Top tips from fin services veterans on how to invest in a downturn

It has been more than a decade since the economy has seen a real significant cyclical downturn. As inflation bites, central banks have moved to raise interest rates after 10-plus years at which they sat near 0 percent.

Central banks are signalling they will make further rates hikes next month. US Federal Reserve officials have indicated a second straight 75 basis points rate increase, according to reports. The governor of the Bank of England said a 50 basis point interest rate increase is “on the table” for August in a speech on Tuesday following a 25 basis point increase in June with rates raised to 1.25 percent.

The European Central Bank, too, is deliberating whether to raise rates by 25 or 50 basis points, its first hike in over a decade.

Here’s some advice from three veteran financial services-focused private equity investors on how to invest in a downturn.

Take lessons from history

Joe Giannamore, who founded Europe-based financial services peer AnaCap Financial Partners, suggests that those younger private equity professionals, including those now in senior positions, take lessons from previous downturn periods.

“Read your history, accept that debt levels will reduce, multiples will reduce, that there may be value at investing in this point in time, although your portfolio from the recent past may suffer because it just simply can’t hit the same heights,” he said.

Focus on drivers of growth

Lovell Minnick Partners’ Spencer Hoffman, a partner who joined the US-based financial services-focused firm prior to the global financial crisis, said investors should take the same approach moving into this environment as you would do riding a bike.

“If you look down at where your wheel is pointed, you’re going to hit something or you’re going to lose your balance. You need to keep looking forward,” Hoffman said.

Managers need to focus on what will be driving the companies and markets they are investing in over the next five years as well as over the next 20 years.

“There could be a lot of challenges that need to be dealt with on a short-term basis, but if you maintain a long-term view, that will help you decide how you deal with those short-term challenges as well as find the opportunities to build great businesses for the next decade.”

Focus down on value creation

Make sure that your value creation relies more on operating performance over use of leverage and banking on big exit valuations, said Michael England, a partner at Pollen Street Capital. This should apply through the cycle, rather than as a downturn hits.

The firm has focused on three overarching trends: where technology is disrupting and accelerating change in financial services; where small businesses, particularly SMEs, are poorly served; and how the world transitions to a green environment.

“If you look at those three categories of overall growth, those are things which are not cyclically related… Within those big core macro drivers, you should be able to find businesses which are capable of growing regardless of cycle,” England said.

Managers must also maintain price discipline, which is important on a through cycle basis. It was a crucial year for price discipline in 2021 as valuations sored.

“Obviously, for those who didn’t, it’s sort of too late,” he added.

That’s why sector specialism is crucial to maintaining that discipline, England said. “It gives you a better chance of delivering the operating performance and it gives you a better chance of finding the businesses at good prices that can deliver that growth profile.”

There’s a lot of liquidity out there, so be careful of pitfalls

The private equity industry should also be grateful that there is a large wall of liquidity in the marketplace, which should provide a “rising tide to float most boats”, said Giannamore.

Managers should take a cautious approach when it comes to making investments. One key concern for Giannamore is the impact quantitative easing will play alongside other measures governments and central banks are using to tackle rising inflation.

“We have a third leg to this stool. They’re chopping two legs in terms of fiscal spending and interest rates, but quantitative easing is really only being liquidated at a very modest level over a very long time period,” he said.

There are two equally plausible outcomes, according to Giannamore.

“You raise interest rates to 3 percent, inflation gets dampened down, recession pulls in demand, you kill demand and you reset,” he said. “The alternative is that the QE liquidity in the system continues to pump inflation in a manner that we’ve not seen before – because we’ve never utilised that type of liquidity to this extent in the marketplace – and rates have to keep rising in order to try to get inflation under control with a stagnating economy.”