The current period of global economic expansion is one for the history books. Fuelled by low to non-existent interest rates since 2007-08 and massive injections of central bank cash, the IMF says growth in 2018 will average 3.9 percent globally, a record. It expects this to continue into 2019 before slowing. Then the ride might get bumpy.
Three-quarters of economists surveyed by US trade association the National Association of Business Economics forecast a recession in 2020-21. Other surveys of economists and business record a similar sentiment. With a slowdown at some point inevitable, the question for private equity is what impact this might have on portfolios – and whether private equity may be a systemic risk, given its increased economic role over the last 10 years. The Bank of England, the European Central Bank and the Federal Reserve have all cautioned that the growth of leveraged buyouts warrants greater oversight.
One way to answer whether these fears are justified is to look back a decade ago and see how private equity fared. A new paper does exactly this – and the results are encouraging.
“One part of the story is private equity-owned businesses weren’t leveraged like they were in the 1980s at 90-10 [debt to equity] or even 95-5; it was more like 70-30. So there was certainly some learning that took place”
“When we began the research we weren’t sure what we would find,” says Harvard University professor Josh Lerner, one of the authors. “We really only had the experiences in the 1980s to learn from, where many private equity-backed companies went into receivership. This suggested private equity backing might be quite harmful during a downturn. On the other hand, we could imagine a world where the relationships the private equity groups had with banks and the funds that they had raised would allow them to re-equitise businesses and enable the continuation of credit lines. And we found that the evidence largely supported the second scenario.”
The paper by Lerner, Shai Bernstein at Stanford University and Northwestern University’s Filippo Mezzanotti looked at whether private equity contributes to financial fragility during economic crises. Focusing on UK-based private equity-owned businesses, it found that across most metrics – investments made, cost of debt, asset growth and operational support from the financial backer – private equity-backed companies outperformed peers during the crisis. Internal rates of returns of vintages in the years leading up to and during the financial crisis also bear this out.
Lerner says lessons from previous private equity blow-ups played a big part in the relative stability during the 2007-08 period. “One part of the story is private equity-owned businesses weren’t leveraged like they were in the 1980s at 90-10 [debt to equity] or even 95-5; it was more like 70-30. So there was certainly some learning that took place.” But he cautions that only goes so far. “We do see economic cycles where the same things are repeated.”
Other analyses support Lerner’s findings. HEC Paris professor Oliver Gottschalg’s work on private equity performance and alpha generation through economic cycles comes to a similar conclusion.
“While there were many things done in the 2006-07 period which turned out not to be good ideas, private equity overall delivered on its promise to generate alpha, and default rates at private equity-owned companies were lower,” he says. “Private equity has a five, six, seven-year horizon so they could literally be patient, transport businesses through the downturn and leave them well positioned for an initial public offering or trade sale.”
He says two tools criticised by some at the time as recklessly loose enabled companies to work through problems that might otherwise have hurt them. “Covenant-lite debt terms and payment-in-kind loans gave GPs more time to work on the transformation of a business. But this is not to deny there were painful losses.”
Toys ‘R’ Us has become the posterchild for these losses. Owned by Bain Capital, KKR and real estate firm Vornado Realty Trust, its demise highlights a broader trend: private equity-backed bricks-and-mortar retail businesses bought ahead of the crisis have not obviously benefited from private equity ownership. A separate study by Lerner and colleagues recorded a 6 percent rate of job loss at private equity-backed retail companies from 1980-2000. Lerner points out that these “huge” losses came before the rise of online retailer Amazon, implying that the Amazon-plus-private equity effect on retail jobs might be even more pronounced.
“Outside of a downturn and on the average, specialisation helps returns”
Gottschalg says the retail experience is instructive for firms looking at their strategy ahead of a downturn. “Sector generalists do better in a downturn than sector specialists, because downturns hit sectors asymmetrically. If you have 12 portfolio companies and two or three are in the same sector you have to roll up your sleeves and work on those – but it is a minority of your portfolio and is supported by the seven or eight in better sectors. But as a specialist your whole portfolio might get hit if you are exposed in the worst-hit sectors.”
This presents a tricky calculation for some firms that target the higher returns that come with a sector-focused approach. “Outside of a downturn and on the average, specialisation helps returns,” says Gottschalg, who also attributes weaker performance to those who try to ride a sector wave. “GPs that timed the market but without adding lots of value were hardest hit [during the crisis]. Strong alpha creators were those that did well in the crisis and were more likely to outperform in the future.”
In response to the weaker case for private equity when looking at the retail sector and job numbers, Lerner says the new study is “not looking at everything”.
“We’re looking at investment and market share. We’re not looking at employment or wages, where you can imagine there may be very different results. There are many stakeholders we’re not considering,” he says. But he reiterates that “it’s hard not to walk away with a sense that companies backed by private equity did relatively better during the crisis”.
The paper makes convincing reading. But it doesn’t consider limited partners fully. And it’s with this key stakeholder group – and a relatively new financing tool – that Gottschalg says there may be trouble brewing.
Fund level credit lines that allow GPs to invest and pay distributions from an advanced loan rather than from the fund have exploded in popularity in recent years, and if the wrong set of circumstances come together, Gottschalg says LPs may find themselves on the hook for big bailouts.
“If interest rates rise and companies contract, banks will want to get out of those fund level credit lines as soon as they can – and when they do, LPs have to chip in the cash. That’s a legal commitment. I was talking to an LP with $1 billion in unfunded commitments and they need to have that money ready if crisis strikes. So you have this mechanism that will force LPs to put in money for a fund that might not be worth anything any more to cover a bridged investment made at a time when things were better. The question is how rapidly this money will be called after the crisis. [Compared with the LPs] GPs have total optionality on this.”
Whether fund level credit will be the thing that crashes firms and companies when the next recession hits is impossible to determine. A general is always fighting the last war, the saying goes, and compared with 2007-08, these credit lines – and their behaviour in a crisis – are a dangerously unknown quantity.