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October 6, 2022
The headlines about private equity’s best year yet in 2021 are not hype. Last year, buyout activity doubled in value reaching $1.2 trillion, compared to $577 billion in 2020. And, it turns out that private equity’s standout year during an economic downturn isn’t surprising.
Following the dot-com crash of 2001 and the global financial crisis of 2007-2009, analysis of Pitchbook data shows private equity had above-average returns and bounced back more robustly than Standard & Poor’s 500 index. Also, Neuberger Berman found that private equity experienced lower drawdown rates and a quicker recovery than public funds during the early 2000s, the global financial crisis and the 2020 COVID-related downturn.
We’ll provide some perspective on how poised private equity is to do well. Even amid the most challenging global economic issues like oil price volatility, supply chain meltdowns, labor’s massive exodus and rising interest rates. No tea leaves here. We think the center of private equity’s transcendence over worldwide pessimism might surprise you.
Last year was truly remarkable for PE globally and in the US mainly. Many have noted during times of uncertainty, the private market is more resilient than the public market. At the same time, it is always true that past performance is no guarantee of future results, experience matters. Despite economic uncertainty and ongoing geopolitical conflicts, there is an expectation that the private market will outperform the public market, partly because of active management, access to capital and falling valuations.
In early 2022, PE dry powder was at an all-time high and began to fall below its peak to $3.2 trillion in the first quarter. At the same time, globally, PE raised $137 billion between Q1 and Q2, according to Pitchbook’s Global Private Markets Fundraising Report. The pressure comes from limited partners who want the typical return timeline of about three years.
General partners are under pressure to deliver in an increasingly competitive environment. Large investors with a lot of cash can buy at lower valuations in the S&P 500 and Nasdaq Composite in a bear market. Still, unforeseen global events or a market pullback make exits uncertain. GPs must balance making a good deal (due diligence) and meeting LPs’ expectations for value creation, growth, a winning exit strategy and impact investing through ESG initiatives.
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How GPs use their stockpile of dry powder in the coming months will tell us where PE will fare. For example, despite the Federal Reserve’s interest rate hike, leveraged buyouts continue, even as higher interest rates impact the internal rate of return.
We may see deal size decrease. By acquiring a smaller company struggling to grow, these add-ons are opportunities. GPs using this “buy-and-build” model look for earnings before interest, taxes, depreciation, amortization (EBITDA) and growth potential. They stay close and meet with management more often, if necessary, to improve operational efficiency and create equity value. The add-on strategy is attractive to GPs looking to diversify their holdings, buy at a lower multiple than their platform and bolster a platform’s value. However, there are many ways PE can take advantage of a recession.
Private equity investment trends in three areas — the middle market, cross-border deals and venture-backed pools — provide lessons for the astute.
A trend of note is acquiring middle market companies, with $25 million to $1 billion in annual revenue, to scale a platform company. By focusing on smaller deals with accretive multiples, the platform company and the add-on become more valuable together than each was separate.
The middle market has found another exit for sponsors than the volatile stock market. In 2021, add-ons reached 67.9% of all middle market in software, health care and industrials. Much of the middle market activity — 40% of fund closures and a quarter of fundraising dollars — was powered by a hungry crop of emerging managers. They will likely shape PE in the future as they carry forward the creative deal-making experience born out of uncertain times.
Despite economic challenges, M&A deals in the first half of 2021 set records in volume with 60,000 disclosed deals up from 50,000 pre-pandemic, reaching $5 trillion in value for the first time. Throughout this boom, PE has become a significant alternative creditor to banks.
Additionally, PE cross-border activity has become more prevalent in Latin American markets such as Brazil’s and could hit $80 billion in 2022. PE sees the opportunity for value creation in companies with solid fundamentals that lack credit sources or suffered a steep revenue decline during lockdown periods. In addition to the fundamentals of market share, vendor and customer relationships, and employee retention, managers must mind the regulatory hurdles of M&A deals.
Currently, the tight competition for skilled talent prompted 52% of managers to turn to a third party to help with regulatory compliance, according to Auxaudi’s survey of 100 senior-level PE investors from the US, UK and Europe.
Turning to venture-backed companies, especially in the tech sector, PE could emerge stronger from the next recession. Buyouts of VC-backed companies have become more desirable for startup sponsors to exit than alternative strategic acquisitions or IPOs.
PE buyouts of VC-backed companies represent another way for GPs to meet LP expectations. According to Pitchbook, VC exits by PE buyout increased from 9.7% in 2010 to 16.4% in 2020. In particular, buyouts in software SaaS and tech-enabled companies are attractive because they hit VC milestones and bring new and complementary technology to a platform. PE will continue to apply rigorous due diligence to these nurtured startups.
No doubt, GPs face many challenges — LPs’ exit expectations, unpredictable geopolitical effects on markets and increased competition for talent — ahead. Fortunately, the historical analysis from the 2000s to the COVID-era economic downturns shows that PE is resilient compared to public markets. Many have suggested — and we agree — that PE’s potency stems from strategic management.
A company’s performance in a bear market often depends on the relationship between GPs and senior management. As Pitchbook’s Madeline Shi pointed out, GPs are bringing in interim CFOs for cash flow management, consultants to develop pricing strategies for inflation and procurement specialists to lower production costs to address future headwinds.
Former Apollo GP Sachin Khajuria sums up the secret weapon of PE during a recession this way: “The psychology of winning goes inside the mindset of these successful investors.”
A recession is not a time for PE to hold onto their stockpile of dry powder but to leverage it in creative and adaptive ways.
PE has proven to outperform the public market, but as we’ve said, there are factors outside GP’s control; at the end of the day, their collective brainpower and savvy will determine the success of any strategy. Investors in hot new sectors like software, health care and fintech benefit from a synergy of deep sector knowledge and trusted relationships. Private equity is a people business.
After a deal, attention to operations management is priority No. 1. In light of the unprecedented three years we just had, managers trust the fundamentals: Keep infrastructure costs low and recruit talent at the expertise level needed to achieve value.
Approaching Uncertainty
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