VSS and Boathouse choose Sourcescrub to help them find and connect with private, pretransacted opportunities "let's talk!