In a period where outlook is uncertain, the big questions for PE are: What did the industry learn from the Great Financial Crisis? How has the industry model developed since? How will PE respond differently next time?
According to a new report by EY, four ways in which PE firms today are better prepared for an economic downturn are as follows:
The industry has more capital at its disposal
As long-time limited partners (LPs) in PE increase their exposure to the asset class and a wide range of new entrants – including family offices, sovereign wealth funds and high net worth investors – invest in PE for the first time, PE firms have more capital at their disposal than ever before.
PE funds are currently estimated to hold more than US$1.4t in immediately deployable funds, and when other adjacent asset classes are added – credit, infrastructure, real estate, growth capital etc. – the aggregate amount of committed capital PE can readily deploy stands at more than US$2.6t.
Furthermore, the significant growth of direct investments, co-investments and separate accounts – so called “shadow capital” – in recent years means that PE firms and other private capital investors have even more capital at their disposal than is commonly reported.
The industry has diversified in ways that increase its resilience
The last decade has seen PE firms increasingly diversify across a wide array of private capital strategies, including growth capital, real estate, infrastructure, sector-specific funds, and private credit, in particular. Private credit, in the forms of direct lending, distressed, special situations and other strategies, has grown to become a US$800b industry and is expected to double to more than US$1.4t by 2023, according to Preqin estimates.
As demonstrated during the last downturn, distressed lending proved particularly useful as a countercyclical source of capital, and, together with private credit’s significant dry powder, represents an important credit buffer during times of weakness in the traditional credit markets.
PE firms have expanded operating capabilities
Many PE firms have significantly expanded the depth of their sector expertise. They’re using data and analytics to build tested playbooks to accelerate the value creation process. Many are also using a shared services model to drive efficiencies across the portfolio in areas like procurement.
As such, firms are better situated than ever before to respond to the challenges of economic dislocation at their portfolio companies. Moreover, they’re well positioned to capitalize on the opportunities it might afford, such as investing in complex carve-out assets in need of optimization or buy-and-build strategies to effect consolidation.
LPs are more sophisticated and have access to better tools
During the last crisis, many LPs were constrained from investing additional capital in PE by the “denominator effect”, which happened when the valuations in their public portfolios fell dramatically, and many LPs found themselves suddenly overallocated to private investments relative to their target allocations.
Today, many LPs are closely monitoring their pacing in the event of a potential fall in public equities, and others are tweaking their investment process to allow for greater flexibility.
The market for LP secondaries – the buying and selling of limited partnership fund interests – has also seen significant growth over the past decade. In fact, 2018 saw record levels of such transactions. The result is more flexibility for investors to adjust to volatile market conditions.
In summary, PE has evolved significantly over the last decade, and this evolution will continue. PE firms now have access to more capital to double-down on promising companies experiencing temporary distress from macro forces. Funds have improved operating capabilities to help companies make more informed decisions. And, their wholesale expansion into adjacent asset classes – credit in particular – gives funds new means of providing support in ways they largely did not have a decade ago.