In the last few months, we have seen a reset in U.S. public markets due to inflationary pressures, rising rates, and uncertainty. Markets are still looking for the bottom even though there is talk of a looming recession.
Concerns have been raised over private equity managers who acquired at high valuations. The data analyzed by Bain Capital shows that the U.S. and Europe had a 12x multiple. PE firms invested at those levels could soon feel the pinch.
Economic uncertainty will have an impact, but it also reminds us of how important it is to pick good managers. Disciplined investing based on value creation programs and long-term value is more important than ever.
The high-valuation environment over the last couple of years will likely affect PE managers who have deployed capital with looser selection criteria, focusing on the potential for multiple expansions and trading off the quality of underlying companies for short term returns.
Private equity has historically performed better than public markets.
PE returns have historically been better than public markets throughout business cycles, with the internal rate of return picking up after recessions. The deals from the top-quartile vintages generated a 61% IRR. The S&P 500 had an annual return of -328%.
The performance of PE is usually attributed to three drivers.
Smaller competitors that complement existing platform investments at lower, sometimes distressed valuations can be acquired by funds and their portfolio companies.
It is possible for portfolio companies to seize growth opportunities in a crisis while competitors may be rolling out austerity measures.
It's important to have flexible access to capital during downturns. According to research by Hamilton Lane, the risk of catastrophic loss for companies backed by private equity is less than for public companies.
A study of almost 500 PE-backed companies in the U.K. found that they recovered quicker from the financial crisis than their non- PE competitors.
PE-backed businesses have a competitive advantage due to the active management approach of large funds.
While CEOs of public companies report to their board of directors only once a quarter, and owner-managers have to rely on their own resources, top-tier PE funds actively support the management of their portfolio businesses.
There is a close relationship between company management and the fund managers. Sometimes PE funds hold board meetings or management workshops on a monthly basis, and usually the CEO and GP have weekly calls to discuss affairs. This may increase in times of crisis.
Portfolio companies can often take advantage of outside expertise. Senior advisers who join the boards of companies are retained by the best funds. The portfolio company can use the time, knowledge, and network of these advisors.
There is a lot of operational support offered by most funds. It involves helping businesses develop new capabilities and manage transformation programs. The most recent COVID-19 crisis proved very efficient for companies backed by PE.
Managers are expected to adapt to the new environment. Growth funds will put a higher focus on earlier-stage companies, while actively managing existing portfolios and performing add-on acquisitions.
Growth strategies of PE funds are inherently resistant to market correction because of the underlying growth of the portfolio companies. The question is not if managers and funds can generate targets, but when.
At Moonfare, Ermoline is an Investment Manager.
The opinions and beliefs of Fortune are not reflected in the commentary pieces.
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