Few industries can boast a record year in 2020, but the private equity sector is the exception.
Though the onslaught of COVID-19 related measures took its toll, for the most part, the private equity (PE) market weathered the pandemic storm– and then some. After the number of deals fell 25% in the first half of the year, the sector as a whole still ended the year on a high note, gaining 8% on the previous year by deal value. The momentum spilled over to 2021, where PE was the highest-performing asset class within private markets, with an internal rate of return (IRR) of 27% and $6.3 trillion in assets under management (AUM), an all time record for the industry. Meanwhile in the same year, large American endowments enjoyed returns as high as 30-60% thanks to private markets, with private equity investments leading the gains.
But given its track record in previous market downturns, notably the dot-com bubble of the early 2000s and Great Recession in 2008, private equity’s recent performance isn’t altogether surprising. And though the repercussions of the pandemic are still far from over, by all indications, the PE market can continue to leverage its streak of resilience in times of financial crises. The bulls on the industry have gone as far as to suggest that PE funds might become instrumental to the post-Covid recovery , where the “new normal” includes a pivotal role for them as a supporting structure, though some critics also call for tighter regulations to check their expanding influence.
Private equity is a driver of growth in private markets. Private assets are not traded on a public exchange, and can include private equity (investments made in private companies), private debt (when investors lend directly to borrowers) or other illiquid investments, like real estate and art. While private markets as a whole have been on an uptick, with assets under management (AUM) at an all-time high of $9.8 trillion as of July 2021, both historically and now, the primary driver behind its growth has been private equity investments. Since 2017 alone, investors have poured more than $1 trillion into global private equity buyout funds, dwarfing the cash directed to venture capital, real estate funds, private debt, hedge funds and just about any other form of alternative investment.
The two bubbles that spelt trouble. In the 20 year period ending in 2022, average annual returns for private equity investments were around 14.75%, compared to 9.25% for the S&P 500 and 8.84% for the Dow Industrial Average.
The result varies when looking at different time frames. In the 10 year frame from the last recession in 2009, PE investment returns were generally on par with public equity returns, but if accounting for cyclical patterns, which are typical for public equity markets after financial crises, the PE funds were still outperforming traditional markets, especially in times of economic downturn.
Take for example, the two market bubbles of the early 2000s.
Regarded as the largest financial crises of the recent past, the 1998-2000 dot-com bubble and the 2007-2009 Great Recession (the aftermath of a housing bubble), were both a result of a speculative investor environment that eventually led to an equity market bubble. When investors realized the price detachment, a mass sell off ensued and a period of recession followed.
The earlier of the two, the dot-com bubble, was characterized by overvaluation of internet based companies, and coincided with the rise of private markets in the late 90s – during this time, prominent benchmarks for the traditional markets like the NASDAQ tumbled a whopping 78% in a span of two and a half years and virtually $5 trillion of market value was wiped out of the economy. When the bubble burst in 2001, the market was officially in bear territory.
The Great Recession occurred some years later but followed a similar trajectory: overvaluation of homes led to a bubble, and a recession followed a price correction – the bubble “popped” by 2008, leading to a full blown housing bust. Arguably the housing crisis was an even bigger test of private equity’s (and the rest of the market’s) resilience as it lasted longer and had a greater impact, with the S&P 500 down 48% in a span of 6 months, and about $8 trillion of market value wiped out by 2009.
PE funds fared better than public markets in both of these instances, with a less significant drawback and a quicker recovery period. For example, during the 2000- 2003 financial crisis, the U.S. Buyout Index – a key indicator of PE performance – saw a 27% peak-to-trough decline, compared to a drop of approximately 47% for the S&P 500. In the more recent down cycle from 2007-2009, the U.S. Buyout Index had a peak-to-trough decline of 28%, compared to roughly 55% maximum drawdown for the S&P 500.
Following the 2008 crisis – often the de facto case study for how PE performs in times of economic downturn – the market sentiment that seemed to emerge was that the more debt you have, the worse shape you’re in. So how then did the private equity sector, which involves accumulating debt, fare better than its counterparts during times of financial stress?
A study that looked into this puzzle examined UK based PE backed companies and compared their performance to non-PE backed companies’. While controlling for size and industry, their aim was to isolate the reason for their outperformance during the Great Recession. In the end, they concluded PE backed companies had better access to financing in times of liquidity stress, via their private equity investors, which allowed them to withstand the tougher climate.
“It’s like if you have rich parents and you lose your job, you can kind of isolate yourself from some of these costs in the short run because you can get money from them…” said Filippo Mezzanotti, an Assistant Professor of Finance at the Kellogg, who co-authored the same study.
The authors also concluded that companies backed by private-equity firms benefited from excess untapped capital, or “dry powder” in the years leading up to the recession – the firms that fell in the the top quartile of dry powder possession in 2007, experienced 10 percent more investment than non-PE-backed firms.
The availability of these resources allowed PE-backed firms to cut less spending, and in fact the study reported they spent 5.9% more than the non-PE ones during the peak of the recession.
Private equity emerged from the largest economic downturns of the early 2000s with a higher asset growth and increased market share, while the private market as a whole experienced a period of accelerated growth after 2009. At its pre-crisis peak in around 2007, the entire private-capital industry had some $2.2 trillion under management, while today it manages four to five times as much.
Like any other industry, PE did have its share of Covid related pain but it experienced more of a temporary freeze in operations than a prolonged setback. According to Bain & Company, the total number of PE deals throughout 2020 dropped 25% from the norm in the second quarter—around 1,000 deals – before picking back up in the 3rd and 4th quarters.
The blip was equally short lived in terms of income – PE investments that year generated $592 billion in deal value, 8% higher year over year, with the average investment much larger in value than the preceding years. This helps explain why despite the number of exits trailing those of 2019, global exit value remained on par with recent years.
Unsurprisingly the industries driving these record numbers were those that thrived during the pandemic. The technology sector was by far the biggest winner, with private equity backed IT deals gaining a massive 72.4% from 2019 and tech fundraising in the U.S. surpassing every prior record. Healthcare was a close second, with significant year-over-year growth in investment volume.
PE firms around the globe exited 2020 with almost $1.5 trillion of dry powder, setting the stage for formidable growth ahead. A Deloitte forecasting model predicts up to $6 trillion growth in AUM over the next four years, which would surpass 2019’s AUM at $4.5 trillion. IT and healthcare are expected to remain the biggest sector gainers from PE opportunities.
Going as far as to help the economy?
Some studies have also pointed out that private equity can play a pivotal role in helping smaller companies stay afloat during times of financial stress. Deloitte reports that PE firms helped its portfolio companies with less than $100M steer through the pandemic, providing them not only with capital to get through the liquidity stress but industry expertise to navigate the “new normal”. Combined with attractive returns, this supportive effort might’ve contributed to faster recovery across the globe, potentially carving an important role for PE in times of economic stress in the future.
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