The private equity industry has long struggled to overcome a public reputation for maximising profit and jeopardising healthy businesses by loading them with unsupportable debt and charges. In light of the new world we live in, can the sector restore its image by helping to relaunch economies after the Covid-19 pandemic?
Over the past two decades the private equity sector has evolved from a marginal and mostly obscure corner of the investment industry into a core element of the financial system.
Now the Covid-19 pandemic and its aftermath poses unique challenges for private equity firms and their investors living in a world where company valuations are fluid and volatile, creditworthiness is cloudy and governments seem set to play a far more prominent role in economic management than at any time this century.
In terms of financial heft, private equity should be well placed for a leading more in economic recovery. Worldwide, the industry is flush with cash — or at least commitments.
Private equity funds have a record $2.5 trillion available in ‘dry powder,’ money pledged by investors that firms have not yet drawn down.
The environment promises to be welcoming for firms with money to spend, especially those specialising in distressed debt, of which there is plenty expected to emerge over the coming months and years, or those seeking to build industry-leading portfolio companies through bolt-on acquisitions that add scale.
Alternative to turbulent public markets
True, the market environment for private equity investment was looking less favourable before the pandemic emerged and lockdowns began. The huge pile of dry powder reflects in part an increasing shortage of suitable investment targets, which had been pushing up prices.
But private equity, along with other types of more complex and longer-term investment, looks more attractive to institutional investors than turbulent public equity markets, cash earning next to nothing in interest and bond markets yoked to the imperatives of central bank monetary easing strategies.
Not to mention the clouds gathering over that staple of institutional investment portfolios, commercial real estate.
However, private equity has its own hurdles to overcome to position itself as a saviour of struggling companies and stuttering economies.
First and foremost? A wretched public image, fuelled by both misunderstanding of what private equity is and does and by the industry’s frequent tone-deafness to wider concerns of society.
Private equity’s opaqueness, complexity and lack of public accountability is often placed in contrast with the (supposed) transparency of companies listed on public markets.
Critics such as Sheila Smith, a former senior economist at the UN Development Programme, describes the sector as “termite capitalism”, targeting a business model characterised by reliance on borrowed money rather than investors’ capital, asset stripping and job destruction, opaque fee structures, unsustainable extraction of returns through dividends funds by further borrowing and use of debt and offshore structures to reduce, often to zero, tax liabilities in the companies in which portfolio companies operate.
Investing for the long term?
In vain do private equity companies protest that their business involves not wanton extraction of assets but the creation of value through the restructuring and re-energising of struggling, directionless companies, the empowering of capable managers and the incentivisation of employees, and that they focus on companies’ long-term development, not just the next quarter’s bottom line.
Because it’s such an emotive phrase, they don’t like to speak of ‘creative destruction.’
But that’s a key driver of the private equity model: stripping away dead-end jobs and businesses and replacing them with new ones that are more productive and have a long-term future.
Some of the criticism is certainly unfair. The obsession with the offshore tax haven structures of private equity (and other alternative investment firms) tends to ignore the key classes of institutional investor that are non-taxpayers, such as university endowments and charitable organisations.
Rather than a pure creature of plutocratic vampire capitalists, the private equity industry is driven principally by the needs of their investors: pension funds to meet their commitments to retirees and insurance companies to meet policy-holder claims.
It’s against this unfavourable reputational backdrop that the private equity sector must face the challenges of the post-pandemic world.
What will it look like?
Swings and roundabouts
In the short to medium term, the industry is suffering similar hits to revenue and profit as other businesses. Antoine Drean, founder of private equity placement agency Palico and consultancy Triago, expects profit-sharing – carried interest – on above-benchmark returns to dry up, especially for firms with heavy exposure to the most vulnerable areas of the economy, such as the hospitality, travel and energy sectors.
Hugh MacArthur, Graham Elton and Brenda Rainey of consultancy Bain & Company argue that dealmaking is set for a slump while firms focus on the health of existing portfolio companies and bank lending to the sector is likely to be significantly constrained and subject to significantly tighter conditions (although this is likely to be offset by the sheer volume of dry powder and likely lower valuations of acquisition targets).
They say private lenders, a significant force in the market since the global financial crisis, should also help fill the gap while the need to exit mature portfolio companies in order to provide returns to investors will also spur deal flow.
The Bain & Co. partners also warn that some investors may find themselves financially squeezed if calls on existing capital commitments exceed private equity distributions.
This points to a reduction in fundraising, at least temporarily, after a decade of soaring inflows from investors looking to private equity’s historically higher levels of return to offset the impact of interest rates at rock-bottom or worse.
While the industry’s overall levels of return are likely to take a quick hit from lower valuations on existing investments, especially those made near the peak of the market, the recessionary environment should yield more profitable opportunities.
Private equity and Covid-19: Core role in institutional portfolios
Can we expect a better reputation for private equity in the months and years after Covid-19? There’s no guarantee that public perceptions will change radically in the near future.
Since the onset of the pandemic, the sector has drawn fire from politicians and others over the insolvency of venerable names of American retailing such as Neiman Marcus and J. Crew, although the critics tend to ignore that the businesses have been deteriorating for years in the face of changing consumer habits and growing internet competition.
However, with near-zero interest rates apparently locked in for years to come, barring an upsurge in inflation that stubbornly refused to materialise despite a decade of loose monetary policy, the core position of private equity in institutional asset portfolios seems more likely to strengthen than to diminish.
In a world where job preservation is now a central economic policy objective, private equity firms will also be under pressure to avoid wholesale layoffs and business closures.
They and their investors likely will have more skin in the game as the peaks of bank leverage of recent years recede and the days of egregious debt-driven dividend recapitalisations are probably mostly over for the foreseeable future. If private equity can claim to be playing a role in saving viable companies and jobs, it may become less of a bogeyman for critics of capitalism.
But it shouldn’t count on being better loved.
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