Private Equity Investing During a Recession

A report by McKinsey & Company states that private equity firms with dedicated value-creation teams (teams that work on the companies in the portfolio exclusively, and not on sourcing, due diligence and transactions) did not manage to outperform peers by a significant margin during regular cycles. Per the article, the return differences were only slightly improved leading up to 2008 and even more negligible from 2014 to 2019.

But these teams did seem to add real value during a recession:

During the recession, however, McKinsey found that firms with value-creation teams “meaningfully outpaced the others, achieving a full five percentage points more in IRR (23 percent) than firms without portfolio-operating groups (18 percent).”

Having an operations focused team also had a terrific impact on marketing efforts post recession. “McKinsey reported that average fund size declined 19 percent for these firms, versus an average decline of 82 percent for private equity firms without value-creation teams.”

Private equity funds will not waste another opportunity to invested attractive multiples of depressed earnings.

Investment performance pre and post previous recession:

1. 2006 vintage funds returned median of 8.1%
2. 2009 vintage funds returned median of 13.9%

Fund raising efforts in the most recent years have proven to be the best the industry has seen with PE having amassed ~$1.4 trillion of dry powder that is ready to be put to work. This time around there is also a much larger private credit market that wasn’t available during the Great Recession.

Click on the link below for an interesting read.

In Bain & Company’s 2019 edition of its Global Private Equity Report, the company argues that the private equity firms that will outperform are those that are prepared for a market downturn.

With lofty EBITDA multiples being one of the top cited reasons by PE managers for a reluctance to invest, firms are focusing on precisely where they want to deploy capital. They are “dialing in on the sweet spots and sectors where they are most confident.”

Per the analysis in the report, it can pay huge dividends to know precisely where you want to invest. In a recession, you may only have a small window to take advantage of compressed EBITDA multiples:

“Downturns inevitably create opportunities as markets stall and target company performance weakens. Historically, this brings valuations down—but not for long. In the past two downturns, the average LBO purchase price multiple dropped about 20% from its high but then recovered most of that within two years. It pays to be ready to pounce when the downturn arrives, developing a clear understanding of where the most attractive targets are in a given asset class or sector and striking aggressively as the cycle plays out.”

This article is definitely worth the read. Click on the link below for more information.

An article posted by Bain & Company addressed a few issues unique to this downturn as it relates to investment strategy. But with the amount of dry powder on the sidelines, transactions are bound to resume. Per the article, here are a few variables to keep in mind:

Timing: Investments made during a global financial crisis outperform investments made during upcycles (click on the link below for a good visual).

Industry: The article stated that some industries, like travel and tourism, will likely recover on some unknown time horizon at similar prerecession revenues. But it listed a few niches and industries that are likely to thrive including collaborative software products and health and safety products.

Turnaround Expertise: Does the firm making investments have the expertise required to recognize bankruptcy risk and react before it is too late.

Click on the link below for additional examples.

A study evaluating how 4,700 public companies performed before and after three global recessions (1980, 1990 and 2000) provided some insights on the best path to take for the fastest recovery.

• 17% did not survive the downturn (bankrupt / acquired / private).
• 80% did not recover their sales growth and profit margins three years post recession.
• 9% flourished after the downturn.

Of the 9% that flourished, the companies that deployed “a specific combination of defensive and offensive moves has the highest probability – 37% – of breaking away from the back.”

Companies that cut costs faster and deeper than rivals had the lowest probability (21%), and companies that aggressively invest throughout the recession only fare slightly better (26%).

Click on the link below for some terrific anecdotal accounts.

An article published by the Harvard Business Review cited a study that private equity backed companies outperform equally levered businesses that did not have a private equity sponsor. The primary reason relates to access to capital. As liquidity drys up in a recession, companies with lots of debt struggle if their owners cannot tap capital markets at the appropriate time.

The takeaway is to always have multiple sources of capital available (and to maintain a sensible amount of debt, of course).

Knowing where you want to be invested before a recession hits can be a huge advantage. Bain & Company has access to a lot of transaction data and reported the following during the Great Recession:

“Our analysis of around 24,000 transactions between 1996 and 2006 shows that acquisitions completed during and right after the last recession (2001–02) generated almost triple the excess returns of acquisitions made during the preceding boom years.“

According to Bain, 80% of transactions that had successful outcomes also had a clear investment thesis. For transactions that failed it was 40%.