By Zaid Dudhniwala, BSc Economics @LSE
With the Covid-19 pandemic destroying hopes of global growth and making markets more volatile and fragile than ever, why will Private Equity still make it through strong?
As the current global economic recession is forecasted to cause GDP to fall by 6–7.6% worldwide, and markets reaching all-time highs in volatility, seen in the Chicago Board Options Exchange’s CBOE Volatility Index, commonly known as the VIX, reaching its highest peak since the Financial Crisis, in March, at 82.69%, and still going strong at double pre-covid levels, now at around 33%, it can be deduced that the global financial status is very fragile. The ambiguity around the impact of Covid-19 has left many puzzled as to how to make the most of any capital they have, and how to pay off debt. Having raised all these concerns, the Private Equity industry is still confident that it can withstand any storm, whether that be economical or financial, and come out performing better than ever. One may call this arrogance of the multi-millionaires and billionaires in the industry, however, it is justified confidence when the current climate is considered.
When it comes to breaking down the impact on PE firms, it is important to understand their operations. Most projects that such companies undertake are very long term, measured mostly in years, and so an economic turmoil now, albeit with a delayed recovery, still represents an attractive opportunity for the industry to capitalise on future growth by acquiring companies now. This represents the overarching argument as to why the industry will remain relatively unscathed, irrespective of what happens.
Having said that, one may argue that markets are also rebounding strongly after their dip in March. The S&P has already wiped off all losses for this year, most of which happened in March at the peak of the impact of the pandemic on US markets. Ray Dalio’s Bridgewater Fund losing 20% really epitomised how most investors across markets, let alone the mighty quantitative hedge funds with their algorithmic trading platforms, could not deal with the market depression that happened. Yet still, the excessive quantitative easing (QE) carried out by the Fed at the hands of Jerome Powell, which some may find ridicule in seeing the “money printer go brrrr” memes circulating social media, really provides the reason as to why markets are surviving as of now, and why Private Equity is not the only winner in the financial world.
However, with a positive market sentiment caused by factors that are economically unrelated, seen in the substantial usage of QE by central banks worldwide, there is a mass disconnect created between the economy and the markets, best seen in how markets are on the rise, as the economy falls further. This sentiment is leading to an inflationary impact on securities across markets, especially stock markets, where companies share prices are not reflective whatsoever of the companies they represent, who are most likely suffering shocks to earnings due to the economic effect of the pandemic. Eventually, what you have now is a market on the brink of facing another crash, seen very recently in volatility and the recent S&P blip, as the index is expected to fall by 5% in June. Investors are twitching with uncertainty, and with reason, overall making markets a dangerous environment to operate in.
One may then pose the question as to why Private Equity firms are sanitised from all these negative market impacts. It is understandable that the prospect of a long-term recovery could make their buyout projects worthwhile, across most if not all industries, but why are they not affected by market buoyancy? Once again, the key to the truth lies in understanding the industry’s strong position.
The main reason as to why big names, such as KKR, Bain Capital, Blackstone etc. are still carrying out buyouts like there is no tomorrow, can be seen in the heaps of dry powder in the industry. At around $1.5 trillion at the start of the decade, the industry is well protected, even after any Covid-19 impact. This essentially allows firms to confidently fund their projects with less debt than normal, or to the tune of lower interest rates due to the lower likelihood of defaults. This hence justifies the level of buyouts and the confidence these firms have in taking risk, resembled across the industry.
If this was not enough of a reason, then the current economic position is perfect for private equity activity. A combination of three factors, creates a sound environment for these firms to operate in. Firstly, low interest rates established by Central Banks to boost economic activity, and limit unemployment, trickle down to lower interest payments on leveraged buyouts and their junk-grade bonds, which make up most of PE activity. Secondly, the high levels of QE, specifically now of corporate bonds, and the liquidity injected into markets also means that the bonds that these corporates put out on the market are being purchased, and so there is an element of safety in carrying out such investments. Lastly, the current economic recession leading to many companies shrinking, some on the brink of bankruptcy and many just about surviving in their distressed state, has provided several opportunities for PE firms to come in and buy said companies for cheap. This gives way for rehauling these companies through investment and changes, leading to future gains for PE firms. All in all, producing a perfect climate for such activity.
These factors indicate how PE wins, regardless of the market or economic situation as of now, whereas other industries are petrified with uncertainty, and would not take anywhere near the levels of risk that PE firms are willing to take now with buyout projects.
Despite the advantages to the industry, there has been some heavy backlash. This is especially prevalent in the US, with many democrats, led by Alexandria Ocasio-Cortez, campaigning against Private Equity activity, and supporting a temporary ban on operations. This is justified as a way of securing jobs, as Private Equity firms are renowned for causing mass redundancies in the companies they buy as a form of cost-cutting measures, and if they are allowed full reign across an economy of distressed companies, the impact on unemployment could possibly be devastating.
However, the counter-argument is that without PE activity, these firms would go bankrupt, and end up laying off even more people resulting in a substantially greater impact on unemployment, and eventually causing economic growth to fall further. This discussion is applicable worldwide, regardless of the level of development of an economy. However, most, if not all, global leaders and governments understand the importance of Private Equity in times like this, in keeping companies alive and the economy functioning, and are allowing them to conduct business as normal. This is evident in the lack of regulation in the industry worldwide, especially compared to that of other alternative investors, such as hedge funds who are limited by risk. Investment banks are also crippled under regulation, especially following on from the MiFID II legislative reforms.
In conclusion, the forecast for PE activity is a very positive one, with buyouts and returns predicted to be huge going forward. This would essentially lead to more and more acquisition activity, where several companies will be privately bought, and consequently taken off public markets. Regardless of the circumstances, this industry will win.
