Potential Impact of Recession on the Private Equity Industry

Background

After the COVID-19 pandemic, lockdowns, disruption of global supply chains, and the Russia-Ukraine war leading to higher food and energy prices, the world is in a scenario where inflation and rising interest rates suggest that the economy is approaching the end of the business cycle. The probability of a recession occurring by the second quarter of 2023 seems very real.

This also brings an investment opportunity for PE firms, though, holding record amounts of dry powder, as the valuations of target companies will adjust downwards in response to the economic slowdown. In simple words, this is an opportunity to buy low and sell high. Anticipating this slowdown, companies will also utilize the capital in hand sensibly, as rising borrowing costs will not allow them to take on risky investments. This will further push companies to re-evaluate their corporate strategy and to look closely at selling off businesses and investments that are not yielding returns.

Challenges

Challenges Faced by PE Due to the Recessionary Environment

1. Generating alpha – During the slowdown, portfolio companies’ performance will probably dwindle while increasing borrowing costs have already worsened the situation and impacted margins.
2. Mounting idle cash – PE firms have accumulated over a trillion dollars in dry powder, which they are under pressure to deploy in the environment when fewer good investable opportunities will be available, further creating fierce competition within the already highly competitive industry.
3. Fundraising for smaller PE firms – Because of the significant presence of institutional investors as limited partners (LPs), the sophistication level for choosing general partners (GPs) has also increased. And, despite the huge availability of dry powder with existing big players in the PE industry, it’s becoming more challenging for small and new PE houses to raise funds.

PE Firms Best Bets

Risk Mitigation Strategies of PE Firms

1. Defensive sectors – In order to weather the storm of an impending recession, PE firms will definitely be looking to invest in recession-proof sectors like healthcare, basic consumer goods, utilities, accounting, and financial advisory, as well as some technology businesses like online education.
2. Future technologies – PE firms are more likely to be investing or planning to invest in future technologies like clean energy, blockchain, and cybersecurity, which, despite a slowdown, can turn out to be good investments.
3. PE strategies –PEs are not limited by sector diversification, rather they have expertise in different kinds of strategies to maneuver their position, such as direct lending, mezzanine financing, distressed debt, rescue lending, etc.
4. Diversification – Most PE firms usually maintain quite diversified portfolios, plus they have significant control over their portfolio companies’ operations, allowing better management.

Exiting During Recession

Strategies PE Firms Can Employ to Exit

Historically, to exit a particular investment, the preferred method used was through bringing IPOs by PE firms. However, given the prospective recessionary scenario, IPOs don’t look like a very attractive option anymore, forcing PEs to think about other methods of exiting. Below are some of the options to exit:

1. Strategic acquisition – PEs look for buyers with a strategic interest in the target company and who find a recession to be an opportune time to buy a company at a decent valuation.
2. Secondary sale – PEs can sell a company to another interested PE firm for various reasons, such as generating instant liquidity.
3. Promoters repurchase – A more uncommon but interesting approach is the repurchasing by promoters, in which the company’s management can buy the equity back from a PE firm.
4. Liquidation – Lastly, sometimes when the investment doesn’t turn out the way it was originally planned by the PE and the company’s management, outright liquidation could be a wise option to exit.

Importance of ESG

ESG and sustainable investing have now become very crucial for many institutional investors who don’t want PE funds to overlook this noble idea, despite the volatility in the market, especially with many regulations and legislation developing around it. 2023 will see the implementation of these new regulations, especially in Europe and the U.S., and later followed by other parts of the world, creating a more demanding situation for PE houses and general partners. Further, PE firms showing more conformity with ESG guidelines will not only be in a better position to attract funds from large investors, but they will also be better prepared for the future of the PE industry, as more investors and consumers are becoming mindful of their decisions and their impact.

Conclusion

A recession represents complicated challenges for financial markets, and PE markets are no exception. As this macroeconomic situation is on the horizon, it will not only put pressure on margins and worsen liquidity, but it could also cause a further deterioration in credit quality and weaken investor demand. Moreover, for businesses that have already undergone a buyout, it will be far more difficult to soften the effects of a sustained increase in financing costs, since decreasing earnings and increasing borrowing costs would be concerning factors. This potentially volatile environment will also bring down the valuation of many companies that seemed overpriced previously. Public companies that may report losses due to the recession will see their share prices taking a hit, forcing management to improve the balance sheet by doing carveouts. 

However, PE firms have advantages over public companies to navigate the potential upcoming recession, as they also have the vantage point regarding information and can help to renegotiate the existing debts, and even provide private credit lines directly, if necessary. A slowdown also presents an opportunity for big PE firms to buy troubled public companies when multiples are low, and make them private.     

One good example of PEs’ agility is the recent pandemic, in which they quickly found and invested in companies that were providing solutions to adapt to the new way of living under lockdown, including businesses like education technology, logistics, telemedicine, etc. However, it’s important to highlight that many PE firms also try to predict the market, which most of the time doesn’t end up well even for the most astute investors, hence more prudent PE firms may want to consider riding this economic cycle with discipline, and spreading their entry and exit points to generate consistent long-term healthy returns.

Conclusively, despite the hawkish policy environment and difficult antitrust regulations, PE investors still have a significant available amount of dry powder to execute deals, allowing firms to take advantage of investment opportunities because of lower valuations that may not be available in another period. During 2023 and onwards, due diligence will also play a crucial role to recognize the value of PE acquisitions in the U.S. economy, where higher interest rates, inflation, echoes of war, logistics, and other issues generate a difficult scenario to navigate; nevertheless, historical data shows that during all economic conditions, the PE industry knows how to continually reinvent itself.

How Evalueserve Can Help

Through our MIND+MACHINE approach, we can provide support at every step of the PE deal lifecycle, including the process of DEAL SOURCING (opportunity identification, market assessment, comparable analysis, company profiles, etc.), RESEARCH & DEAL EVALUATION (industry analysis, financial modeling, capital structure analysis, due diligence, etc.), POST-CLOSE DEAL ACTIVITIES (periodic monitoring & reporting, profit improvement strategies, CRM data maintenance & data enrichment, etc.), and EXIT STRATEGIES (exit scenarios & return analysis, potential buyer screening, prepare marketing material, etc.).

We also have the capabilities to help grow the portfolio companies of our private equity clients. We offer solutions to portfolio companies enabling their integral teams to devise business strategies. Our solutions include CFO & CXOs support (variance analysis and financial analysis), MARKETING TEAM support (growth analysis and CRM maintenance), STRATEGY TEAM support (competitive intelligence and sector intelligence), and BUSINESS OPERATIONS support (IPO support, creative support for presentations and business follow-ups to fast-track action items). 

References

1. https://www.cnbc.com/2022/11/10/heres-the-inflation-breakdown-for-october-2022-in-one-chart.html#:~:text=The%20consumer%20price%20index%2C%20a,rose%200.4%25%20during%20the%20month
2. https://www.spglobal.com/spdji/en/commentary/article/us-equities-market-attributes/
3. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review
4. https://pitchbook.com/news/articles/private-equity-q3-fundraising-exits-investments-take-private
5. https://www.ey.com/en_us/private-equity/pulse
6. https://www.forbes.com/sites/jacobwolinsky/2022/07/26/why-a-recession-could-be-good-for-private-equity/?sh=3a9402f51f8f
7. https://www.bain.com/insights/shifting-gears-private-equity-report-midyear-2022
8. Q2_2022_Quantitative_Perspectives_US_PE_Enters_a_New_Regime
9. PitchBook_Analyst_Note_How_PE_Firms_Will_Navigate_Today_s_Complex_Macro_Environment
10. https://www.sourcescrub.com/post/private-equity-during-a-recession-opportunities-risks-and-more
11. https://www.oliverwyman.com/our-expertise/insights/2022/aug/how-us-firms-can-handle-inflation-and-be-recession-resilient.html
12. https://www.ubs.com/content/dam/assets/asset-management-reimagined/global/insights/asset-class-perspectives/private-markets/doc/insights-into-private-markets.pdf   
13. https://www.spglobal.com/marketintelligence/en/news-insights/research/the-big-picture-2023-ma-outlook
14. https://www.jdsupra.com/legalnews/looking-ahead-to-2023-trends-in-private-9279019/
15. https://iclg.com/practice-areas/private-equity-laws-and-regulations/1-2022-and-beyond-private-equity-outlook-for-2023
16. https://www.forbes.com/sites/qai/2022/09/15/if-there-is-a-2023-recession-coming-where-should-i-invest/
17. https://www.reuters.com/markets/us/goldman-ceo-says-reasonable-chance-us-recession-2023-2022-10-18/

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