Private Equity’s Resilience During Recessions

Just as it seemed that global supply chain disruptions were easing, Russia’s invasion of Ukraine has now destabilised conditions for private equity-owned companies around the globe. In addition to squeezing oil supplies, the war is impacting shipments of grains and fertilizers, critical metals, chemicals and gases, adding pressure to rising global inflation.

The timing is unfortunate. Clouds that were gathering in 2021, even as global buyout deal value and exits soared to record highs, are getting darker. While we expected interest rates to rise globally, we didn’t necessarily expect the US. Federal Reserve to project six additional rate hikes this year. In the EU, European Central Bank governing council member Klaas Knot surprised markets when he said in May that possible worsening inflation could require a half-point interest rate hike. Also in May, the Bank of England boosted rates to a 13-year high.

These developments raise the possibility of an economic downturn, even a recession, this year or next.

Borrowing costs, which had been cheap for many years, are rising as interest rates increase. Lenders in the private equity market, now primarily hedge funds, will not let borrowers lock in current rates before they rise further. Borrowers will get adjustable rates no matter what, and private equity will have to adjust. Until recently, companies have been able to pass on higher prices. But slowing economic growth could makes that more difficult.

Public markets have evidently suffered in this year’s downturn. Private markets may be more resilient due to active ownership and insulation from public market volatility given the long-term focus. Despite this, average late-stage valuation decreased by a wide margin in Q1 2022 from the highs of 2021, and some analysts expect this cooldown to continue through Q2.  Recent examples of this in action include the reported recent down-rounds by late-stage start-ups Instacart and Klarna. It’s also worth noting that 2021 was an outlandish outlier. Not hitting those levels again doesn’t mean PE in 2022 has failed, it simply means the market is correcting to a natural level. 

Despite a potentially beneficial valuation reset, investment managers still need to steer through inflationary pressures, rising interest rates and geopolitical disruptions, placing a cloud over the longer-term outlook. In the 1990s, private markets were highly inefficient and less competitive, with most managers using financial engineering in the form of leverage to generate returns. Now, the value creation strategy has progressively transitioned, starting from the early 2000s, to focus on operational improvements. This alteration has helped the industry come through several historical market episodes, even as recently as two years ago. Increased focus on hands-on value creation with a more conservative use of leverage proved to be a winning combination when the pandemic hit.

This transformation has led the way for private equity firms being able to outperform even in times of crisis. Private market funds’ tendency to deploy capital over a period of three to five years, thus mitigating exposure to a single-entry point and valuation environment. We have seen this before with the great financial crisis, with private equity’s 2008 and 2009 vintages delivering solid performances at a time of an incredibly volatile and uncertain environment.

By the end of the third quarter of 2021, private equity firms were sitting on a record £1.18 trillion of dry powder. A similar situation happened during the early days of the pandemic when lockdowns and supply chain chaos generated a wave of panic on public markets. The significant amount of dry powder back then proved vital, as managers benefitted from valuable capital to support existing portfolio companies and avoid any liquidity shortfall. For fund managers, the high amount of dry powder should lead to positive outcomes as they are able to deploy capital in a healthier valuation environment.

Not only can top-tier funds help companies survive downturns, but they may also have the skills and expertise to navigate and capitalise on volatility. Active ownership means PE managers may be able to identify ways to lift earnings, pivot strategies when necessary and step in to assist portfolio companies.

Something similar is unfolding now as General Partners begin to capitalise on solutions for today’s crises. The ongoing disruption of global supply chains is seeing cash surge into logistics companies.

This suggests private investors don’t need to be too concerned. Markets are cyclical and diversifying entry points is the best hedge to generate stable long-term returns. Current market conditions appear favourable for investors and managers deploying capital.