How private equity will respond to the next economic downturn

Private Equity (PE) firms are better prepared for an economic downturn than they were a decade ago for four important reasons.

The last decade has been one of unprecedented growth for private equity (PE). Assets managed by the industry have more than doubled since the global financial crisis (GFC), with firms now managing more than US$3.8t in assets. During this period, long-established funds have become significantly larger and a wide range of new entrants have joined the market.

However, we now enter a period where the outlook is more mixed and uncertain. On one hand, we have a picture of robust, albeit slowing global GDP growth. On the other, there are mounting concerns over the potential for an economic downturn driven by geopolitical instability, changing societal expectations, pockets of market excess and sector disruption, and the overall length of the current economic expansion. In aggregate, it’s a picture of increasing uncertainty.

The big questions for PE are:

• What did the industry learn from the GFC? 
• How has the industry model developed since?
• How will PE respond differently next time?  

Four ways in which PE firms today are better prepared for an economic downturn are as follows: 

1.     The industry has more capital at its disposal

As long-time limited partners (LPs) in PE increase their exposure to the asset class and a wide range of new entrants – including family offices, sovereign wealth funds and high net worth investors – invest in PE for the first time, PE firms have more capital at their disposal than even before. PE funds are currently estimated to hold more than US$1.4t in immediately deployable funds, and when other adjacent asset classes are added – credit, infrastructure, real estate, growth capital etc. – the aggregate amount of committed capital PE can readily deploy stands at more than US$2.6t.

Furthermore, the significant growth of direct investments, co-investments and separate accounts – so called “shadow capital” – in recent years means that PE firms and other private capital investors have even more capital at their disposal than is commonly understood or reported.

2.     The industry has diversified in ways that increase its resilience

The last decade has seen PE firms increasingly diversify across a wide array of private capital strategies, including growth capital, real estate, infrastructure, sector-specific funds, and in particular, private credit. Private credit, in the form of direct lending, distressed, special situations and other strategies has grown to become a US$800b industry, and is expected to double to more than US$1.4t by 2023, according to Preqin estimates.

The demand for private credit accelerated dramatically post-GFC as banks retreated from lower and middle-market corporate lending. For PE firms, entering this market was a natural step forward. Today, private capital managers have moved into financing larger corporations and other asset classes such as venture capital, infrastructure and real estate.

As demonstrated during the last downturn, distressed lending proved particularly useful as a countercyclical source of capital, and together with private credit’s significant dry powder, represents an important credit buffer during times of weakness in the traditional credit markets.

3.     PE firms have expanded operating capabilities

As competition for deals continues to increase and valuations continue to climb, the imperative to reshape portfolio companies via continuously improving their operating capabilities (whether it is adding operating partners, improving technology or developing sector or functional expertise) has become more significant. Currently, PE firms have 30% more operating partners than they had just five years ago.

Many PE firms have significantly expanded the depth of their sector expertise. They’re using data and analytics to build tested playbooks to accelerate the value creation process. And many are using a shared services model to drive efficiencies across the portfolio in areas like procurement. 

As such, firms are better situated than ever before to respond to the challenges of economic dislocation at their portfolio companies. Moreover, they’re well positioned to capitalize on the opportunities it might afford, such as investing in complex carve-outs, assets in need of optimization, or buy-and-build strategies to effect consolidation. 

4.     LPs are more sophisticated and have access to better tools

During the last crisis many LPs were constrained from investing additional capital in PE by the “denominator effect,” which happened when the valuations in their public portfolios fell dramatically, and many LPs found themselves suddenly overallocated to private investments relative to their target allocations.

Today, many LPs are closely monitoring their pacing in the event of a potential fall in public equities, and others are tweaking their investment process to allow for greater flexibility. 

The market for LP secondaries — the buying and selling of limited partnership fund interests — has also seen significant growth over the past decade. Indeed, 2018 saw record levels of transactions. The result is more flexibility for investors to adjust to volatile market conditions.

What it means for PE’s current positioning

In aggregate, PE has evolved significantly over the last decade, and this evolution will continue. PE firms now have access to more capital to double-down on promising companies experiencing temporary distress from macro forces. Funds have improved operating capabilities to help companies make more informed decisions. And their wholesale expansion into adjacent asset classes – credit in particular – gives funds new means of providing support in ways they largely didn’t just a decade ago.