For Private Markets, a Downturn is an M&A Opportunity

By: Gridline Team | Published: 08/03/2022
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Both the dot-com bust of 2000 and the subprime mortgage crisis of 2007-2009 were watershed events. In each case, a long bull market ended abruptly, asset values plunged, and widespread panic set in. While M&A activity naturally slows during a recession, some companies see opportunity where others see only trouble. Deals done during downturns can create large amounts of value.

A PwC analysis of public market returns found that firms that announced acquisitions during an economic crisis delivered over 7% higher returns than the relevant S&P 1500 sector average in the following 12 months.

A Harvard Business Review article confirms this finding: In a study of the 2008 Fortune 1,000 list, the TSR (Total Shareholder Return) of those that had made active acquisitions grew at an average of 16.9% over 5 years, compared to just 4.9% for other companies.

Of course, not all M&A deals are created equal. Value creation depends on the quality of the assets being acquired, the strategic rationale for the deal, and how well it is executed. But for companies with strong management teams and a disciplined approach to M&A, a downturn can be an opportunity to position themselves for long-term growth.

Private markets outperform across market cycles

Whether or not we consider acquisition-related growth, private markets have outperformed in recessions. 

In both the dot-com bubble and the Great Recession, private equity funds had a less significant drawdown and a quicker recovery than the stock market. In the decade following the dot-com crash, private equity returned a solid 7.5% average, compared to just 0.08% for the PME index.

Adding to this, only 2.8% of buyout funds experienced catastrophic loss during recessions, compared to a tremendous 40% of stocks.

Clearly, public markets aren't a safe place to be during an economic downturn. Bonds, too, lack the returns even to match white-hot inflation. Cash, of course, rapidly loses value. This is where private markets can fill the void.

In sideways or bull markets, private markets also outperform. A Cliffwater analysis of PE investments in a 16-year period, including two bear and two bull markets, shows that PE outperformed public equities by 440 basis points yearly. It's no wonder, then, that 90% of LPs expect private equity to continue outperforming public markets, according to McKinsey.

This outperformance has become even more pronounced in recent years. Since 2017, private equity funds generated an extra 83 cents per dollar invested, according to a study by Hamilton Lane. Private markets also show resilience in this year's downturn, with median post-money valuation still rising across most stages.

M&As will fuel even more value

As the analyses above shows, private markets already offer better risk-adjusted returns than public markets. But M&A can help private companies drive even more value.

Fundamentally, an acquisition is an investment. The acquirer seeks to generate a return on investment by growing the combined business. An acquisition can also serve other strategic objectives, such as entering new markets, adding new products or technologies, or increasing market share.

When done well, an acquisition can be a powerful engine of growth. Private market investors will benefit from several macro trends that are tailwinds for M&A activity. For example, supply chain disruptions are causing businesses to reconsider their reliance on just-in-time, single-source providers, and some are seeking transportation fulfillment acquisitions.

So-called "disruptive M&A," or non-tech buyers acquiring tech companies, is another major trend. This has been driven by the belief that digitization is pivotal to success in nearly every industry. McKinsey research shows that digital entrants have rapidly seized 47% of digital revenue across regions and sectors. Finally, a $3.4 trillion dry powder war chest is another reason to expect strong M&A activity in the coming years.

These trends are coming to a head just as private market valuations are becoming more attractive, presenting an opportunity for private companies to buy assets at a discount.

Tech M&As accelerate despite a bear market

M&As tend to ebb and flow with the stock market. But there's one sector that has, so far, been surprisingly immune to this pattern: technology.

Despite the recent bear market, tech M&A activity is still going strong. As Fortune reports, tech M&A in 2022 is up 58% year over year, to $272 billion. From Broadcom's $61 billion purchase of VMware to Microsoft's $69 billion Blizzard acquisition, several big-ticket items have already gone through.

The reasons for this are front and center: first, this recession is likely to be short and shallow; second, businesses have over $3 trillion in dry powder; and third, as we've highlighted, downturn-era M&A can create significant value.

With so much capital sloshing around, it's no surprise that valuations are high, and competitive bidding drives up prices. In this environment, M&A is often the best way to snag top talent, technology, and market share. Private market investors should note that downturns may be painful, but they ultimately create opportunities for those who are prepared to take advantage of them.

The institutional approach

While private markets and M&A activity can create significant value for investors, an institutional-grade approach is needed to take advantage of these opportunities even in downturns.

This begins with creating a diversified portfolio that can weather various market conditions. Without a diverse set of investments, a downturn in any one sector, geography, vintage year, or asset class can decimate a portfolio.

With adequate diversification, it's possible to achieve dispersion of returns similar to that of public markets. In other words, VC returns are far more predictable and dependable when a thoughtful and structured approach to portfolio construction is employed.

Institutional-grade due diligence on each fund is another critical piece of the puzzle. This includes a review of the fund's team, performance, philosophy, investment process, and intangible factors such as perspective and passion.

Moreover, a long-term mindset is essential. Historic VC returns show that the bulk of the value is created in a fund's later years in a J-curve phenomenon.

Executing this institutional approach, however, is easier said than done. Many private equity funds come with a $25 million minimum, and a diversified portfolio requires investing in several funds. For most individuals, this simply isn't possible. High fees exacerbate the issue, as they can quickly eat into returns.

Beyond investment minimums, fund access is often limited based on personal relationships or other factors. This is why working with a platform like Gridline is essential. We provide access to a curated selection of top-tier private equity and venture capital funds so that you can build a diversified portfolio with lower minimums. We also charge lower fees so that you can keep more of your returns.

With Gridline, you can get the institutional-grade approach to investing in private markets that you need to drive value in any market condition.

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