Podcast transcript: Why private equity can endure the next economic downturn
26 min approx | 18 Feb 2020
Hello and welcome to EY’s Next Wave Private Equity Podcast. In our series, we explore the impact that private equity can have on the economy and society, capturing insights from industry thought leaders and private-equity practitioners from across the globe. I’m Winna Brown from EY and I’m your host.
Hi everyone, and welcome to the latest in EY’s Next Wave PE Podcast Series. Today, we’ll be talking about macroeconomic volatility, the potential for an economic downturn and the ways in which that might impact the PE space.
The last decade has been one of unprecedented growth for private equity. Assets managed by the industry have more than doubled since the global financial crisis with firms now managing more than 3.5 trillion in assets. During this period, long-established funds have become 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 the one hand, we have a picture of robust, albeit slowing, global GDP growth, and on the other there are mounting concerns over the potential for an economic downturn driven by geopolitical instability, 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? And how will PE respond differently next time?
Today, I’m delighted that we’re joined by two EY experts on the matter, Andrew Wollaston, Global Private Equities Transaction Leader, and Pete Witte, Global Private Equity Lead Analyst. Thank you both for joining me today.
So, Andrew, perhaps we can start with you. Can you tell us a little bit about where we’re at in the cycle and when we might actually see another economic downturn? Do you think the next downturn will be different from the last?
I think we first need to recognize that across the globe, we still have positive growth, albeit in certain countries, in certain sectors, growth is slowing. In addition to that, we’ve got wage rises in most economies, still got the readily available credit, which is important for functioning economies, and the world stock markets are high. In fact, over the last 10 years, we’ve seen asset prices almost double.
But you need to recognize that a large amount of that has been created through how we reacted to the last global financial crisis, and in particular, the use of quantitative easing, which, at the time was an experiment and it’s, in many eyes of many economists, that’s an experiment that’s yet to play out.
So, while I’d say things are looking reasonably positive on the global stage, there are some geographies that are showing weakness, and in particular, I’d call out the UK, possibly as a result of Brexit, that some believe that Brexit is not really masking the underlying fundamentals in the UK, and Germany is weak. And I’d also point out Australia. Australia escaped recession in the global financial crisis, but it is certainly showing weakness today. So, some geographies are slowing faster than others, and it remains to be seen exactly, you know, how those particular geographies will play out.
One thing I would say though, is that when you look at the history of economic cycles, they tend to go in decades. So, we are now 10 years on from the global financial crisis, and I’m not saying that necessarily history will dictate the future the same pace in every cycle, but I think we do need to recognize that credit markets have been strong for a long time. The interest rates that are being applied to both sovereign, corporate and personal debt are probably the lowest they’ve been for a very long time, and I think a lot of economists recognize that we are late stage in the macroeconomic cycle.
As to your question as to when the next recession will come and what form it will take, my crystal ball - and this is my view, not necessarily a house view - is that we are going to see some recessionary pressure in 2021. And I say that because the two biggest economies on the planet are obviously the US and China. I’m amazed at how the US, and particularly the US President, seems to manage or perhaps impact stock markets in particular, but I think right now we have, obviously, the trade war between the US and China. That is suppressing, to a degree, growth in equity markets. I think that is going to get resolved early next year. I think it has to be resolved, because your president is looking for reelection in November.
So, I think next year we are going to see a climb in asset prices, a climb in world stock markets. I, then think we’re going to have an overheat at the same time as China is slowing, and therefore, six months after the November elections in the US I think we’re going to see some significant pressure.
Now, will it be another global financial crisis? I don’t think so. You know, that crisis was triggered by problems in the financial sector, largely, and a lack of confidence in global banks. I think there’s been a lot of work done over the last 10 years to strengthen the financial sector, through regulation in particular, and so I’m not fearful that we’re going to have a financial crisis in the same way as we did back in 2008, 2009. But I do think we are going to have recessionary pressures isolated to certain geographies and certain sectors, and I think we will see those playing through, as I say, in about 2021, and it won’t be global in nature, but it certainly will be for some countries and some sectors.
So, as to question of timing, I think we will see certain recessionary pressures coming in in the mid of 2021. And why do I say that? The US elections will be in November 2020. Right now, global stock markets are suppressed slightly because of the US-China trade war. My prediction is that that will get settled early in 2020 ahead of the US election.
I think we’ll then see quite a boom in the American economy, and possibly in the Chinese economy as well, and, arguably, that will lead to a certain overheating, which six months after the November elections in the US I think we’ll begin to see some of the recessionary pressures, particularly in certain geographies. And I would call out Germany and the UK and possibly Australia, but some others as well, particularly those that are linked to certain sectors and are likely to suffer from some of the other trade issues that are percolating throughout the global economy.
Okay. Andrew, so we’ve got a little bit of time to prepare in advance of the potential next downturn. Pete, what do you think happened with respect to PE during the global financial crisis? What did PE do well and maybe not so well? And, potentially, what can we learn to prepare in advance of the next downturn?
Well, it’s interesting. I mean, over the last 10 years or so, there’s been a lot of postmortem analyses done on the financial crisis and how capital markets responded to that and how private equity responded to that. I think we have to really consider that the financial crisis was, for the most part, private equity’s first real test of the model.
Since the financial crisis, there’s been a lot of postmortem analyses done by private-equity firms, and the capital-markets participants as a whole around what went right, what went wrong. And I think that we have to consider that the financial crisis was really the first real test of the private-equity model. You probably remember that as the credit crunch unwound in mid-2008, there was all this media attention on, you know, the refi cliff of leveraged loans and high-yield bonds that needed to be refinanced, somewhere in the neighborhood of US$500 billion or so, and there was all this handwringing going on around how private-equity-backed companies were going to be able to respond to that, what private-equity firms needed to do. And there was a lot of pessimism about the ability of the industry to really survive.
Now, fortunately, some of those scenarios really never came to pass. In fact, the industry came out of the financial crisis pretty well. You know, I was reading in one of the trade magazines a few weeks ago, and there was some data published that private-equity-backed companies defaulted at a rate of about three percent during the financial crisis versus about six percent for non-PE-backed companies, which is interesting. And I think that one of the reasons for that is essentially just access to capital.
There’s some research that was published out of Stanford and Kellogg a while back that looked at this issue. It suggested that PE-backed companies actually invested more during the downturn than non-PE-backed companies. That was because they had better access to relationships with the banks. They had access to more sources of funding at a time when the markets were essentially locked up. And so, I think that access to capital during periods of economic dislocation and tough times is one of the components of the private-equity model that makes it a little more resilient, and I think it’s a dynamic that we can expect to play out in future periods of dislocation.
Andrew, anything you want to add to that?
Well, I’d comment that when I see clients. And, as you know, I wear another hat at EY, which is to lead our Global Restructuring Practice, and they’re quite intrigued by the fact that somebody who leads private equity and restructuring together is talking with them. And one of my standard questions is to say, “What did you learn from the last global financial crisis, particularly in the context of perhaps some recession coming? And what will you do next time that’s differently from last time?”
And, invariably, their response is, “We were way too cautious in 2009, 2010 and 2011. We should have put more money to work. We didn’t because, as GPs, we were overly cautious, and our LP funders were saying to us, ‘Be careful. Don’t catch a falling knife.’” You’ve got to remember that in 2008 and 2009, you know, the world was in a very difficult place, and I think it was a depth of recession that was compared at the time to the 1929 crash.
But this point about being overly cautious, perhaps not recognizing the situation for the buying opportunity that it was and could have been, I think resonates very strongly now with an industry that has more capital than it had 10 years ago, is very keen to put that capital to work and is very keen to learn that while one doesn’t want to be frivolous and reckless with LP’s money, one must recognize that, as the cycle dips, it does present an excellent opportunity to buy.
Well, yes, that makes complete sense. And do you think that the industry, as a whole, has taken on that perspective? And do you think … How are they going to weather that next downturn? Are they going to batten the hatches or are they going to be a bit more bold than we saw in the last crisis?
I think they’re very much going to be a lot bolder. But let me come back to this point about recklessness, because, if the industry had not changed at all since 2009, merely being bold could be classified as being reckless. But there’s some fundamental changes that the industry has gone through, and I’ll cite just a couple by way of example.
The first is I think a greater understanding of sectors. So many of the private-equity houses have sectorized their operations over the last 10 years. You know, particular MDs or partners are now responsible for particular sectors. You very rarely get generalist investors now at private-equity houses. So, a greater understanding of the sector, a greater understanding of the cyclicality of the sector, understanding of the sector’s ecosystems, how they’re going to be impacted by various events I think is much more engrained into the investment thesis these days.
The second thing I’d call out is the investment time horizon. You know, the traditional PE industry has been three-year money, and, increasingly, funds are now talking about six-, seven-, eight-year time horizons. And the beauty of that is if you think about going into a downturn and making acquisitions in a downturn, it’s not so much the impact that the economy will have, or the circumstances will have on the industry while it’s in a downturn. It’s how that business will capitalize on the opportunity in the upturn, when its competitor set are beginning to struggle, and it can effectively consolidate the industry and take it forward.
We see a lot of private-equity houses now modeling the upside through a downturn recognizing the low points and making sure that certainly in debt-financing terms they are getting their debt-leverage ratios right, their covenants buttoned down, so they’re not going to lose control through a downturn, but making sure they really do model the upside and how they’re going to capitalize on weakness elsewhere in the industry.
And the third thing I would call out is the growth of credit in the last 10 years. All the major private-equity houses now have credit arms. Those credit arms today are investing in either public- or private-market debt, which is giving them, again, a greater access to data and understanding about how businesses are performing. But it’s the extent to which that credit can play in different parts of the capital structure, can both aid businesses that they want to keep for a longer term by providing maybe credit capital or taking other debt providers out of the capital structure and replacing them, but it also goes to how you can capitalize on weakness in the market by distress-for-control(?) strategies in your investee’s competitor set in order to acquire some of those companies that are going to be weak through the downturn to bolster M&A add-ons to your particular investee company.
The industry has evolved a lot in the last 10 years, but I would cite those three particular evolutions as being critical to the way that I think private equity will respond differently to the next downturn.
So, what I’m hearing is, effectively, they’ve derisked their portfolio, because they’ve now expanded into different kinds of funds to be able to take advantage of downturns. So, to your point with the credit or investing in their own capabilities, so when they have an investment or an investee that they’ve invested in, they have the right people in place to really work on the back office and gain those, the value-creation opportunities to be able to help weather the storm through a downturn. And also, they’ve brought their LPs along for the ride, because now it’s no longer that quick three-year turnaround. They’ve educated them and set their mindset that there’s a longer horizon. So, it’s all of those coming together, potentially some things that they’ve learned from the last downturn, potentially getting a bit smarter about thinking forward, but sounds like they’ve got a really good model to help them weather the upcoming turn.
Just one thing I want to ask, though, I mean, it still seems that if there is a downturn, there’s going to be a lot of pressure, I mean, pressure on results and making sure they made those right choices when they made those acquisitions, right? Because good companies survive. Companies that are a bit weaker, I mean, I guess the faults start to show.
Do you think that the funds will tolerate the low performances from their portfolio companies? Are they …really vetted that into their plan? And will the LPs be tolerant of the low returns? I mean, everyone wants a good return.
Great questions. I mean, a couple of other evolutions that have occurred in the industry, which I think go to respond to your question.
The first is most private-equity houses now have operating partners. So, to the extent to which there is performance or underperformance, performance issues or underperformance in portfolio companies, there are now managing directors and partners in private-equity houses who can quickly understand why those are occurring, step in and make the requisite changes in order to address them. So that’s happening. And that goes to your point about derisking portfolios, but also being quick to respond if underperformance begins to creep into an asset. You know, gone are the days that private equity would be reluctant, but happy just to pass the keys on to lenders. I think they’re now going to work quite hard to retain control.
The second thing I’d point out from an LP’s position is 10 years ago, LPs that were with a fund that began to underperform across its portfolio had little choice but to stay in the fund. Today, there’s a very good secondary market in LP positions, and the ability for LPs to trade out of positions is an option today that didn’t exist 10 years ago or certainly didn’t exist in the quantity or the volume that it does exist today. So, I think there’s, you know, a couple of other things happening in this market which future-proof portfolios, but also give options to capital to move if it doesn’t feel that a particular house is performing particularly well.
And Pete, what have you been seeing around the models in the way that the industry has been readying itself?
Andrew, you touched on this earlier, but it’s interesting. It’s just the amount of capital and the degree to which the industry has grown over the last 10 years. Essentially, the private-equity industry has doubled in size in that period of time, and, right now, private-equity firms manage somewhere around $3.4 trillion. They’re expected to manage, you know, somewhere around $5 trillion within the next four to five years.
So just massive amounts of capital, and a lot of that is dry powder. You know, somewhere around - depending on how you count it - between $700 billion and $1 trillion of dry powder. And so that’s capital that’s readily available to help support companies, good companies, to take market share during a downturn, but then also to fund new acquisitions and to do it at prices that are a lot more attractive than what’s out in the market today.
That makes a lot of sense, but if we kind of turn the track a little bit, how will a downturn in the economy potentially impact PE’s desire to continue to focus on the social-impact funds that we’ve been seeing pop up in a number of PE houses? Do we expect them to slow down investment in this area of the sector of the industry?
Social considerations now go across the portfolio. It’s not just looking for assets that may do good things for society. It’s how you manage your portfolios on a day-to-day basis. And, therefore, when you think about a downturn, you think about the next downturn, I think this is quite an important point for the industry, because there is greater recognition that private equity and private capital is increasingly important to our global economies.
If you look over the last 10 years at the decline in public companies and the rise in private companies and the greater transparency you get in public companies, the less transparency you get in private companies, a lot of regulators, politicians and those that are looking at this industry want to see private equity being socially responsible through the next downturn, and increasingly in its day-to-day investing.
So, I think when the downturn comes, how private equity puts capital to work, but also protects, drives value, preserves value in the companies that it’s already got are going to be a testament to the drive and ambition that the industry has around societal issues.
I think the growth of impact has been one of the most powerful trends that we’ve seen in the last 10 years. I think that LPs are really demanding these funds much more than they have in the past. I think that there is a mainstreaming of impact that we haven’t necessarily seen before. The difference now is that impact has been around for quite some time - right? - but in a very different form.
A lot of those earlier funds tended to focus on more of the impact than the return side, and so they sort of used a concessionary model of returns. And now what we’re seeing is large funds that are being raised by mainstream private-equity funds who are placing equal value on both societal impact and the return component as well. And I think that as, you know, the direction of travel for the global economy continues to focus on commerce as a lever for positive social change we’ll continue to see assets flow into these funds. And I think that’s a strong secular tailwind that will continue, you know, regardless of sort of where we are in the cycles.
Pete, that’s great news to hear. I’m sure that everyone within the sector is going to be really happy about the fact that the social-impact funds will continue to be strong and focused, notwithstanding any downturn in the economy.
If we were to kind of circle back now. We talked a lot about a lot of different issues today and how a potential recession may impact or not impact the private-equity industry. If you had some words of advice for either the PE houses or the portfolio companies, in terms of preparing for the eventual downturn and helping them get ready to see the other side, what would they be, Andrew?
Well, a couple of things, and I think some of the houses are already doing this. I think every target you currently look at today you should be looking at in the context of what’s going to happen to it in a downturn, but, more importantly, how will it recover from a downturn and what are the growth opportunities and strategies to be followed in a rising market, but where some of the competitor set are weaker than you are and perhaps have less access to capital. So, I think that’s a key way of thinking about investments in the current environment.
So, my second point would be for GPs to strengthen their platforms. We’ve mentioned the importance of credit. Many platforms have already got a credit arm. For those that don’t, you know, maybe a strategic alliance with a credit fund that is pure play credit and not private equity could be a way of strengthening the platform through an alliance.
Tangential to that, I would say strengthening operating capability, again, hiring people who are professional operators who can help both defensively protect investee companies through a downturn, but also be relevant to acquisition targets in helping understand the operation improvements that can be made to aid the target’s ability to grow in an upturn. So, taking some steps to strengthen and diversify the GP capability would be my second point.
You know, sector selection gets really important given where we are in the cycle. Firms are tending to focus on either counter-cyclical or non-cyclical industries at this point. We’re seeing more of that. We’ve seen a lot of money flow into the tech space, you know, somewhere in the neighborhood of like $180 billion last year. You know, a lot of that is flowing to companies with very resilient models and very, you know, high recurring revenues. So, I think the sector component is an important element of that.
And I think to just making sure that leverage levels continue to make sense in light of a potential 20, 25, 30 percent decline in EBITDA. I think, by and large, we’ve seen that the industry has remained pretty disciplined with that. There are a few deals out there with some fairly high levels of leverage, but, by and large, I think the industry average is somewhere around six percent, which is roughly where we were back in 2006, 2007. So, for the most part, the industry has remained, you know, fairly disciplined about how they deploy that.
So, in summary, what I’m hearing from both of you is that we expect PE to stay strong during any future economic downturn, and this is probably largely in light of the hard work that they’ve done since the global financial crisis to really prepare themselves through leveraging, investing in credit, making strong choices around the investment opportunities that they’ve taken that is expected to make them more resilient against any future downturns.
Also, I’m hearing that I think that PE is positioning itself to actually take advantage of any opportunities that may come out of a downturn, and they’re in a better place to do so after all that they’ve learned and how they’ve prepared. So exciting times ahead. Thank you both for a very informative discussion. We really appreciate your insights, and we appreciate you taking the time to speak to our audience today.
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