Private Equity and Recessions
Private equity companies make money in a recession by buying companies that are deeply undervalued and turning them around for a profit once the status quo normalizes. During a recession, many companies struggle to stay afloat and may be forced to sell assets, segments, or even the entire business at a discounted price. Further, pressure given the current economic environment (combined with a higher cost of debt) leads to companies also facing maturity risk with any long-term debt coming due. With blood in the water, private equity firms that are well-capitalized and have access to long-standing lender relationships can take advantage of opportunities to purchase companies at a lower cost basis and significantly enhance their investors’ returns.
Generally speaking, once a private equity firm has acquired a company they will typically implement a number of changes in order to improve the company’s operating and financial performance. This may include cutting costs, streamlining operations, or divesting non-core assets. The goal is to increase the company’s revenue and profits, making it more attractive to potential buyers when the economy improves.
One of the ways private equity firms can increase a company’s value is through leveraged buyouts (LBOs). This is a transaction in which a private equity firm borrows a large amount of money to purchase a company, using the company’s own assets as collateral. The private equity firm then uses the cash flow generated by the company to pay down the debt. This can be a highly profitable strategy if the private equity firm is able to improve the company’s financial performance and increase its value before selling it.
But during a recession, the LBO is further compounded via distressed investing. Distressed investing involves investing in companies that are in financial trouble, such as those in bankruptcy or on the brink of bankruptcy. Private equity firms can purchase these companies at a steep discount and then implement changes to improve their financial performance and make them more attractive to potential buyers. While it is tricky to perform an operational turnaround when facing recessionary headwinds, well-capitalized private equity firms can purchase companies and “ride out the storm” until things normalize and then prepare the target firm for a disposition.
Some private equity firms also focus on specific sectors or industries that are less affected by a recession. For example, healthcare companies are often considered to be more resilient during an economic downturn, and private equity firms that specialize in these sectors may have better chances to generate returns.
Private equity firms generally use exits to generate returns. Exits generally refer to the process of selling the company or taking it public. Private equity firms may choose to sell their portfolio companies to strategic buyers, such as other companies in the same industry, or to financial buyers, such as other private equity firms or hedge funds. They may also take the company public through an initial public offering (IPO). Given recessionary headwinds, this would generally happen once the equity capital markets stabilize.
While private equity firms can be successful in generating returns during a recession, it is important to note that not all private equity firms are created equal. Some firms may have better track records of successfully turning around companies, while others may not have the same level of expertise or resources. Additionally, the specific strategies and tactics used by private equity firms can vary widely, and what works in one situation may not work in another. It is always recommended to ask during an interview key questions that can assess a company’s ability to weather the storm. Topics can include:
- How much “dry powder” does your investment fund have?
- How has your investment thesis evolved given the broader economic environment?
- Who are some of your key investors and how have their preferred return requirements changed over the past 12 months?
- How has the fundraising process been going over the past few months?
To summarize, private equity firms can make money in a recession by buying companies that are deeply undervalued, implementing changes to improve their financial performance, and exiting the investment through a sale or IPO once the markets stabilize. However, the success of private equity firms during a recession depends on the specific strategies and tactics used, as well as the expertise and resources of the firm. Candidates seeking a move to private equity should ask key questions during the interview process to determine a firm’s ability to remain afloat during uncertain economic conditions.