The Rise and Rise of Private Equity
Private equity firms are a type of financial sponsor that conduct leveraged buyouts by using both finance raised from limited partners (such as pension funds, endowment funds, investment funds, high net-worth individuals, etc) and a heap of debt to buy companies, fix them up, and ultimately sell them for, hopefully, a profit. High value companies such as AA, Saga, and Halfords have been listed on the stock market by private equity owners. The whole process is a little like house flipping, and the best case scenario involves nurturing failing companies to achieve rapid growth by improving efficiency, cutting costs, and boosting cash flow in order to raise a substantial profit for minimal down payment. The heyday of private equity was in the mid-2000s, but they’ve gradually risen to prominence again since the Financial Crisis in the climate of extremely low interest rates and valuations.
What makes Private Equity so Attractive to Investors?
Spectacular returns are the big selling point for private equity. Over the past 25 years, returns have averaged 13%, compared with the 9% for an equivalent investment in the S&P 500 according to the investment firm Cambridge Associates LLC. The big advantage here is that private equity managers have much more flexibility to transforming the private companies they takeover, whereas the ability to make transformative changes to public companies is inevitably restricted. Moreover, the aggressive use of debt provides tax advantages and incentivises private equity fund managers to devote considerable resources to the success of any firm they take on.
For the company itself, receiving private equity investment means a huge injection of liquid capital and therefore the ability to grow quickly, alongside the expertise of private equity managers. Start-up companies are also able to attempt heterodox growth strategies without the restrictions of being a publicly listed company. Investment in start-ups is known as venture capital funding.
Private equity firms are also increasingly being seen as a compromise to the problem of excessive short-termism in public equity markets since they usually invest in firms for between 4-7 years on average.
Is Everyone a Fan of Private Equity?
Private equity firms are certainly not always viewed as the Good Samaritan of the financial world, finding struggling businesses, patching them up and sending them on their way. Many critics believe that private equity firms prioritise short term gains over long term value, desperately inflating the value of any company they swallow up and leaving them doomed to fail.
One example is Toys R’ Us. Critics argue that after Bain Capital and Kohlberg Kravis Roberts took over Toys R’ Us in 2005, they saddled the company up with $5 billion in debt, reducing the ability of the firm to innovate without actually creating any positive change to the efficiency of the business. By 2007, interest expense absorbed 97% of their operating profit, crippling their ability to compete with the likes of Amazon, and filling for bankruptcy 10 years later.
The case of Toys R’ Us is no exception, either. In April 2017, a report by Newsday found that of the 43 largest retail or supermarket companies that had filed for bankruptcy since the start of 2015, 40% were owned by private equity firms.
Whether these firms would have prospered without private equity, or whether their bankruptcy was the inevitable outcome of structural decline is impossible to prove. To be sure, there is a correlation between firms becoming bankrupt and being backed by private equity owing to a special type of funding, called distressed funding, or more pessimistically named ’vulture financing’. This refers to investment in troubled companies with underperforming assets or business units, clearly carrying immense risk, and increasing the propensity for private equity-back firms to go bankrupt.
How is COVID-19 Changing Private Equity?
Private equity firms are adapting to the massive uncertainty of the pandemic, pivoting their strategies away from the ephemeral and towards business that will succeed in post-pandemic markets. Collectively, private equity firms are steering 65,000 firms through the pandemic, and the longer-term structural shifts are still unclear. After the Financial Crisis, private equity bounced back incredibly quickly in some industries, but for others it only just recovered before the current recession, clearly fund managers have the dilemma of assessing which industries will bounce back, which will hibernate, and which may never return.
Central bank responses to the pandemic in pumping money into circulation helped private equity firms to avoid liquidity crunches, and investment activity picked up again in autumn. Fund managers have expressed confidence in tech and new investment opportunities have been catalysed by the pandemic here, however retail, restaurants, hotels and travel are all creating serious headaches for private equity fund managers and being forced into hibernation.
The low valuations in some of the most desperate industries are presenting private equity firms with the potential to make incredible returns if they recover, though the continued lack of clarity on what a post-pandemic world will look like is continuing to frighten investors away from these opportunities.
The Rise and Rise of Private Equity:
One of the biggest financial trends in 2020 was a surge in private equity-backed IPOs, especially within the tech industry, which reached an all time high. This is just the tip of the iceberg for private equity however, and its growth is backed by several years of consistent expansion.
Four major factors have contributed to the rise of private equity. Capital abundance driven by ultra-low interest rates has significantly lowered the costs of a leveraged buyout, though it should be noted that this does not benefit those private equity firms looking to buy, since easy capital sends assets prices soaring and is helping to undo some of the low valuations caused by the recession. Nevertheless, low interest rates have given private equity fund managers no issues with finding capital, and this trend is certainly expected to continue with both the FED, ECB and Bank of England expressing an intention to maintain low interest rates.
Alongside low interest rates, there has recently been greater flows of borrowed funds into ever fewer hands, increasing the concentration of capital to the major private equity houses.
Private equity has also been successful in meeting the demands of investors to be able to customise their portfolios and increase the liquidity of their investment. The idea that limited partners are locked into illiquid private equity funds for a decade or more is disappearing with the rapid growth of the secondaries market and a broader trend to accelerate the speed of deal-making. Whilst this encourages the growth of private equity, it is sure to attract further criticism by creating the impression that private equity, too, has an excessively short-term perspective and can detrimentally impact the longer term prospects of any business it acquires.
If anything, 2020 has also shown the flexibility of private equity firms to bounce-back and adjust to structural shifts and recessions. In conjunction with the broader climate of low-interest rates, capital concentration and rapid deal-making, the rise and rise of private equity doesn’t seem to be slowing down anytime soon.