Private Equity has had a remarkably strong run over the past 40 years. 2021 was a record year for the industry, both in terms of new capital raised and the public offerings of PE backed companies. There is – as yet – no hard evidence that ongoing performance is about to reverse but clearly headwinds are building. In this article the Sarasin Bread Street team consider these headwinds in the context of the development of the asset class since the 1980s.

A tougher environment to generate equity returns

The strength in private equity returns in recent years has been helped by the technology sector. Once the graveyard of many investments, and which many of us learned the hard way in 1999/2000, since 2010 it has been the sector that has delivered the best returns, both in public and private markets. The outlook for the sector seems to be changing though as the world rapidly adjusts to its post lockdown reality of rising interest rates and absorbs the implications of a likely long drawn out Russo-Ukrainian war.

More broadly, global economies are now facing supply shortages of everything from fertiliser to automotive chipsets, rising energy and food prices and inflationary increases across all sectors. This points to a much tougher environment in which to generate equity returns: whether a company is in private hands does not make it immune to economic forces.

To understand how PE might perform in the future, it is helpful to review the past: looking back to its modern beginnings in 1977 (when US investment firm KKR effectively pioneered the industry in North America and began its leveraged buy-out programmes), shows that since this time the industry has been through three significant cycles of private equity underperformance.

This leads to the recurring question: how will the PE industry cope with what could be the end of a decade long growth cycle for PE?

Longer hold periods and amend and extension of loans

This in itself is unlikely to lead to an increase in company failures. Businesses generally only fail when they run out of liquidity, which is effectively cash and credit to meet their liabilities when they fall due. Valuations will decline, but a valuation is only a measure of what a company is worth at a point in time and is most likely not what it will be realised for, unless the owner is a forced seller.

Private equity managers will not sell (and indeed don’t have to sell) until the price is right to generate the targeted required return, and unless the company faces a liquidity crisis that they cannot refinance, they will continue to hold. This will lower the potential for an acceptable internal rate of return (IRR) when the exit does eventually come but likely doesn’t lead to a lost investment. The banking system supported this strategy following the 2008 financial crisis and regularly consented to amend and extend the terms of debt packages, rather than force a default and risk the return of the loan principal.

Approximately half the capital structure of a typical buyout investment comprises debt but the majority of current debt packages do not contain covenants. It is not in the interests of the employment markets and economic stability as a whole for the banking community to place a company into default because it has failed a covenant test. Central banks have been very aware of these problems and have therefore supported a light touch on the corporate loan market.

Advantages of private equity model in challenging times

Inflation is coming back strongly for the first time in 35 years, and the waters are beginning to become increasingly uncharted. Private equity-backed companies are unlikely to fail en masse, but neither will they be exited at valuations needed to generate the required mid-teens IRR and two times cost money multiple that investors have become accustomed to. This is where the advantages of the PE model come into play. The ability of company management, with the support of the PE owner, to take rapid operational and strategic action, unencumbered by the constraints and time pressures of public governance and investor reporting, and the cash drain of equity buyback and dividends, greatly assists businesses to thrive (or frankly, just survive in very difficult times).

This cycle will take time to runs its course because of uninvested capital. For first time PE investors, this points to being highly selective and only investing with proven quality PE managers and being cautious about the speed of committing fresh capital to new funds. Notably, history shows that some of the best returns are made from funds raised in recessionary vintage years.

Read the full Q3 2022 thought piece

 

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