Equilibrium of capital


Filling an economic void

The past few years have seen private equity funds raise significant amounts of capital. A few months ago, it looked as though the industry had too much cash at its disposal, yet with many companies now crying out for capital, the situation is very different today.

It now seems like another era entirely. At the end of last year, excess liquidity was continuing to drive record-breaking figures for private equity on several fronts as investors increased their allocations to the asset class in a search for yield in a prolonged period of low interest rates. Indeed, the industry’s assets under management surpassed the $4tn mark for the first time in 2019, according to Preqin figures[1].

Back then, it was possible to argue that there was something of an imbalance between the large supply of capital and the number of good quality investment opportunities. In fact, before the pandemic hit, purchase price multiples were another record-breaking metric, pushed higher by increasing competition for deals. In the first three quarters of 2019, the average purchase price multiple on large US buyouts was 11.5x EBITDA, according to S&P[2], up from 10.6x in 2018 and the highest ever average. Meanwhile, the lack of high-quality deals is also reflected in the fact that 30% or more of the value of exits annually by private equity firms in the period 2017-2019 was to other private equity sponsors, according to Dealogic[3], far higher than the previous post-financial crisis years.

All change

Yet so much has changed: we now have an imbalance in the other direction. While we still have low interest rates today (in many cases, these have been cut still further), the economic shock caused by the Covid-19 pandemic and the resulting lock-downs across many parts of the world mean that liquidity is now at a premium. We are unlikely to see private equity smash any more records for the foreseeable future, yet what we will see is a period in which the industry has the potential to generate strong returns with the significant dry powder it has amassed.

With vast numbers of companies needing more funding and support than ever to survive, private equity’s dry powder looks limited compared to the investment that will be necessary over the coming period. The amount of capital raised globally but yet to be invested stood at a record $1.43tn in December 2019, a figure that had almost doubled since 2015, according to Preqin figures[4]. Yet this figure is dwarfed by the $3tn federal relief commitments made so far in the US alone, with further stimulus packages under discussion[5]. And there are clearly similar, significant funding packages to support businesses in markets across the world, totalling many more trillions of dollars.

These state-backed measures are clearly necessary as we face the biggest economic shock in living memory. Over the coming period, we are likely to see governments owning or partially owning large swathes of business in a bid to keep their economies going. While Boeing, for example, opted not to tap the US federal government for a bail-out and went for a $25bn bond issue instead, its case makes clear that governments are prepared to provide financial support to prevent large companies failing and to keep competitors in markets (no-one, after all, wanted to see the Airbus-Boeing aircraft manufacturing duopoly become a monopoly). Yet this state assistance will have to come to an end at some point and governments are unlikely to want to remain significant shareholders in companies. In addition, we are likely to see many corporates start to divest non-core businesses to raise badly needed capital.

Enter Private Equity

And this is where private equity comes in. Over the medium to long term, we are likely to see a busy time for the industry as firms identify attractive investment opportunities. Almost overnight, what was once an oversupply of capital to private equity houses has become a distinct advantage for the asset class. While liquidity may be constrained elsewhere, private equity firms will have the firepower to acquire stakes in companies at potentially much lower valuations than we have seen for some years.

Previous downturns have actually proven to be some of private equity’s best vintages. Firms with capital to deploy are in a great position to provide funding and help rebuild, refocus and strengthen businesses both within their existing portfolios and through new investments. Given the scale of funding needed, they are also in a position to be highly selective about the companies they back. Provided firms are able to pick businesses with a strong future at a time when wholesale change has made looking to past performance often irrelevant to what may come, the next few years could be a new golden age for private equity returns.