by Brian DeChesare Comments (8)

Private Equity: The Biggest Loser from the Coronavirus Crisis?

Private Equity Biggest Loser

I’ve written about areas that might be “safe,” or ones that might benefit from the pandemic and recession/depression: restructuring, distressed private equity, and healthcare investment banking.

But outside of those, how much damage will there be in other sectors?

This downturn is odd because many industries have been destroyed, others have stayed about the same, and a few have benefited.

So far, job losses in the finance and insurance sectors have been very mild.

But job losses rarely give you the full story, especially in industries with relatively low headcounts.

One example is private equity (the normal kind, not distressed), which directly employs relatively few people.

Despite that, most of the PE industry could be in for a tough period, and it will probably be less appealing if/when the crisis ends.

That’s because government actions have propped up asset prices while doing nothing to help struggling portfolio companies.

Normally, firms want to acquire fundamentally solid businesses at bargain prices – but the current situation is the exact opposite of that:

The Typical Arguments in Favor of Private Equity

When this crisis began, sites like Vanity Fair published articles declaring that “private equity is winning the coronavirus crisis.”

They argued that PE was “too big to fail” and that, like the big banks after 2008, it would emerge victorious but with more regulations and restrictions, such as the end of the tax loophole on carried interest.

I also heard from many readers who thought the industry would come out ahead because:

  1. Firms have so much “dry powder!” They’re up to $1.5 trillion in unspent cash, so they’re perfectly positioned to take advantage of a recession/depression.
  2. Private equity is a “long-term” asset class, so an economic catastrophe in one year won’t make a difference to performance over 5-10 years.
  3. And in the worst-case scenario, PE firms can just make a few “capital calls” and ask their Limited Partners (LPs) for additional funds.

However, I’m skeptical of all these points:

Point 1: Why “Dry Powder” Doesn’t Necessarily Help in This Crisis

“Dry powder” is useful if prices have fallen significantly, while business fundamentals have taken only a minor hit.

For example, it was helpful in the 2001 – 2003 and 2008 – 2009 periods because equity markets fell significantly, and many industries declined – but not catastrophically so.

That meant that PE firms could find solid companies at bargain prices and ride out the recovery.

This time around, prices haven’t fallen nearly as much due to massive intervention from the Fed and other central banks.

The S&P 500 dropped almost 35%, but then rebounded, and now we’re back to early 2019 levels.

Sure, it has been propped up by Big Tech, but even companies like Disney that should be devastated are not down that much.

The only companies that are still down significantly are ones like airlines that will have to restructure or liquidate.

Even in the credit markets, prices haven’t fallen that much because of the Fed’s promise to buy every asset imaginable (take a look at the chart for VCLT).

On a recent podcast, Howard Marks from Oaktree even said, “I wish the Fed would get out of the way” because its actions were preventing bond prices from falling.

That leaves us in a strange state: business fundamentals have collapsed in many sectors, but equity and fixed-income prices are still high – the exact opposite of what PE firms want.

Point 2: Is Private Equity a “Long-Term” Asset Class?

My answer here is: “Kind of, but less so than you might think.”

Yes, some private equity funds last for ~10 years, but fundraising cycles have been accelerating.

Once a firm raises a new fund, it waits an average of just over 3 years to raise the next one.

That means they’re using short-term performance data from the first few years to market the next “long-term” fund.

Many PE firms already play games with their performance data by including both realized and unrealized gains, and we’ll see even more of that as they try to “exclude” coronavirus-related losses.

That will make it more difficult to raise funds because LPs will become more skeptical of the performance figures.

And if firms want to list their legitimate results, it will slow down fundraising cycles because they’ll have to wait for a recovery before raising their next fund.

Point 3: What About Capital Calls?

In theory, PE firms can ask their LPs for additional capital when needed.

But if the LPs are not in a position to provide that capital – usually because they’d have to sell other holdings to raise the cash – then all bets are off.

LP defaults were already happening when the crisis first began, so they’re probably up to an even higher level now.

And even if a capital call works and helps portfolio companies survive, it still reduces returns, further hurting performance data.

Broken Business Models and Politics

Finally, a few other factors have emerged that make me skeptical of the industry’s prospects.

The first is that the business model of traditional leveraged buyouts doesn’t work in a pandemic.

Adding leverage and making companies “more efficient,” usually by cutting costs, work as long as sales continue to roll in.

This model also works when interest rates are low because additional leverage isn’t that expensive.

But what happens if a company’s revenue suddenly drops by 50% or 80%?

At that level, low interest rates and “added efficiencies” are irrelevant because the company can’t even cover its baseline operating expenses.

PE and VC-backed companies cannot claim government money from the CARES Act (and likely any future stimulus), so firms don’t have many options for troubled portfolio companies. The main ones are:

  1. Hope a capital call works or attempt to raise additional funding in the public markets (accept dilution and lower returns).
  2. Restructure or declare bankruptcy (potentially get wiped out if creditors seize control).
  3. Hope for a quick recovery and enough cash to last until then (well, the deus ex machina works in movies, right?).

Even if there is a “quick recovery,” such as one that takes 1-2 years rather than 10, there’s another problem: significant political pressure will build against the industry.

The government’s response to the pandemic is only widening income and wealth inequality, so you can expect protests and demands for new regulations, wealth taxes, financial transaction taxes, restrictions on leverage, and more.

Politicians will point to companies like J Crew, Neiman Marcus, and Toys R Us, say that private equity firms crushed them and destroyed jobs, and use it as justification to change the industry.

In other words, Elizabeth Warren’s proposals could easily become a reality.

What About Other Sectors?

I’m not going to write a full breakdown here, but in short:

Investment banking will hold up a bit better because companies always need liquidity and funding. Yes, very few M&A and equity deals are taking place right now, but debt offerings and restructuring deals are off the charts.

The same applies to areas like corporate banking: whenever companies panic and need liquidity, CB benefits.

Hedge funds will be a mixed bag. Yes, the crisis has created some opportunities, but central-bank intervention has also hurt their ability to find bargains.

Venture capital will also be mixed; some tech and biotech portfolio companies may benefit from the crisis, but many of them are not true tech companies.

For example, Uber is more of a “bad transportation company” than a tech company, as it loses absurd amounts of money and has low gross margins.

Companies like that will suffer, so the results will vary tremendously by the fund.

Corporate finance and corporate development are completely dependent on the industry.

Neither one will do so well at airlines, retail, restaurant, or travel-related companies, but they’ll hold up in less-affected sectors.

In corporate development, one positive is that professionals don’t necessarily “need” M&A deals to stay employed; they could work on joint ventures or partnerships, or they could survey the industry landscape and do research.

Commercial real estate will also suffer, but mostly in the office, retail, and hotel markets; demand for industrial space (warehouses) and data centers will rise, and multifamily demand won’t change much.

The Bottom Line: Is Private Equity the Biggest Loser?

Looking at everything above, I’ll revise my initial thoughts a bit.

I don’t necessarily think that private equity will be the “biggest loser” in the finance industry as a result of this crisis, but it will be among the sectors that decline in the long term.

The biggest issue is that business fundamentals have collapsed, but asset prices have not fallen nearly as much due to massive intervention from central banks.

Also, the traditional LBO business model doesn’t work in times of severe crisis (as some former PE insiders have noted).

That said, growth equity firms and smaller PE firms that do not rely on leverage and cost-cutting may hold up better.

I don’t think you should necessarily “avoid” private equity because of these points.

The large firms will probably continue to recruit on schedule, as usual.

But in the long term, the industry will become less attractive, the pace of fundraising may slow, and there will be fewer openings.

And once the politicians pile on, things could get even worse.

M&I - Brian

About the Author

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.

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  1. Why do you think the outlook for distressed PE is so much better than standard PE? I would think both would have a pretty negative outlook given where returns have been.

    1. Because distressed firms can still find opportunities in companies whose market values have declined – look at some of the deals being done with airline and travel-related companies. I don’t necessarily think the outlook is vastly better than the one for normal PE, but it is at least somewhat better.

  2. Hi Brian,
    thanks for this interesting read.
    I have 2 q’s
    1- do you think business fundamentals will bring down the market to the same extent as the mid-March crash when Q2 results are announced? Don’t investors already know fundamentals will be bad and therefore the stock market has already priced this in?
    2- I’ve just received an offer as a financial analyst for a solar IPP – it involves both corporate and project finance and I’m genuinely passionate about clean tech. However, I’m also very interested in investing and want my next job to teach me as much as I can learn about investing for personal wealth development– basically I’d like a job which can help me in the event I don’t have a job and be financially independent– but I live in Dubai where the asset / investment management funds are mainly family offices with a predominantly male workforce. I’m also not convinced I’ll
    a) I’ll enjoy investment management
    b) if anyone has a clue how financial markets actually work- i.e. if this is a sustainable model for investing, which makes me think maybe I can do investing as a side thing + invest in RE.
    I’d appreciate any guidance as I’m totally lost at this point.
    Thanks,
    Kriti

    1. 1) I think the issue is that overall indices like the S&P 500 will look deceptively high, but that hides the huge variance where companies like Amazon have done well and others have struggled. The overall index may or may not fall, but as more individual companies start defaulting and declaring bankruptcy, there will be even more of a divergence between winners and losers. But, if I had to bet, I still think many indices will fall further.

      2) I don’t know much about clean-tech investing/finance, but if you have a solid offer at this firm, in this market, I would accept it. Maybe it’s not your ideal job, but you could probably use it to transition to something else afterward, such as infrastructure / project finance / clean-tech advisory roles.

      1. 1) I hope so- I’m short SPY!
        2) I am leaning towards accepting it, and it’s a small team with great experience + solid series A funding from last year, though they’re down 18% q1 because of C-19 and it’s a risky bet. I should’ve also mentioned I already have a job at the big 4 as a valuations analyst (2nd year) but find myself demotivated at how unimaginative and uninspiring it is (and my team sucks but I can deal with that). So I’m not sure if I should stick with a safer job at the big4 or make the jump- would really value your advice. More importantly, do you think my line of reasoning for wanting to join an investment fund (public equities) is rubbish? I.e. people don’t seem to think market experts know where the market it headed anyway so I a job in the industry won’t be much more useful than doing my own research + reading some solid investing resources? I wish private equity was more accessible to the retail investor, do you think that model could ever work?
        Also would love to know how you make your investment decisions- any particular strategies you follow/ resources you’d recommend?
        Thanks very much, appreciate your insights!

        1. I don’t know, I don’t think it’s a great idea to leave a Big 4 firm in a stable role in this year, of all years, to jump into something unproven. These transitions are usually only worthwhile if you’re sure you want to completely switch careers and go to the investing side rather than client work. If you just want to make money yourself on the side, there are dozens of other ways to do that while you’re still working full-time. There is some truth to market forecasts mostly being wrong, at least ever since central banks began to control the markets.

          Making investment decisions is too big a topic to discuss in a comment response here, but take a look at some of the examples on this site – the Uber valuation, the Snap valuation on YouTube, etc., to get a sense for it.

  3. Avatar
    John Dionne

    You have taken a moment in time and act like it is permanent.

    PE transforms business, and is far less a game of price. This is not rhetoric

    1. You raise a good point, but some moments in time are so extreme that they make a permanent impact. I think it’s clear by now that this crisis is not going to be a “short blip,” and we’re looking at a multi-year recovery at the very minimum. Just look at what happened to big banks after 2008: yes, the subprime crisis was a one-time event, but it led to big changes in the industry, like the effective elimination of prop trading.

      PE “transforming business” is a nice marketing line, but probably not true in the average case. Yes, some true operational and turnaround firms may do this, but what about firms that do not focus on operations? Returns haven’t even been that great over the past decade, so I’m a bit skeptical.

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