Economic Turmoil, Capital Scarcity Leads to Outsized Private Equity Returns

1052439_11958235While the current market environment is creating challenges for private equity, if history is any guide, it will also create opportunities for top-tier players in the industry to generate attractive profits.  In the past, periods of recession, economic turmoil and capital scarcity have set the stage for outsized private equity returns.

For investors who are interested in taking advantage of opportunities in private equity, there are a number of key success factors to keep in mind regardless of the economic environment.  These include being able to (i) identify and access the best private equity managers, (ii) build a diversified portfolio to mitigate risk, (iii) deal with the significant administrative burden a diversified private equity portfolio creates, and (iv) implement a systematic approach to building and maintaining exposure to the asset class.  For investors who do not have the resources to support an in-house private equity team, partnering with an experienced private equity advisor is a prudent way to benefit from exposure to this rewarding asset class.

Recent events have created some unique issues in private equity investing, as well as some interesting opportunities.  One issue that has dominated discussion recently has been the shift to “fair value” accounting for private equity investments.  The shift to “mark-to-market” accounting for private equity firms has put pressure on interim valuations across the private equity industry. Investors need to develop their own understanding of how private equity fund managers are implementing this new approach, in addition to the potential for increased volatility in the reported values of their private equity holdings over time.

The ability of private equity fund managers to generate distributions through trade sales or public offerings has declined dramatically during the current economic slowdown.  The industry has also seen a decline in deal activity in part because tightening credit conditions have made financing transactions more difficult.  Some private equity-backed companies are also facing serious financial headwinds, and in some notable cases bankruptcy.  Interestingly, however, private equity-backed companies have generally experienced a lower default rate and longer time to default than non-private equity-backed enterprises.

At the same time, the current environment is also creating opportunities. Even as private equity managers work to address the key challenges facing their existing portfolio companies, those with available capital are increasingly focused on the promising buying opportunity they see ahead. Private equity managers that are focused on distressed investments – buying good companies with bad balance sheets – are becoming more active in the current environment.  In addition, for investors with the ability to purchase secondary interests (i.e., commitments in existing private equity funds), the current economic difficulties have compelled some holders to consider selling.  Knowledgeable private equity investors with an ability to evaluate portfolios can purchase these interests at attractive prices, sometimes gaining exposure to otherwise difficult to access fund managers.

Overall, the current economic environment has created a number of interesting and unique challenges, as well as opportunities, for the private equity investor.  Partnering with an experienced private equity advisor provides a way to both navigate the risks and take advantage of the historical return potential that these opportunities represent.

Stuart Waugh is managing partner, Northleaf Capital Partners