Private equity goes shopping?

Private equity firms have been making the news as the beneficiaries of the economic downturn caused by COVID-19. While the stock market has gone through a jarring decline, private equity may benefit from discounted buyouts of established businesses, such as Virgin Australia, as businesses are strapped for cash. As reported by the Financial Times, Boston-based Advent International, for one, is eyeing firms in healthcare, technology, and consumer sectors, which ‘might not have been interested, or needed capital, or sought a partner’ before the current crisis.

However, this does not mean that private equity firms are immune to coronavirus’ impact on the economy. Over the past week, they have attempted to lobby policymakers to providing their portfolio companies access to the new loan package aimed at supporting medium-sized businesses. Businesses backed by private equity might be ineligible for the new package as assessment of business size looks at the size of all portfolio companies combined, rather than individual firms. While private equity firms can try to assuage policymakers by highlighting the number of employees relying on their portfolio companies, it is difficult to say whether this is enough to convince the government, especially since it may go against EU state aid laws. Furthermore, demands like such seem unfavourable in the current economic landscape. Bain & Co reported in 2019 that the private equity industry have amassed £2.44trn in unspent cash.

The secret towards the success of private equity firms lies in its ability to raise significant amounts of debt to finance corporate buy-outs.

The secret towards the success of private equity firms lies in its ability to raise significant amounts of debt to finance corporate buy-outs. This allows them to collect impressive amounts of money, reduces the amount they need from equity, which in turn increases returns when they sell portfolio companies. Record-low interest rates enable these firms to obtain leveraged loans fairly easily, with 40% of all leveraged loans outstanding to PE-backed companies.

When the deal has been drawn, private equity firms transfer the debt to the company, meaning that PE-backed companies face higher debt loads than their non-PE-backed competitors. While this may encourage efficiency and drastic restructuring to turn struggling businesses around in normal circumstances, it may backfire during crises. As firms face a zero-revenue environment, the only option is to cut costs, potentially resulting in thousands of redundancies and mass closures, such is the case with Cath Kidston’s rescue deal.  A blog post in the LSE Business Review argues that ‘The PE business model is designed to funnel income from portfolio companies and PE funds upwards to the PE firm’. PE-backed companies are vulnerable to default and bankruptcy during economic downturns due to their higher debt load.

Private equity firms do bring expertise to reorganise inefficient businesses.

Over the past decade, private equity has been a rising star in the world of high-yield investment. Private equity boasts higher returns compared to stocks, and are known for enabling investors recover their investment sooner than IPOs. This may be credited to aggressive initiatives to overhaul struggling companies and push them for rapid growth. Private equity firms do bring expertise to reorganise inefficient businesses. On the other hand, it’s a risky business for companies to sign deals with private equity firms in the first place. They may be forced to take out loans, often at junk bond rates, in order to pay dividends to investors. This risk may be obscured when the economy is performing well. But times like this may be a wake-up call for the perceived utopia of private equity.

What can private equity firms do, then, in the face of public scrutiny and operational problems with portfolio companies? A McKinsey report recently suggested that this is high time for private equity to consider investing based on environmental, social, and governance (ESG) factors. The temptation to buy low to sell high may be strong, but in a credit-deficient environment, private equity firms should ensure that their money goes to businesses which can viably function during and after the pandemic. Companies with a strong ESG proposition are generally in a better place to weather crises, as they are more likely to obtain subsidies and government support, and have established methods of cost reduction through environmental policies like minimizing energy consumption. If private equity wants to offer itself as the mainstream form of investment, playing the long game may be the best strategy.