It is late 2022, and economic uncertainty is the topic du jour. With the stock market in bear market territory, record levels of inflation, and a Federal Reserve hell-bend on raising interest rates to get inflation under control, investors are searching for alternative investment opportunities, and some see the private markets as an attractive choice. Pundits disagree on whether we are officially in a recession, but one thing is sure: these are challenging economic times.
Making sense of the macroeconomic ramifications and how the private equity asset class will perform in the current economic climate in which inflation, compounded with an external shock (War in Ukraine) and low unemployment levels, is top of mind for many investors. Although we do not have a crystal ball, we can look at data from prior recessions and economic downturns to better understand the risks and opportunities in private equity during these tough economic times.
This article covers the opportunities and unique challenges a recession poses to the private equity asset class and how having the right processes and technologies in place can mitigate those challenges and open up new acquisition and value-creation opportunities for PE firms.
Private Equity During The Dotcom Bubble and Great Financial Crisis
Most people are familiar with how the public markets performed during the Dot Com Bust of the early 2000s and the Global Financial Crisis, where the S&P 500 lost approximately half of its value. However, the private markets did much better than public equities during these two macroeconomic events.
According to a report by Neuberg Berman, during the Dot Com Bubble, The US Buyout Index saw a 27% peak-to-trough decline compared to a drop of approximately 47% for the S&P500.
Similar to the Dot Com Bubble, during the Great Financial Crisis of 2008, The US Buyout Index saw a decline of 28% compared to a roughly 55% maximum drawdown for the S&P 500. Furthermore, a study conducted in the UK after the Great Financial Crisis (GFC) found that PE-backed companies recovered faster and captured more market share than their non-PE-backed competitors. As always, past performance is not indicative of future results.
In hindsight, fund managers at some private equity funds wished they had deployed more capital during the recessions to acquire high-quality companies at a steep discount.
Although some managers are thinking about not scaling back on their investments during a recession and even doubling down on companies with strong economic fundamentals, there are still risks associated with investing during a period of economic contraction.
Private Equity Risks During a Recession
Where are we in the cycle? Economic data is sending mixed signals, and we don’t know the full extent of the financial downturn; will it be a brief inflationary period that cools down with one more rate hike? Or will we enter a prolonged period of stagflation with a protracted economic malaise that lasts well into the decade?
Fortunately, private equity firms today are awash with over $2 trillion in dry powder, adding an extra layer of comfort. However, this does not mean funds should not approach this period with caution.
Managers should refrain from overexerting themselves by taking advantage of multiple opportunities now that we are in a healthier valuation environment. During recessions, portfolio companies might struggle and require an injection of capital, which can help them gain market share and experience higher asset growth during the crisis- a net positive in the long term. Regardless of how much cash is in their coffers, firms should refrain from using the bulk of this capital to secure new investments.
Every decision your firm makes during a downturn should be well thought out and deliberate. If there is a strong urge to “stop the bleeding,” you should reconsider the decision and ensure the move makes sense for your long-term strategy, especially during this period of lower valuations.
By having a healthy stockpile of capital, your firm can avoid making drastic decisions that may result in long-term damage.
Opportunities During a Recession
The unprecedented amounts of available dry powder, combined with more modest valuations, afford private equity firms opportunities that may not have been available during a bull market. Most importantly, the ability to buy low, create value, and sell high.
According to research from McKinsey, one of the reasons PE firms performed better than public companies was their ability to diversify their portfolio during economic downturns. Private companies in the middle market can face multiple financial difficulties during a recession, including fewer customers, higher levers of churn, etc. Managers can capitalize on these headwinds to find opportunities at more reasonable valuations.
In recent years, PE funds have diversified their structure and offered private credit lines to middle-market businesses seeking non-bank financing sources. During an economic downturn, when banks decrease lending, PE firms can lend capital to middle-market companies to diversify their portfolios and spread their risk. Again, managers should conduct the appropriate due diligence before making private loans, especially in turbulent economic times.
Similar to what we saw during the brief pandemic-induced recession of 2020, this current downturn will likely result in PE firms acquiring more companies and lending more capital to struggling organizations. To do this efficiently, firms must have the right processes and tools.
Efficiency During an Economic Downturn
As economic uncertainty rises, growth slows down, and capital becomes more scarce, firms must operate more efficiently to take advantage of opportunities while mitigating risks.
As every PM manager can attest, private equity is a people’s business, and who you know is crucial for your firm’s success. According to Sachin Khajuria- Partner at PE firm Apollo and author of the book Two and Twenty: How the Master of Private Equity Always Win, “there is nothing automated about finding a target, talking to management, and debating with colleagues. The PE process works because it relies on human relationships.” In short, relationships are the foundation of a team’s dealmaking.
To take advantage of opportunities during a downturn, PE managers must act decisively with speed and agility. The quality of your firm’s relationships and how you leverage them impacts your ability to source, analyze, and close deals. Enter the private equity relationship intelligence CRM.
A private equity relationship intelligence CRM such as 4Degrees is designed to set your firm apart from the competition, making your team more productive by empowering you with the resources to close more deals in less time. By automating time-consuming processes such as manual data entry and providing end-to-end visibility to your deal pipeline, your team will have more time to take care of other higher value-adding tasks and build stronger relationships.
As middle market valuations drop and more PE managers compete for the same deals, access to proprietary deal flow can set your firm apart from the rest. 4Degrees empowers firms to source proprietary deal flow by analyzing all the data points across your firm’s relationship networks to uncover new opportunities and get warm introductions to potential companies, industry experts, investors, etc., in seconds. Armed with these connections, you can act quickly on these insights and get introduced to and evaluate more potential deals in less time.
Transforming your firm’s relationship network into your best source of opportunities will make you a more efficient investor with access to a robust deal pipeline, subject matter experts, and capable management teams.
To complement your network and use a two-pronged approach to sourcing proprietary deals that fit your investment thesis, your firm should implement an intelligent deal-sourcing platform. Coupled with a relationship intelligence CRM, a platform such as Grata enables managers to access a wealth of hard-to-find middle-market company intelligence in seconds. Access to this high-quality information allows you to surface relevant acquisition targets and leverage 4Degrees to find a warm introduction without spending hours trying to get in front of a company’s management team.
Grata’s machine-learning, AI-driven platform constantly refreshes and adds private company information for dealmakers to search by keyword, industry, location, size and more.
No other platform or tool can surface the breadth and range of insights. Interested in finding municipal HVAC companies – since government contracts are recession-proof? Ctrl+F in your spreadsheet won’t cut it. Want to find subscription car washes for a recurring revenue play? Databases only provide high-level company descriptions.
Private equity can be a very well-performing asset class during a recession. By understanding the risks and opportunities and having the right processes and technologies in place, your firm can punch above its weight and deliver high-quality returns to its LPs.