Structural and strategic factors mean private markets are well-placed to capitalise on dislocation, says Chief Investment Officer Michael Mowlem
Volatility seems to be a constant theme of our time. Recent years have seen significant turbulence in public markets as geopolitical tensions and shocks, such as Covid-19, buffeted the economy, leading ultimately to rising interest rates and soaring inflation which took their toll. Stability still seems some way off, with investors seemingly taking fright at any negative news, with the example of the market sell-off in the summer of 2024 and the Bank of England warning months later that stock market vulnerability remains a major concern.1
But every cloud has a silver lining and private equity is well-placed to find it. In times of public market stress, opportunities for value creation still exist and can increase for those with the right strategies. The private equity industry has a long track record of overcoming macroeconomic challenges and benefiting from disruption in public markets, and it looks likely to follow suit today.
Driving outperformance in tough times
According to the British Venture Capital Association (BVCA), “Private equity and venture capital is an asset class with a history of delivering returns in excess of those achieved by the public markets.” The evidence though is compelling. Its latest research into investment performance shows that private equity funds returned 15% per annum over a 10-year investment horizon, compared to 5.3% for the FTSE All-Share Index.2
Outperformance is therefore demonstrated to be a long-term trend, in good times and bad. But it’s worth zooming in on how private equity performs relative to public equities, specifically during downturns. This is when the difference in fortunes becomes particularly striking. Studies have shown how private equity fared much more strongly compared to public equity benchmarks following both the 2001 bursting of the dotcom bubble and the 2008 global financial crisis, for example:
The reasons for this sustained resilience are both structural and strategic. On the structural side, private equity models provide a buffer against short-term shocks. They are designed to take a long-term approach to investing, with a focus on delivering growth and creating value over several years. Their innate illiquidity acts as a control against investor panic, while discipline and discernment in deal selection are also important performance factors.
How does it do it?
On the strategic side, there are many ways in which private equity can take advantage of public market dislocation. These include:
- Capitalising on undervalued public assets
When stock markets take a tumble, private equity firms get a chance to acquire public companies at attractive valuations. Buying low and selling high is a key principle of private equity practice and falling share prices allow private equity firms to snap up undervalued public assets with greater potential for multiple arbitrage when the time is right to sell at a later date. Buying at lower prices also means there’s less of an impetus to ramp up gearing in order to drive returns.
Away from the glare of quarterly earnings targets and the relentless shareholder and media scrutiny to which public companies are subject, private equity owners have the time and space to reshape businesses for the better, adding value in the process.
Data from PitchBook shows that 136 take-private deals took place in 2023, and the signs show that 2024 is on track to follow a similar course, with 97 deals at the end of August.4 Recent examples of UK-listed companies being taken private include The Restaurant Group (acquired by Apollo Global Management for £500 million), veterinary pharmaceuticals company Dechra (acquired by Swiss private equity firm EQT for £4.5 billion), the £4.3 billion acquisition of cybersecurity company Darktrace by Thoma Bravo of the US, and AIM-listed geo-spatial software provider IQ Geo taken private by KKR funds.
- Being agile and embracing distress
Private equity firms have the means to deploy capital quickly, so they can be agile and seize the moment when good opportunities arise, as above or for example when a large group wants to slim down and refocus its operations during times of market stress by carving out and divesting a non-core (yet still profitable) part of its business.
Taking this opportunistic approach one step further, downturns clearly offer increased scope for investing in distressed assets that have been negatively impacted by market conditions. Private equity investment can provide a lifeline for companies or divisions that are struggling, but still have sound business models and turnaround potential.
This kind of investing is complex and requires particular skillsets and experience to unlock value. But by acquiring assets at a significant discount, focusing on the fundamentals, and using active management techniques, including operational and financial restructuring, private equity players can return these businesses to health and generate outsized returns as a result.
Success stories include Advent’s 2014 investment in activewear brand Lululemon Athletica. Advent had been a previous investor in the business, which IPO’d in 2009 and when they acquired a significant stake from its founder in 2014 for $845m, it supported an active turnaround strategy. It was worth around five times more (with a market capitalisation of $20bn) by the time Advent exited five years later.5 Today, the company has a market value of $36 billion6.
- Playing to market timing
Private equity firms have the flexibility to time their exit plans to optimise returns. During periods of market turbulence, they may hold onto investments for longer with an increasing trend of establishing continuation vehicles if necessary to give existing investors an opportunity for liquidity while waiting for the right moment to divest key assets.
By waiting for markets to stabilise or recover before selling to another private equity buyer or seeking a floatation IPO, they can reap the rewards of an improved valuation environment on exit.
Private equity investors also have the freedom to invest more capital in follow-on funding rounds where appropriate, to ensure portfolio companies can capitalise on market recovery or specific opportunities for growth, to maximise success. Indeed, BVCA figures show that 60% of businesses that received investment in 2023 had previously received funding from the same private equity backers.7
Taking a patient approach, yet having a willingness to be opportunistic, being disciplined but flexible: all these traits enable private equity firms to play to the prevailing market conditions of the time and turn challenges into opportunities. Private market investments provide a valuable counterbalance to public market investments in well-constructed portfolios. Even more so when assets are acquired at lower prices, the cost of capital is contained, and value can be maximised through business transformation and timing the market recovery.