Private equity has become an increasingly popular asset class among all accredited investors. Once reserved for the ultra-elite institutional investors, dedicated private equity funds are now offering this alternative asset class to accredited investors, institutional and individuals alike.
The interest from any potential investor is undeniable: traditional asset classes, such as public equity or fixed income, struggle to beat private equity returns. Using the most recent Cambridge Associates US Private Equity Index data (September 30, 2021), the 5-year compound annual growth rate (CAGR) of this private equity fund composite returned 22.9% net of fees to investors. For comparison, the S&P 500’s 5-year CAGR through September 30, 2021, was 14.7% and the Barclays U.S. Aggregate Bond Index 5-year CAGR through September 30, 2021, was 2.9%. The margin by which private equity fund returns have beaten S&P 500 returns is likely to widen even further based upon this recent market sell-off, as the S&P 500 5-year CAGR through May 11, 2022, is now just 10.5%.
Given private equity’s growth, both in terms of dollars invested and number of funds, it’s not illogical to wonder what to make of the private equity opportunity, as we appear to be heading toward an uncertain economic climate, evidenced by increasingly negative economic indicators. This topic of timing is one of the top questions that Roebling Capital receives from existing and potential investors as Roebling raises its second fund. For dedicated private equity funds, an economic downturn represents buying opportunities on attractive terms and the flexibility to make long-term strategic decisions without having to worry about short-term fluctuations in stock price.
There’s considerable research and data that demonstrates private equity fund’s outperformance during all periods, but especially during depressed economic periods. In fact, if you observe private equity fund performance by fund vintage (i.e., the year in which capital was raised), in general, you will discover that firms that have raised funds just before, during, or just after an economic recession tend to outperform the returns of funds raised during more favorable economic periods. Based upon a Cambridge Associates study on private equity returns by fund vintage, funds raised in years 2001, 2002, and 2009 generated the strongest returns of any year between 1994 and 2016. There are many contributing factors to explain this.
First, buying during a depressed economic cycle provides some advantages. Aggregate earnings by company tend to be flat or even declining during prolonged periods of economic distress. Buying an asset at or near the trough of an economic cycle makes growth more likely when headwinds turn to tailwinds, which improves the return profile when coupled with a lower investment basis that reflected the earnings during the challenging period. For reference, if a business peaked at $3MM annual EBITDA and was purchased at that point, a private equity fund would have had to increase EBITDA by $300K to generate 10% growth. However, if that same business is now generating $2MM annual EBITDA due to a depressed economic climate and is instead purchased at this point, that same fund would only have to increase EBITDA by $200K to generate that same 10% growth. Simply put, higher growth is more probable for strong businesses in defensible industries (on an entry vs. exit basis) when buying during depressed economic periods.
Also, buying during a depressed economic period can yield a more favorable valuation when considering the purchase price relative to earnings (e.g., “EBITDA multiple”). While this phenomenon of a lower valuation is not a given during a recession, buyers are typically willing to pay more for growth than they are for a flat earnings stream. Additionally, there’s typically less demand from buyers, but the supply of businesses for sale does not decrease at the same rate. So based upon lower growth expectations and pure supply and demand dynamics, EBITDA multiples will decrease. As economic conditions improve, the recent growth profile of a business along with increased demand from buyers will cause EBITDA multiples to rise. Historically, a full economic recovery has been likely to occur over the typical 3-year to 7-year private equity fund hold period, so a private equity fund can then sell a company for a higher EBITDA multiple than its purchased EBITDA multiple. This reality, combined with the aforementioned EBITDA growth potential, increases the likelihood for outsized returns at the time of exit.
In addition to the attractive buying opportunities during an economic recession, dedicated private equity funds also provide managerial and financial support to companies in their portfolios, which can decrease risk and drive attractive return profiles. During a depressed economic period, access to capital can become scarce, particularly for those who are not well versed in the capital provider landscape. Because private equity funds routinely use numerous capital providers, including senior lenders and subordinated debt lenders, maintaining capital accessibility is much more probable and efficient for private equity portfolio companies. Simply put, dedicated private equity funds know how to structure, restructure, and seek alternatives that allow companies to access capital in a variety of economic climates. This capital accessibility improves the company’s risk profile and overall outlook as it pertains to pursuing strategies with normal or even above-normal levels of aggression.
Dedicated private equity funds also take a proactive approach to improving their portfolio companies by dedicating staff and external resources to portfolio companies and leveraging experiences gained during past economic cycles with numerous other holdings. These experiences provide a framework for operating the current portfolio companies and incorporate learnings from prior experiences, both good and bad. It’s extremely valuable for a company to have dedicated resources with such experience and expertise. These best practices enable a portfolio company to a) prevent major stumbles that otherwise would have occurred and b) recover much quicker than other companies that are navigating the economic conditions without this support.
As you can see, the private equity asset class shouldn’t be any less attractive during an economic downturn or recession, and an economic contraction may actually be the perfect time to become more bullish on private equity and increase your allocation accordingly.