May I interest you in a fine vintage? It would contrast magnificently with all the spiked punch you've been drinking of late, which no doubt will leave you feeling rather queasy.
Put another way, you should expect good investments to be made over the next few years, while the past two years may well be spectacular duds. Here's why: Anecdotally, a convincing case can be made for the argument that funds launched amid recessions should outperform funds raised amid strong economic environments. A new fund closed during a weak economy tends to acquire assets at lower prices and often from motivated or distressed sellers. There is often an absence of competitive bids as the fearful stay on the sidelines. While debt availability and pricing during, or shortly after, a recession is usually not attractive, buyout firms can always refinance later when banks have a greater appetite for risk (see dividend recaps, 2006).
It is interesting to note how quickly the Great Men of private equity have switched from heralding a bold new era of private equity largeness to gleefully relishing the opportunity to pick up gems strewn around the site of the credit market train wreck.
At event after event and in article after article, general partners in the buyout world now describe a world of private equity opportunity with a different kind of enthusiasm than was exhibited during the days of 12-times leverage and PIK-toggles. The difference is, in early 2007 GPs suspected their success was due to luck; in 2008, GPs know their success will be due to smartness.
Being greedy when others are fearful is the very model of smart investing. Being greedy when others are greedy, circa January 2007, isn't dumb, but only dummies don't carry an underlying dread that the binge is going to cause acute indigestion.
The cynic would say that GPs, by showing so much enthusiasm for a credit crunch and recession, are attempting to portray the burning of Rome as a great time for a marshmallow roast. But in fact, GPs who have been through a recessionary conflagration before know that the worst of times lead to the best of funds. And they have the personal track records and industry data to back this up.
The numbers seem to bear out the anecdotal evidence, but with a twist. According to the State Street Private Equity Index, a new performance measurement from State Street's Private Edge Group, the best vintage years for private equity over the past 17 years have been 1993 and 2003. The years 1991 and 2002 are not far behind. While the long-average performance of private equity, net of all fees, has been roughly 15 percent, the average performance of funds launched in the vintage year 2003 is just over 33 percent. The average performance of funds launched in 1993 is nearly 27 percent.
What is notable about the years 2003 and 1993? Both come directly after recessions. If one defines recessions technically, they are limited to periods of economic contraction. According to the National Bureau of Economic Research, the last two recessions spanned March to November 2001 and July 1990 to March 1991. According to State Street, 2001, 1991 and 1990 aren't bad as vintage years – all of them outperform the long-term average of 15 percent by a wide margin. But for some reason, funds launched about a year after the end of actual economic contraction ends do very well, on average.
This may have to do with the difference between the technical definition of a recession, and the aftermath of a recession that people tend to remember as being just as ugly. Prices are still low, messes are still being sorted, and wounds are still being licked. But the period following a downturn, as opposed to the period directly in the haze of one, is characterized by greater confidence that the worst has been seen. After this deals happen and high-quality assets change hands at a greater rate.
Gerard Labonte, vice president of Private Edge, puts it this way: “At the bottom of the cycle in 2002 to 2003, where risk aversion was king, the disciplined investor had a rare opportunity to regain selectivity and generate exceptional returns to current date.”
What have been the worst vintage years for private equity? Would you be surprised to hear that the years 1998 and 1999 were stinkers in the single digits? Prices were high and shortly thereafter the markets tanked. Kind of makes you worry about the years 2006 and 2007. Good thing we have the prospect of a nice recession to keep hope alive.