This isn’t the first time—and it certainly won’t be the last—that private equity firms are bracing for an economic downturn. Although private equity firms usually earn their best returns after a recession, only the most strategic private equity firms get through a downturn successfully. While the U.S. is not quite in a recession (technically), private equity investors and their portfolio companies are dealing with persistent inflation, interest rate hikes, talent shortages, supply chain issues and continued geopolitical tensions. It’s safe to say the U.S. is teetering on the edge of a recession and experiencing softer market conditions, at the very least.
Private equity firms must make smart decisions given today’s environment if they expect to yield strong returns after the storm has passed. According to Bain Consulting’s midyear private equity report, investors can often earn superior internal rates of return in the years following a recession if they invest correctly. Finding strong companies whose valuation has suffered from a general economic pull-back can be rewarding. In this regard, following the burst of the dot-com bubble, buyout funds generated a median IRR of 25 percent in 2001, 40 percent in 2002, and 47 percent in 2003. In 2009, after the Global Financial Crisis, they posted a 24 percent IRR.
Unfortunately, identifying those rewarding investment opportunities is also more difficult during a downturn, and identifying and evaluating strong companies to acquire in an otherwise dislocated and soft market is fraught with risk and uncertainty. However, working with trusted advisors can make all the difference.
For example, during a down market, strong companies are often more widely marketed during a sale process, and can quickly become the interest of many competing buyers, which often leads to inflated sale prices (i.e., more dollars chasing fewer “good” deals). And there is pressure to get those deals done quickly. According to digital consulting firm West Monroe Partners, its clients used to have between 30 to 45 days of exclusivity, in which sellers were not allowed to engage in discussions with other potential buyers on deals. In today’s environment, these periods are closer to two weeks. The competitive and timing pressure for putting money to work for quality acquisitions can frequently lead to overpaying for an asset.
Broken deals, which costs investors time and money, are also a challenge during down markets. A transaction priced during last spring looks very different with today’s interest rates applied to it. These types of changes can impact a firm’s investment thesis or may mean the deal no longer fits its investment thesis at all, but deal inertia may cause a buyer to push forward into a deal that no longer makes sense. What’s more, in calmer markets, private equity firms could reasonably assume that past performance is predictive of future performance, but that assumption would be a illusory trap in today’s market. Was rapid growth over the past three years a sign of real strength, or will that growth degrade or reverse in light of a pull-back? Making the right call means doing the work to find out.
Working with trusted advisors can help investors think through all these potential pitfalls. Good advisors have insights into how macroeconomic conditions and industry trends may impact a target company and the relevant investment thesis. Businesses cannot be evaluated in isolation with a view only towards their performance or operations. Secondary and tertiary conditions, such as supply chain, employment and general economic conditions, are impactful and can be material to a proper evaluation and analysis. Good advisors understand and appreciate the interaction of elements as it relates to certain industries and sectors. And understanding these elements can help evaluate how a business will perform into, and out of, a downturn.
In addition to being harder to evaluate opportunities, recessionary periods often bring with it more litigation and regulation. Preparing an effective legal strategy prior to a down market is crucial. Legal advisors can help clients understand potential risks and proactively address or mitigate them before issues or loss contingencies may arise.
However, the key to working successfully with advisors is having strong relationships prior to a downturn. Private equity firms that don’t have strong relationships will find it difficult to make connections during a down market, as the most valued or best advisors will already be fully engaged in supporting their most trusted clients. Private equity firms should be working to specifically bring their relationships closer and look to them to play a more active role as deal making and assessment becomes increasingly difficult.