Data & analysis of historical PE trends during a downturn
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Key takeaways
- US lenders struggled to fund leveraged buyout activity during the last recession, resulting in an 81% decrease in deal value between 2007 and 2009 and a median debt/equity ratio that dropped below 50% for the first time. In the event of an economic downturn, we do not anticipate a limited credit market to be a key factor hampering dealmakers. Instead, we believe a growing number of nonbank lenders will continue funding activity should commercial bank lending significantly tighten.
- Currently, PE managers are sitting on more than $550 billion in dry powder. In addition, we’ve seen a roughly 379% increase in sovereign wealth fund capital vying for existing targets since 2008. With this amount of capital ready to execute transactions, we believe a significant problem the PE industry faces moving forward is the potential for this vast amount of money chasing a limited number of quality targets to drive industry IRRs well below limited partner expectations.
- Changes in the PE landscape over the last 10 years provides opportunity for quick moving PE investors and trouble for the rest. Developing non-bank lending networks, sourcing deals in less saturated markets, and planning for longer hold times with lower exit multiples will help PE investors deliver strong returns throughout a recession.
Introduction
For those PE investors and LPs that believe an economic downturn may come sooner rather than later, we analyze deal flow, debt/EBITDA ratios, and capital deployment during the last recession as well as the key differences between then and now. Further, we propose a three-point plan with expectations for lower valuations and longer hold times, increased nonbank lending, and a higher number of sub-$100 million deals. As discussions surrounding a US recession increase, it is important for LPs and fund managers to examine the macro landscape. This is even more crucial for 2015 vintages and beyond as they will still hold large sums of capital to be deployed. To be clear, we do not predict if or when a down cycle will begin. However, given increasing fear of such an event, the current 84-month long expansion, and an understanding that our economic system rides on a series of ups and downs, we know a retraction is bound to happen at some point.
A brief recap
2008
As fears spread that numerous major financial institutions would become insolvent in early 2008, the PE industry experienced an 81% decrease in deal value between 2007 and the end of 2009. Despite holding nearly $460 billion in dry powder during the recession, we saw a 47% decrease in deal volume and median deal size dropped from $75 million in 2007 to just $30 million during 2009. With billions in dry powder, decreased company earnings resulting in lower acquisition multiples should’ve provided an environment richer in targets.
However, deal volume did not pick up again until 2010, as the median debt/equity ratio dropped under 50% for the first time in our dataset, bottoming out at a 3.1x debt/EBITDA multiple. Given the nature of US banks during the last recession, the main driver that led to the plummet in PE capital deployment between 2007 and 2009 stemmed from the lack of credit major US lenders could extend. With limited leverage and increased equity needed to close transactions, PE firms struggled to find deals with attractive return profiles.
What key driver will change next?
A looming supply-side risk
In the event of the next down cycle we do not believe credit will be the major factor disrupting the PE industry. If bank lending tightens significantly, a large and growing source of debt from alternative lenders will step up as it has following 2009. The most consequential problem PE funds face down the road is a low supply of quality portfolio companies relative to the number of financial sponsors chasing them. We’ve reached this conclusion based on five main data points:
- Dry powder for US PE reached $552.57 billion and total invested AUM neared $1 trillion as of 3Q 2016, both the highest numbers in our dataset.
- The total number of vintage funds to begin deploying capital between 2012-16 is 32% greater than in the five years leading up to 2008.
- Shadow capital chasing similar targets has been steadily increasing since 2008 with a 379% increase in the amount of money deployed by sovereign wealth funds and a 56% increase in the number of PE deals involving co-investing or direct investments by LPs since 2008.
- Strategic acquirers have been extremely active with over $1.3 trillion of deal flow in 2015 and 2016 combined—2017 is on pace to surpass even those numbers. While providing exit opportunities to sponsored companies, corporates are now becoming direct competitors to PE firms as they look to acquire businesses that could support strategic initiatives.
- An analysis of data from the Census Bureau shows the number of privately held companies in the US is 5% lower in 2014 than it was in 2007 and the rate at which new businesses form has held below the rate of business closures since 2009. This last point is a long-run risk that goes well beyond the next down cycle, but is interesting to note given the erosion of PE IRRs over the last 17 years.
How to deal with the next downturn
Pessimistic Modeling
The first and most obvious step is to begin building a steeper downside into LBO models. Our data shows that the median EV/EBITDA multiple on leveraged buyouts dropped from a pre-crisis high of 10.1x to 6.5x for deals completed in 2009. For deals completed in 2016, the median EV/EBITDA multiple stood at 10.5x. Given how quickly the market can change and an understanding that multiple expansion and speed of exit are the two most crucial factors driving IRR, funds should model an acquisition’s potential IRR and MOIC as if it were to sell at three to four turns lower and/or be held longer than the current average of five years. There should also be increased emphasis placed on developing due diligence processes to understand downturn resistance at the product/ service level. A key point of emphasis there is understanding how demand is likely to change given a negative economic outlook which allows a more accurate projection of top-line growth when modeling out a downside scenario.
Nonbank Networking
Second, deal flow will not experience the same tumble as it did in 2008, as a growing number of nonbank lenders can continue funding activity the event commercial bank lending significantly tightens. Private lending by alternative asset managers is estimated at $4 trillion and that number is likely to continue climbing according to a report by Goldman Sachs. Goliath PE firms like Blackstone and Apollo have already started moving into the direct lending space and nonbanks will pull even more of the credit market share in a downturn. Mega PE funds, alternative lenders, or business development corporations sit in an advantageous position to step in and provide the debt necessary to continue fueling LBOs. With that said, PE groups should be developing relationships with lenders whose sources of capital and deal capacity will not be restricted during an economic downturn. Having that network of alternative lenders will allow GPs to pull the trigger on attractive acquisitions quicker than competitors who haven’t developed similar relationships.
Down Market Deal Flow
Third, we see deal flow moving in two directions during the next downside. Mega funds with billions in dry powder will move up market, buying out large corporations as earnings take a hit and high multiples fall quickly. For the rest of the PE industry, the saturation of money in the $100 million to $1 billion market space will force funds to move deep down market as they look for less competitive and cheaper deals. For this reason, the average PE firm should start developing the resources to source deals in the sub-$100 million middle-market space now. Although our dataset shows a negligible difference between returns based on fund size, we do believe lower-middle-market acquisitions provide a more attractive opportunity in a downturn for three reasons.
First, EV/EBITDA multiples trend lower the further down market you go, allowing for greater multiple expansion. Second, smaller companies tend to operate with more inefficiencies allowing PE firms to grow top line and expand margins by streamlining operations. Third, the amount of companies operating within this EV range outweigh the number of small PE firms that focus here. This space was a refuge for PE during the last recession as deals valued at less than $100 million nearly doubled their 10-year average to 19% of all deal value during 2009 and was the most consistent source of PE volume during the last recession.
Conclusion
Regardless of the economic environment, we see an increasingly saturated PE market where increased competition is driving IRRs below historical returns. To conclude, we are not saying a recession is imminent, as this will depend on a wide variety of factors including (but not limited to) the economic and regulatory reforms proposed by the current administration and the long-term effectiveness of banking reforms following the last recession, along with a slew of other global macroeconomic and geopolitical events. A recession will exacerbate the problems PE investors face and those who understand their macro environment and adjust behavior now will outperform.
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