- Jakub Kozlowski
An Economic Downturn & Private Equity in 2023
"The Worst is Yet to Come", said the International Monetary Fund regarding their economic outlook for 2023. The U.S. is likely to enter a recession within 6 to 9 months, prompting many European governments to brace for a "deep" crisis; some have even encouraged citizens to take cold showers to save energy. Amid this pessimistic outlook, private equity (“PE”) firms are assessing strategies to avoid taking financial cold showers themselves. Although the damage of each economic downturn has been different, their intrinsic characteristics have generally been the same. The PE industry, however, has evolved considerably in the last two decades with experts highlighting that it is yet to enter its "golden era". This article explains how PE firms might navigate the economic headwinds in 2023 in relation to two key stages of their business models: financing deals and exiting investments.
Private Equity in a Nutshell
PE firms raise capital from institutional and/or wealthy investors for investment funds. These funds, usually structured as limited partnerships (or, as private fund limited partnerships in the UK), buy out companies using a mixture of debt and equity. The leverage inherent to these transactions makes them riskier investments, but also offers the prospect of higher returns. These returns are then distributed amongst the PE firm and its investors when an overhauled company is sold; this typically occurs 7-10 years later.
Why would a PE firm consider seeking new investment opportunities during a recession? While the Global Financial Crisis of 2007-2009 (“GFC”) is incomparable in terms of its magnitude to the recession that the world will likely face in 2023, it does provide a useful case study for industry experts. Instead of “buying the dip,” PE investment activity slowed from $800 billion to just $170 billion during the GFC. As a result, many PE firms missed the chance to earn superior Internal Rates of Return (IRRs) in companies that could have been acquired at steep discounts. It therefore seems likely that, with stock markets predicted to hit new lows in 2023, PE titans will focus heavily on take-private deals and PIPEs.
Traditionally, a simple buy-out transaction is financed by debt obtained from banks. However, this debt might be more difficult to obtain during recessions, and perhaps generally due to the regulatory pressures exerted on banks by post-GFC reforms. As a result, there has been an unprecedented growth of private credit in the PE world. Broadly, this concept concerns the practice of PE firms making loans to one other. For example, Blackstone and Apollo agreed to finance a significant part of the purchase price that H&F and Permira have to pay to acquire Zendesk. This represents a significant shift from a decade ago, when lending to PE-backed companies was primarily underwritten by banks. That H&F and Permira chose other PE firms to partially finance their deal demonstrates the maturation of the private credit industry.
Private credit might prove to be an important source of financing deals in 2023 if the recession hinders direct bank lending. But, despite growing popularity, private credit is not necessarily cheap. Private credit agreements typically use a floating rate. As central banks increase interest rates due to inflationary pressures, this floating rate mechanism makes loans from private credit more expensive. Whether this will discourage PE firms from private credit arrangements during the upcoming recession depends on the particular circumstances of the deal. If a promising target is to be acquired for an unusually low price, the PE firm might be willing to accept a private credit arrangement, even at a high interest rate. However, it has been observed that key players in the PE industry have become competitors, collaborators, and partners. Thus, it is also conceivable that PE firms seeking to maintain good relationships with their counterparts might be willing to provide credit at more favorable terms.
PE firms can hold investments for longer than expected if poor economic and market conditions make such decisions appropriate from a business perspective. General Partners usually have discretion to extend a fund’s investment period for up to 2 years. However, one should not assume that all PE divestments are paused under these circumstances. Some investments must nonetheless come to their natural conclusion to provide liquidity to Limited Partners. Traditionally a PE firm would exit its investment in one of three ways: through an IPO, a secondary buyout, or a sale to a corporation. Nevertheless — and especially in the case of IPOs — the prospects of a successful exit are slim during economically turbulent periods where investors are risk-averse. Apart from secondary buyouts and sales to corporations, industry experts have noted the growing use of continuation funds which will likely provide an additional avenue for exits in 2023. Functionally, continuation funds facilitate the sale of a portfolio company from one fund to another, where both of these funds are controlled by the same PE firm; in effect, this means that a PE firm sells a company to itself.
Depending on their size and business model, most companies struggle during recessions. Selling from one fund to another can provide “more runway” if a PE firm holds companies that have strong fundamentals but suffer from an economic slowdown. This means that 2023 might compel some PE houses to use continuation funds specifically to buy more time to manage distressed businesses whose valuation would otherwise be too low in traditional exists, such as an IPO.
Problems as Opportunities
This article does not intend to illustrate the whole evolution of the PE industry over the last decade. Instead, it focuses on key developments that might be of particular importance for PE firms in the upcoming recession. While GFC might have challenged PE firms considerably, the industry is performing better than ever. And, while the 2023 recession will pose problem that private credit and continuation funds might help address, it will also provide an opportunity for the PE world to test itself once again. As demonstrated by the GFC, such tests are indispensable elements of the industry’s continuous innovation.
Jakub Kozlowski serves as a Graduate Editor of the NYU Journal of Law & Business. He is a Corporations LLM candidate at NYU where he focuses on M&A, private equity and securities law. He is also currently a Research Assistant at the Institute for Corporate Governance and Finance. Prior to attending NYU, Jakub completed the LLB and LPC in England and interned at several law firms in Poland and USA.