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Get Ready – What about Private Equity?

Historical data shows that private equity’s outperformance increases during distressed periods. Investors turning their thoughts to portfolio construction ahead of the next downturn may want to consider adding a private equity allocation, not only for its outperformance potential, but also for its lower volatility potential.

But why? Private equity acts as a portfolio diversifier and has generated strong historical returns at a time when growth has become increasingly hard to find.

In fact, the virtue of private capital is that it can withstand short-term volatility in valuations of assets held for the long term – and now is the time to prove that.

When the bear market panic we are now living through falls into depressed acceptance of lower valuations, this vast pool of private capital should quickly go to work in the M&A market. In fact, it already is. At the end of February, a consortium of private investors, led by Advent International, Cinven and German foundation RAG, agreed to pay €17.2 billion for the German conglomerate thyssenkrupp’s Elevator business. The deal should complete by the end of the third quarter this year.

What is private equity looking for right now? The managers of these vast pools of capital will be searching for assets in fixed-income and resilient sectors that are either less likely to be affected by such events and effects as Covid-19 or where its impact can at least be quantified by forward jvc’s and warranties. 

One large and powerful group of investors, with plenty of money to put to work, need not panic quite so much at the precipitous falls stock markets have suffered due to the spread of the coronavirus Covid-19 and the lockdowns that have followed. Instead, its members are already looking for bargains amid the carnage, sometimes hunting alone, sometimes coming together in packs. 

In that wonderful, bygone, sunlit age – back at the start of February – data from Preqin, Dealogic and other sources suggested that across funds dedicated to buyouts of established companies; venture capital to support growth; dedicated infrastructure, real estate, special opportunities and distressed funds, managers of private equity had more than $2 trillion of dry powder – money that had been raised in large rounds of fund raising but not yet invested. 

In the first phase of any financial market panic, correlations go to one. Investors sell anything they can see a bid for, irrespective of quality. The only surprise about government bonds, credit and stocks all crashing at the same time is that anyone should be surprised. Cash is king. 

The guardians of these large pools of private capital are sitting on a lot of it. If governments can hold societies and economies together for now, central banks protect financial systems and their portfolio companies survive, then these private cash buyers will be big drivers of whatever happens next. 

“This is different from what happened during the financial crisis in 2007/08 and the dotcom bubble in 2000,” Klaus Hessberger, co-head of the strategic investors group EMEA at JPMorgan, tells Euromoney. Klaus Hessberger, JPMorgan.

In the last crisis, Hessberger worked in equity capital markets, seeking various pools of capital that overleveraged corporates might tap for rescue equity raisings and rights issues. Private equity had already done its work. “In those days, there was less dry powder available,” Hessberger recalls. 

“Private equity had previously amassed large funds but then invested most of it in big leveraged buyout acquisitions in 2006 and 2007. “This time, most funds have a lot more capacity to invest, having just finished their fundraisings.” Much of that uninvested cash comes from long-term investors such as sovereign wealth funds, pension plans, wealthy family offices and some public funds allocating to alternatives.

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But what exactly is private equity? Private equity is medium to long-term finance provided in return for an equity stake in potentially high-growth unquoted companies. Private equity investments typically support management buyouts and managing buy-ins in mature companies, as opposed to venture capital which provides funding for early-stage and younger companies – more information about venture capital can be found here.

As a model private equity is a proven driver of sustainable business growth. This is achieved through operational expertise, sound management and, importantly, through the close working relationship between the private equity backer and the company management team. In contrast with publicly-listed companies, which can often have thousands of shareholders, private equity managers work alongside the management team to enhance the running of the business. This governance structure leads to much shorter lines of communication between manager and investor, ensuring constant engagement between the two.

This ‘active ownership’ approach means the private equity manager will work alongside the company management team to enhance the value in the business. This can involve all areas of operation, from the top-line growth, efficiency savings, cash generation and procurement, to supply-chains, marketing and sales, improving reporting and human resources. Such an approach becomes self-perpetuating and ingrained within the company, ensuring that the business remains committed to creating value and increasing growth even after the private equity firm has sold its stake.

Private equity firms will typically look to hold investments for between four and seven years, at which time they will look to sell, or ‘exit’, their stake, either on the stock market, to a corporate buyer or to another investor.

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