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White & Case Private Equity Viewpoint - Issue #1

Private equity firms find opportunities as volatility continues to dominate the financial markets

Stepping into uncertain times

The White & Case Private Equity group discusses how well equipped the private equity industry is for the uncertain conditions investors face today

There has been much political upheaval in the last 12 months, from the change in the US administration to questions over the future unity of Europe. Anecdotally, there's a sense of uncertainty about future policymaking, how this will impact the economy and what it will mean for investors, including private equity funds.

Recent research confirms this sense of unpredictability. The Economic Policy Uncertainty Index, devised by economists from Stanford, the University of Chicago, and Northwestern, measures the occurrence of words in newspaper articles that relate to economic uncertainty and politics, as well as the number of expiring tax laws and the spread among economic forecasts. The change in presidency is the third-biggest source of uncertainty since the Index was introduced more than 30 years ago, ahead of both the 2008 financial crisis and the 1987 stock market crash.

Investors like certainty. It helps them to deploy capital with confidence. Private equity funds are no different in this respect, however they are also some of the most tenacious investors in the world and possess a knack for turning uncertainty, and even market disruptions, to their advantage.

In recent years, funds have not only become more operationally minded, creating lasting value in investments by genuinely transforming companies, there has been a growing tendency to think longer term. Funds with extended life cycles are beginning to be raised, and we would expect this to smooth out the effect of uncertainties or market swings as divestment schedules become more flexible.

While the details of much of the new administration's policies remain to be seen, many sectors stand to benefit from new tax and regulatory rules, and investment programs. For instance, America's infrastructure is likely to receive substantial investment, and this will benefit funds that are targeting these assets as well as the construction businesses required for them to be built and renovated.

More generally, any reduction in regulation and a lowering of corporation tax would be a boost for business. Of course, there is concern that protectionist measures designed to make America more competitive relative to other countries may have unforeseen, undesirable consequences such as raising import costs. Such knock-on effects have the potential for investors to lose confidence, which could depress what have become frothy stock markets and filter into private market valuations. This would certainly give cause for caution. However, stock market turbulence can play to private equity's advantage, as IPOs become more challenging and such sales divert to buyout funds.

Furthermore, so-called PIPEs (private investment into public equities) and take-privates become more attractive to the buy-side, and an easing of private valuations would be welcome after a period of persistently high purchase multiples.

Not only that, we have seen a healthy pipeline of corporate divestments to private equity in recent years as businesses continue to home in on their core products and services. If uncertainty continues, so will the pressure on corporates to sharpen their focus through such disposals. 

Clearly private equity, like every other investor type, would like to see a clear, predictable path ahead. But the tools and know-how at its disposal mean that, even in the period of uncertainty that we find ourselves today, the industry will remain very much open for business. 

Preparing the ground

Josh Lerner of Harvard Business School

Josh Lerner of Harvard Business School on private equity's knack for navigating uncertainty

Brooklyn Bridge, New York

Currency risk: Here to stay

Tom Speechley, Partner at The Abraaj Group

Tom Speechley, Partner at The Abraaj Group, examines how private equity GPS are managing the associated risks of currency volatility in emerging markets

Hong Kong

To hedge, or not to hedge?

David Fann, President and CEO of TorreyCove Capital Partners

David Fann, President and CEO, TorreyCover Capital Partners outlines some possible options for currency risk management within a private equity portfolio

digital financial stock display

Preparing the ground

4 min read

Josh Lerner of Harvard Business School on private equity's knack for navigating uncertainty

Every day investors face risks of all kinds in the pursuit of returns, from the political to the economic, from changing consumption trends to technology disruption. Broadly speaking, investors do not like uncertainty, and it is not generally healthy for public markets.

Few industries thrive on disequilibrium like private equity

The political shifts of the last 12 months towards economic populism and nationalism—discussed at great length elsewhere—are likely to be associated with a rise in uncertainty.

If we are indeed entering an era where a lot of things we took for granted in places like the US, such as the rule of law, are no longer guaranteed, this could present challenges in the long term for equity investors of all types.

Similar concerns might be raised regarding the prospects for private equity, whose performance has historically been quite correlated to that of public equities. At the same time, few industries thrive on disequilibrium like private equity. When you look at many of the successful investments that private equity has made, they tend to be in industries in transition, whether due to regulatory changes, such as in telecommunications and healthcare, or due to changes in patterns of global competition.

Forecasting market tops is a perilous business. I recall a bunch of venture capital groups getting out of the market for internet start-ups in 1996, as they saw valuations as unsustainable. They were right—but they nonetheless succeeded in severely damaging their reputations, and even firms' futures, by missing out on four years of the boom before the dotcom bubble eventually burst.

That said, there are big differentials between private equity vintage years. Those vintages that turn out to be the market tops, such as 1986 (prior to Black Monday the following year) or 2006 before the global financial crisis, substantially underperform. Only tomorrow will we know how today's vintage will perform.

Some comfort should be taken from a recent working paper we released. We matched British companies backed by private equity with counterparts not owned by financial sponsors by industry and size to see how they performed in the financial crisis.

We found that the firms with private equity backing undertook capital expenditures and other kinds of investment at substantially greater rates in the wake of the crisis.

Private equity firms' active engagement in the companies that they own will prepare them for — and help them to manage — the worst.

Their ability to invest more appeared to be due to their ability to raise capital relative to the others. The firms backed by private equity firms have more equity investment—which presumably reflects the fact that private equity firms themselves had deep pockets to continue to fund those companies, while their counterparts had to rely on declining public markets and other alternatives, which was a more difficult row to hoe. They were able to access debt financing, as well.

One suggested explanation for the latter pattern was that their private equity backers had developed strong relationships with banks over many years.

While the others were grappling with credit lines being pulled after the financial crisis, the private equity-backed firms got more forbearance from the banks and a greater willingness to extend credit lines, reflecting their sponsors' deep relationships with the financial institutions.

Whatever the precise reason for this continued investment during hard times, it is fair to assume that whatever lies ahead in this period of uncertainty, private equity firms' active engagement in the companies that they own will prepare them for—and help them to manage—the worst.


Josh Lerner
Jacob H. Schiff Professor of Investment Banking at Harvard Business School and head of the Entrepreneurial Management unit.

He founded and runs the Private Capital Research Institute, a nonprofit devoted to encouraging access to data and research about venture capital and private equity.



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