The last great recession of 2007-09 showed the resilience of private equity (“PE”) even in a financial crisis. Although the current pandemic situation differs significantly, historic performance bodes well for PE’s ability to capitalise on a floundering economy: funds discharged in 2007-09 are estimated to have generated a median annualised return of 18%. On the contrary, investors’ confidence in other stewards of capital is waning. Hedge funds have posted around a third of PE’s percentage returns in the past 5 years, while banks generally hesitate to invest in high-risk periods.
Additionally, interest rates are low and expected returns from public markets are also low, putting greater pressure on PE as investors reallocate capital there. Indeed, the stakes are high for PE to remain steadfast through the recession due to its impact on the macroeconomy—in America, the 8,000 firms owned by PE houses contribute 5% of the country’s GDP as well as a similar proportion of its workforce.
The Situation Now
According to investment reporter Preqin, PE firms have collected $1.6 trillion in ‘dry powder’ as of mid-2020. Dry powder is unallocated capital, or cash reserves, which are high in liquidity and can be deployed at short notice. Firms might use this capital to invest in new acquisitions or bail out failing companies on their portfolios. The Economist notes that the 4 prominent listed PE houses (Apollo, KKR, Carlyle and Blackstone) posted portfolio losses of $90 billion in the first quarter this year, yet to put this number into context, it counts for around 7% of their accumulated assets. The ultimate performance of PE in the pandemic will therefore depend on the relative losses from existing investments compared to gains from deals created by the crisis.
Shareholders of PE houses remain optimistic: share prices in 3 of the 4 major firms reached their lowest of the year to date during March (when lockdown began), however have been on the mend since then and as of June are almost levelling with pre-lockdown prices. Yet deal-making appears to be lagging behind in regaining confidence, as McKinsey noted that buy-out activity was “pretty much dead”. Carlyle recently cancelled a deal to buy 20% of shares in American Express Global Business Travel; in the rare successful cases, acquisitions are concentrated in the healthcare and technology sectors. For instance, EQT (a Swedish firm) recently shelled out over $1 billion to take over Schülke, a German disinfectant producer. Interestingly, healthcare and technology are foreseeably among the best-performing industries throughout the pandemic, due to their importance in facilitating continuation of economic activity. This should correlate with high valuations, and indicates that PE houses are presently inclined to invest in strong markets with predictable returns, perhaps at the expense of high-risk opportunities afforded by a recession.
A Mountainous Threat
The major challenge to PE at the moment appears to be the mounting accumulation of leveraged companies and debt instruments in their portfolios. In 2019, Bain & Co. reported that 75% of PE-helmed deals were leveraged at more than 6 times, and Moody’s pinpoints the industry as responsible for the majority of junk-rated firms’ defaults. These debts may falsely lull PE investors into a sense of security when returns are high, but equally jeopardise the fate of companies under their portfolios unless managers act to ensure their survival.
To add fire to the flame, lending is becoming more difficult as The Economist notes that specialist private-credit firms are increasingly used, which have less motivation to accept lower interest during a recession compared to large banks. Furthermore, firms owned by PE funds are either ineligible for governmental bail-out schemes, or are unwilling to agree to guarantees in exchange for loans.
Weathering the Storm
However, three factors may explain the staunch confidence in PE firms during a pandemic recession. First, short-term failures to repay debts can be overcome by restructuring them. There is a growing trend of using ‘covenant-light’ debts, which allow companies to suffer landslide falls in profits without triggering a penalty liability towards creditors. Additionally, firms have been building up credit businesses on the side, amounting to a third of the top 4 firms’ holdings. This means that managers have access to greater expertise and resources, so are more likely to negotiate favourable restructurings of portfolio companies’ debts to tide them over the recession.
Second, PE firms can tap into massive reserves of dry powder as well as raise capital in ways other than debt. Blackstone has allocated $30 billion of reserves “to support companies on defense and then also doing offense when there will be opportunities”. Alternatively, funds can call on ‘recycled capital’ from their investors, and are already doing so more frequently—even after an exit and after cash returns, if the investment period has not ended, funds may ask for the capital back for re-investment where necessary. In any case, the lack of confidence in banks and hedge funds has led to increasing demand for alternative assets, so that capital can be raised via listings.
Third, funds can make the most of falling valuations and snap up bargain buy-outs. The gap in the market left by other types of investors can be filled by PE, especially when it comes to distressed securities. The 2008 crisis showed that banks were not inclined to take on high risk-high return distressed debt, yet this is PE’s bread and butter. This recession’s particular circumstances may also be a motivating factor for funds to provide liquidity to companies that are experiencing short-term difficulties, as many investors predict that economic activity will bounce back quickly once the threat of the pandemic wanes.
The Road Ahead
Indeed, PE managers such as the founder of Apollo have plans to scoop up distressed debt and failing companies (especially in the leisure and travel sectors) with collapsed prices in order to make up for the losses incurred by bailing out portfolio companies. Johannes Huth, the director of KKR in Europe, laments having “devoted all [KKR’s] energy to rescuing companies [they] already owned” in 2008, but intends to make use of collected dry powder to take advantage of the recession—20% of the firm’s staff have been instructed to seize buying opportunities. Investment software provider eFront recommends that funds should act as soon as possible to invest in a recovery, as those who start as soon as possible will reap larger benefits; yet managers have different personal views and prefer to bide their time, such as Carlyle founder David Rubenstein who believes the best opportunities will still be available in a month’s time.
It is, unfortunately, rather uncertain what shape the recovery after this recession will take in the long term, given the unprecedented influence of the pandemic. Whether PE will come out stronger depends on firms’ strategy and the timing of deals, Bain & Co. warns. While high-valuation deals completed pre-crisis may be a cause for concern if company performance comes under pressure, achieving an overall growth in the market will require the counteracting force of superior returns on investments made during the recession.