Sticky inflation has dealt a severe blow to economies worldwide, and private market investors are not immune to its effects. A recent survey of alternative investment professionals found that 74% believe the U.S. is already in a recession or will enter one by the end of this year.
A recession is nothing new for private markets, although there tends to be a lagged effect as businesses and investors react to changes in the economy. In the early months of a recession, private investors focus on assessing the damage and stress-testing their portfolio holdings. This is followed by a period of cost-cutting, fast-tracking profitability, making bridge loans, and restructuring balance sheets.
Beyond six months, investors seek unconventional exits like merging portfolio companies or restructuring them as spin-offs. Even in a recession, there is still value to be found in active managers who can adapt their strategies to the current market conditions.
An opportunity to optimize portfolios
Decreased consumer spending and higher interest rates have hurt returns, and investors need to assess how to best maintain or improve performance in the current environment. In many cases, private equity losses have not yet been booked due to the illiquidity of the investments, but that doesn't mean they won't materialize.
There are several ways to stress-test portfolio companies to gauge their resilience to a downturn. One method is to model different scenarios, such as a prolonged recession or a sharp increase in interest rates.
Another is to look at the sensitivity of earnings before interest, tax, depreciation, and amortization (EBITDA) to changes in key variables such as revenues and costs. This can help investors identify which companies are most at risk and take steps to mitigate the impact on their portfolios.
Active managers are well-positioned to take advantage of the current market conditions. Many have been through previous downturns and know how to navigate the challenges that come with them. They also have the flexibility to adjust their strategies as needed, which is critical in times of uncertainty.
For example, rather than continuing with a "growth at all costs" mentality, many VCs are shifting to focus on profitability within a set timeframe, looking at metrics like the Rule of 40, which says that a small, fast-growing company's combined growth rate and profit margin should exceed 40%.
Achieving that doesn't always mean cost-cutting: It can mean the opposite. Research finds that firms with PE backing can increase capex compared to peers during crises, resulting in increased market share and higher asset growth. Not only do they grow faster during recessions, but they also come out of them more robust and with faster recoveries.
The opportunity for portfolio optimization is well-evidenced by the performance of private equity following past downturns. Following the dot-com bubble, buyout funds generated explosive returns, with a median IRR of 25 percent in 2001, 40 percent in 2002, and 47 percent in 2003. And in 2009, after the Great Recession, buyout funds outperformed the public markets again, with a median IRR of 24 percent.
This time, private equity firms are seeking to take advantage of the current market conditions by flexibly deploying capital, seeking out distressed companies, "buying and building" through add-on acquisitions and opportunistically exiting portfolio companies.
The bottom line
A recession is a challenge that private investors are well-equipped to handle. By taking proactive measures to grow their portfolio companies and deploying record dry powder, they can emerge more assertive on the other side.
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