How private equity performs during downturns

A recent study by Oliver Gottschalg, a professor at HEC Paris Business School, explores “the GP effect” across private equity downturn deals done over a 25-year period. The study identifies downturn deals by looking at the evolution of the stock market index from acquisition to the PE firm’s exit. A situation in which the stock market returns are negative – or at least so low that they would have been unable to cover the cost of debt in the buyout – are called “downturn deals”, Gottschalg explains.

Ultimately, the study seeks to understand how likely it is for PE-owned businesses to experience economic downturns and how often PE owners succeed in navigating their portfolios through such periods.

Using HEC Paris data on 12,434 realised buyouts worldwide by 195 PE firms – each of which made at least nine realised buyouts – from 1993 to 2018, Gottschalg was able to measure the proportion of downturn deals in this “universe” of buyouts. Some 4,018 downturn deals, or about 32 percent, were identified based on this method.

“When we look at the performance outcome of those 4,018 downturn deals, we are able to document an impressive ability of PE to deal relatively well with downturns and add sufficient levels of alpha, ie outperformance over stock market trends, so that deals are brought to an overall positive performance outcome,” Gottschalg says. “We shall call such a deal, which generates a strictly positive return despite a poorly performing stock market environment, a ‘downturn success’. Overall, we observe 2,625 downturn successes out of 4,018 downturn deals, which corresponds to a downturn success ratio of 65 percent.

“This is a remarkable number in itself and provides strong empirical evidence in line with the long-standing academic predictions regarding the superiority of PE in particular in downtown situations.”

“We are able to document an impressive ability of PE to deal relatively well with downturns”

Oliver Gottschalg
HEC Paris Business School

Key drivers

The study also sought to answer the question: how does a downturn deal turn into a downturn success? To this end, Gottschalg says buyout deals were analysed by industry, geography, the year of the deal and PE owner. “Using multivariate statistical methods, we observe that the investing PE firm [is] by far the most important determinant of whether a downturn deal becomes a downturn success or not,” he says.

“The so-called ‘GP effect’, ie the specific ability of some – but not all – PE firms to guide companies well through difficult economic times, is about 10 times more relevant as a determinant of the outcome of downturn deals than other factors.”

The study also looked into the link between fund managers’ performance across multiple crises: that is, a manager’s downturn success ratio in a given five-year period is significantly correlated to its downturn success ratio in a subsequent five-year period, says Gottschalg. Attributes such as active ownership, a hands-on approach to portfolio management and long-term nature – all of which are inherent to PE – are at the root of firms’ ability to weather a crisis, according to the study.

All that being said, recessionary periods aren’t all the same; high interest rates and rising inflation make the current downturn different.

“One [piece of] advice I could give an LP today is… they are very likely to be better off if their money is in the hands of those GPs who have done better in past downturns.”