How private equity is preparing for a potential downturn

Private Equity (PE) firms are already planning for a potential market correction and the opportunities it might afford.

While most of the world continues to experience steady, albeit slowing economic growth, uncertainty around trade policy, a softening Chinese economy, rising levels of corporate debt, and an inverted US yield curve are leading many to take a more cautious stance.

As consensus grows regarding the lateness of the current macro cycle, PE firms are already planning for a potential market correction and the opportunities it might afford. With valuations for PE deals exceeding the peak of the Great Financial Crisis for the last several years, the investment decision itself has become more comprehensive in its risk considerations.

In particular, firms are continuously evolving and adapting to the markets in five manners, including:

1.     Posturing defensively in sector selection

With the threat of an economic downturn, PE firms are refocusing on more resilient and noncyclical sectors and avoiding more vulnerable cyclical industries. More recession-proof and defensive industries with lower fixed costs and high recurring revenues are among the key targets. Companies in the technology and business services sectors have seen tremendous interest from PE over the last two or three years, while more sensitive sectors such as retail and energy have seen declining interest. Currently, PE is prepared to pay a premium for resilient businesses.

2.     Managing debt levels

PE firms are making certain that leverage levels are resilient and ensuring covenants are not so tight that economic weakness could push a company immediately into a debt restructuring. While several high-profile deals have recently featured higher leverage, the industry as a whole has remained largely disciplined, with debt ratios in the 6.0x EBITDA range.

3.     Leveraging advisor relationships

Firms are also working more closely with advisors to prepare their portfolios across a range of areas. By focusing on them now, firms are working to ensure that solutions are in place well ahead of a potential downturn and ready to be deployed when they’re most needed.

• One of the major challenges during the global financial crisis (GFC) was accessing working capital. Firms are working with portfolio companies to build flexibility into their funding mechanisms and improve key working capital metrics.
• PE firms are also working with their advisors to sharpen their diligence of potential deal targets. They’re starting the process earlier and running robust downside scenarios that include coping with protracted economic downturns and the potential for digital and sector disruption. Firms are commonly modelling the potential for a 20% to 25% decrease in EBITDA, as well as a flat or contracting multiple environment.
• The last decade has seen PE firms invest heavily into data analytics and the ability to drill deep into the financial and operating metrics of their portfolios. In recent years, data analytics technology has advanced from analyzing past events to predicting future ones, maximizing the value of data and providing actionable insights, something which becomes particularly valuable in times of volatility.

4.     Strengthening the general partner (GP) platform

GPs have been focused on strengthening their platforms in two meaningful ways:  improving the quality of balance sheets and ensuring the skills of investment and operating teams match future challenges. Recent efforts to increase permanent capital are expected to be a safeguard if liquidity dries up across financial markets. There is an urgent need to address downside events and PE’s close relationships with financial institutions are likely to be tested.

5.     Providing flexibility to invest across the capital structure

The rise of private credit strategies has enabled PE to be in an even stronger position to provide flexible capital across the entire capital structure. During the GFC, distressed debt and special situations funds proved highly effective in both restructuring and rescuing companies as well as in generating returns for investors. By leveraging PE’s limited partnership fund model, both these and the many more direct lending funds today can be expected to act as sophisticated, sector-focused and disciplined lenders to mitigate distress and provide an important buffer to potential economic shocks — both to companies and the broader economy.

A decade ago, much of the lending to PE-backed companies was underwritten by banks and then syndicated to a wide range of fixed income investors. Today, a growing proportion of the debt that’s backing the PE portfolio has been provided directly by private credit funds disintermediating the banking market. 

PE’s No. 1 priority – putting capital to work more quickly

While PE firms were active during the last recession in terms of supporting their existing portfolios, they were less active in pursuing new opportunities. Between 2007 and 2009, new PE acquisitions fell almost 80%, from a peak of nearly US$800b to just US$170b. In hindsight, the industry missed a significant opportunity to acquire high-quality assets at deep discounts.