Insights / 30 April 2020
Buyout spree in the offing but returns could take a hit
A study published in 2015 by Gianfrate and Loewenthal in The Private Equity Journal compared more than 700 UK-based, private equity-owned portfolio companies to a relevant set of non-PE owned peers, and found that PE portfolio companies earned 8% higher market share during the 2008 financial crisis and attracted roughly 6% more investments (normalised to assets) in the years immediately following.
According to the Boston Consulting Group, the cornerstone of private equity’s largely successful track record in bear markets lies in the fact that their portfolios are more recessionproof than other industries. BCG research shows that from 2005 to 2007, cyclical industries represented 25% of buyout deals for the top 10 private equity firms. But from 2016 to 2018, that percentage fell to just 17%. Private equity firms, it would seem, learnt their lesson from the crash of 2008 and are displaying increased wariness towards cyclical sectors.
Private equity investment in industries such as retail, hospitality and leisure – which have been most affected by the Covid-19 crisis – now stands at around 50% of its level just before the great recession. The average allocation to these industries was around 3% in 2016-2018, compared with 6% in 2005-2007. Over this time, BCG found that private equity firms increased their allocation to the tech sector, which has performed relatively well so far in this crisis.
It is important to note, however, that these limited partners were not making these allocations in anticipation of a global pandemic; rather, they were likely based on factors such as the mitigation of digital disruption in the retail sector, and so forth. However, this redistribution of funds reflects the industry’s efforts to factor in the impact of downturns in their returns expectations.
Regardless of the reason, portfolio allocation serves as a major factor in private equity’s resilience to crises. BCG credits the ever-increasing emphasis placed on operational performance as the second pillar of this resilience; they look to the trend among top-tier LPs of appointing dedicated operating partners and bringing in external advisers to strengthen their operating management expertise as proof of this. According to BCG “the emphasis on operational improvements and value creation has created stronger companies and greater optionality, improving the industry’s ability to withstand economic headwinds”.
It has been shown therefore that operational infrastructure and tactical portfolio allocations both contribute to the capacity of LPs to withstand economic downturns, but arguably their greatest strength lies in what was thought to be a weakness during bull runs; namely, the amount of dry powder they have at their disposal. At the start of February 2020, data from Preqin and Dealogic estimated that across funds dedicated to buyouts of established companies, venture capital, infrastructure, real estate, and distressed funds, LPs had in excess of $2tn of uncalled capital.
Also in February, consultants at Bain estimated that across all fund types dry powder had hit $2.5tn in total by the start of 2020. This means that the vast amount of capital available to private equity firms can now be deployed to buy companies at discounted rates which, given the consensus before this crisis that virtually all markets were overvalued and overlevered, could prove lucrative to the savvy investor. Coupled with the desperate shortage of liquidity which a lot of companies are now facing, it comes as no surprise that LPs are gearing up for increased buyouts.
It would appear, however, that within this industry renowned for faring well in economic downturns, firms are not all operating on a level of parity; there are those whose track record in previous crises exceeds others. After analysing the cash flows of 3,833 buyout funds and 33,838 underlying deals across regions from 2004 to 2015, a recent report from investment analytics company Cepres shows that deals done by debut private equity funds after the 2008 crash posted a 55.6% IRR, compared with third generation funds, which returned 40.9%.
One analyst at Cepres attributed this success to the need for first time managers to gain the trust of their investors, and the trend towards greater discipline which results from this, as well as underlining the likelihood of this being repeated in the Covid-19 crisis. First-time funds also have a higher deal recovery rate; 67.6% for investments made in 2009, with a deal default rate of 18.4%, which is in contrast to third generation funds’ reported recovery and default rates of 44.8% and 17.5%, respectively.
However, the president of Cepres has recently gone on record to caveat these figures, stating that the current situation is likely to have massive downward pressure on debut funds. Indeed, in 2019, data provider Preqin calculated that first time funds accounted for only 5% of the total fundraising in 2019 – the smallest proportion ever recorded in the industry globally. In contrast, since 2009, the proportion of capital raised by debut funds has been between 10% and 23% of the overall amount.
And it is not just debut funds which Cepres is issuing mixed signals for; they also recently published a separate report which warns the coronavirus outbreak could cut private equity’s long-term return multiples by 10% between 2020 and 2021. This prediction is based on the multiple on invested capital, and factors in anticipated disruptions to supply chains along with previous crash scenarios, arriving at the conclusion that returns in 75% of traditional industries will struggle to recover to pre-crisis levels. Technology businesses, in stark contrast, are expected to exceed historical valuations. Cepres expects overall cash flow patterns to return to normal only from the fourth quarter of 2020 for contributions and fourth quarter 2021 for distributions.
The fact that the same financial analytics firm has published two seemingly contradictory reports in such a short space of time is testament to the sheer unpredictability of the situation we find ourselves in. In essence, any prediction made about how the private equity industry as a whole will fare in the face of Covid-19 would be speculative and reductive; it is only through the resilience, versatility, and fundamental merits of their underlying portfolios that any private equity firm can be assessed, along with their level of preparedness. There are some sectors which will emerge from this dire situation in a better state than when they entered; some which will emerge reasonably intact; and some which may not emerge at all. However, these are all short-term outcomes and, to paraphrase John Maynard Keynes, in the long run we are all uncertain.
Michael Johnson is group head of fund services at Crestbridge, an advisory and corporate services company.