Private Equity and the Financial Crisis of 2008-2009
Private equity is often assumed to be one of the riskiest asset classes. This means that if this assumption is correct, we should expect private equity to be hit quite significantly during financial crises. However, looking at the Global Financial Crisis, this was not the case. Private equity experienced less significant drawdown and enjoyed a swifter recovery than public equities. In the following sections, I will first illustrate the impact of the Financial Crisis of 2008-2009 on private equity. Then, I will look at the lessons learnt from the crisis and shed light on the future of the industry after the COVID-19 pandemic.
Private Equity and the Global Financial Crisis
Most seemingly financially sound stewards of capital were exposed as anything but during the Great Recession. Bank bosses were shown to have taken on too much risk, and this is increasingly recognised by the public who can now watch Hollywood blockbusters such as ‘The Big Short’ which make such ideas accessible for the general public. In the aftermath, hedge fund managers have fallen from superstardom, returns in the financial industry have generally been pedestrian, and there has been a veritable increase in the level of regulation.
However, the private equity industry has been an exception to this trend. The funds it deployed during the crisis yielded a median annualised return of 18%, and its role in the financial industry has been elevated. Investors, ranging from public pension funds to university endowments, have increased their supply of cash to private equity firms. The biggest of these have evolved into financial conglomerates straddling buyouts, property and credit markets, taking over some of the roles that Wall Street banks used to play. In 2020, assets under management have ballooned to more than $4trn, and the 8,000 firms run by private equity in the USA now account for 5% of its GDP, and a similar share of its labour force.
It is commonly believed that public markets tend to overreact to bad news, but also recover at a quicker pace. However, during the Great Recession, this was not the case. The time to recovery for private equity was around two times faster than its equivalent public benchmark. Academic research has shown that UK private equity-backed companies during the crisis faced fewer financial constraints and were better able to continue investing compared with non-private equity-backed firms. Funds that started in 2006, prior to the recession enjoyed a satisfactory median 8.1% annual return, while those with a 2009 vintage delivered a much greater 13.9%. This is because private equity firms can quickly make investments in struggling companies and vacuum up assets if hedge funds, mutual funds, and other traditional managers are forced to sell. The resiliency of private equity portfolio companies can also be explained by the stronger relationships they have with banks than the average firm.
During the crisis, private equity firms were hyper-focused on the survival of their portfolio companies, including taking market share from struggling competitors. Research shows that funds raised during the crisis had a lower performance than public equity but were still in line with the expected average performance of around 3-5% annualised returns. Altogether, this suggests that private equity offered greater protection of value during the financial crisis than public equity.
A number of lessons have been learnt from the financial crisis of 2008-2009. Prior to the COVID-19 economic crisis, the global economy was experiencing one of history’s longest economic expansions. Fuelled by low to non-existent, and even at times negative interest rates and massive injections of central bank cash, the IMF calculated global growth rates of close to 4%. However, in the midst of the pandemic, governments have shut down their economies in order to ‘flatten coronavirus case curves’ and preserve public health. This has crippled GDP growth rates and weakened financial activity across the globe. Thus, it is worth looking at the lessons learned from the 2008-2009 crisis in the realm of private equity.
Private equity as an industry has learnt from its previous failures. This is why it experienced a degree of relative stability during the Great Recession. During the crises of the 1980s, private equity-backed businesses were sometimes leveraged on a scale of around 90-10 (debt to equity) or even 95-5, but this stabilised to around 70-30 by the time of the crisis. This shows that some learning certainly took place. Default rates tended to be lower, and since private equity has a 5 to 7 year time horizon, they could be patient and guide businesses through the downturn and leave them well-positioned for an initial public offering or trade sale.
The rapid growth of private equity in the years prior to and during the relatively narrow scope of the 2000 dot com bubble bust meant that for many private equity firms, the Global Financial Crash was their first experience in managing significant macroeconomic headwinds and possibly their first experience of a major correction. One of the lessons from the 2009 crisis is that the private equity industry is vulnerable to the credit cycle. Median Internal Rates of Return (IRR) for global buyout funds show relatively low performance just prior to the 2000 and 2007 recessions, and stronger performance during both recoveries as private equity deployed capital in a lower valuation environment. Recognition of this pattern is keeping firms disciplined in today's market and has helped firms to prepare for the next downturn – which turned out to be catalysed by the COVID-19 pandemic. Interestingly, at many firms, today's senior leadership teams are populated by professionals that were in the junior and middle stages of their career during the 2008-2009 crisis, and this means that the lessons of the previous crisis are fresh in their minds.
When the global economy unravelled in the latter half of 2008, financial journalists turned a spotlight on the ‘gaping hole’ of more than $570bn in loans that private equity portfolio companies needed to refinance. Credit agencies were pessimistic in their outlook and predicted widespread defaults. While there were some defaults, these scenarios of financial Armageddon did not actualise. While many were arguing that private equity was contributing to the economic fragility during 2009, research showed that private equity-backed firms actually increased Capex investment relative to their peers.
In a period where many non-private equity-backed firms were financially constrained, private equity’s access to capital, both from its own funds and from its strong relationships with banks and other lenders, allowed private equity firms to support companies in ways that other financial backers could not. The private equity model seems to have provided additional security and flexibility in terms of capital access even during a time of widespread economic turmoil. Despite these successes, there are some further lessons to learn. Private equity firms should apply caution as the credit market weakens and should stay clear of cyclical industries at market peaks. Moreover, the most important take-away is that once economic dislocation hits, private equity firms should not be overly cautious as they were in 2009. Instead, they should seize upon a rare buying opportunity.
Private Equity and the COVID-19 Crisis
Unlike previous recessions, the pandemic will probably have many second order and even longer-term effects on business models, consumer behaviour, national and local policies, and operations. While the first-order effects are evident, the long-term shifts remain shrouded. Despite this uncertainty, central banks have injected large sums of cash into their respective economies and have, in total, spent around $9trn. This vastly exceeds the $2trn stimulus during the 2009 crisis. Consequently, equity markets have enjoyed a strong recovery and are only slightly lower than they were at the start of 2020. However, beneath this stimulus, it is unclear how healthy companies and sectors are. This will only be revealed when economies ‘return to normal’.
In the midst of this uncertainty, private equity firms are adopting a range of stance. Managers are pivoting some portfolio companies into future growth and are riding the waves of economic chaos with cost cuts for survival at others. The stakes could not be higher for these managers. The performance of the industry depends on its ability to steer a highly diverse portfolio of about 65,000 companies to safety. It may be the case that picking long-term winners will be more important than picking short-term ones.
Understanding which to opt for requires research into the second and third-order effects of the pandemic. For example, over the short to medium-term, investments in micro and shared-mobility providers might drop. However, over the long-term, autonomous vehicles, micro-mobility solutions, and other technologies that support physical distancing could benefit. This will also be aided by progress in 5G and its roll out across advanced economies. One second-order effect across industries has been to cast an intense spotlight on racial and gender equity. In the shadow of the Black Lives Matter movement, private equity companies seeking to improve their record on social issues may want to consider what some scholars have pointed to as the ‘correlation between financial performance and racial/gender diversity’.
Clearly, the COVID-19 crisis is a complex one. Since it affects all industries, there are expected to be fewer 'green shoot' areas where companies emerge victoriously. Rather, the narrative is more about survival. Companies might need to rethink their business models rapidly to survive the current crisis, and private equity managers may aim to back medium- to long-term survivors rather than to unearth new models. It is granted that governments and central banks will continue to buttress their economies. However, this will have a distorting effect. Even if the real-world economy freezes in the short term, a sudden rush of liquidity will energise financial markets and distort valuations. Furthermore, managers will need to disentangle the effects of temporary measures from permanent trends and assess the prospects of companies once the crisis subsides.
Some in the industry believe that economic stimulus will facilitate revival, and others think that no amount of liquidity will stave off an impending global economic collapse. Ultimately, investors should be primed and ready for increased volatility, downgrades, and defaults. Along with this, of course, is an opportunity for a well-calculated approach to credit investment if private equity managers can choose wisely.
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