Private equity looks to find opportunities in a market downturn. 123rf
The looming economic downturn is unlikely to curtail the rise and rise of private equity.
Last year private equity groups announced a record 14,730 deals globally worth US$1.2 trillion, nearly double the previous high set in 2007, according to Refinitiv data.
The value of the 61 deals by private equity firms targeting Australian companies from January to the end of May marked the best start to a year on records dating to 2000, according to Refinitiv.
EY's NZ Private Capital Monitor showed 2021 was another year of record activity, with $4.3 billion of combined investments and divestments across private equity and venture capital transactions, weighted heavily towards divestment.
There was an increase in the total number of investments in 2021 (179) compared to 2020 (128).
"We see private capital continuing to play an important role throughout the coming year in accelerating the ambition of many New Zealand businesses as they cope with uncertainties stemming from a range of challenges such as supply chain issues, labour shortages and an inflationary environment," the report said.
Big listed companies are already in the sights of private equity, KKR's A$20b bid for Australia's Ramsay Health being a case in point.
Mark Lister, head of private wealth research at Craigs Investment Partners, says private equity will continue to be very active globally, including here in New Zealand.
Sharemarkets are bear market territory and the possibility of recession — particularly in the US — is looming.
"When you look at history, downturns are the time when private equity comes into its own because the cashed-up private equity firms want to take advantage of lower valuations or to support more businesses who are finding it more difficult to raise capital," says Lister.
"If you look back at private equity funds and how their returns have been, it's always the ones with a GFC vintage that look really strong because they did their buying in 2009/10/11 when things were a little bit beaten up."
"Some private equity funds have got money to spend and will be rubbing their hands with the prospect of weakening markets over the next 12 months or so."
Overseas, private equity has the reputation as being a buyout firm — paying high prices, stripping out costs, leveraging them up and selling back to the market.
The New Zealand private equity model is much less gung-ho.
Our share market's contribution to GDP is small compared with the proportion in other countries.
"We have a much bigger proportion of companies that are in private hands — a nation of small and medium-sized businesses — compared to other countries," says Lister. "There are lots of companies out there that need capital, but many are not quite ready to be listed on the NZX.
"That's where the private equity firms come in with a partnership approach. You are not likely to see New Zealand private equity firms combing over the NZX and hoovering up companies as you see sometimes overseas, but I think you will see them do lots of behind-the-scenes work in the New Zealand economy.
"That will potentially set us up for more NZX listings in the future as these companies grow."
But has the rise and rise of private equity been at the expense of the traditional Initial Public Offerings (IPOs) and public listing approach?
Lister replies, "some overseas private equity firms have come in with offers that you can't say no to — stocks that otherwise might have been listed on the share market.
"If you are in a weak market, it's better to be a buyer rather than a seller. It's the same in any asset class.
"We are in a weak market and if that weakness continues then that's a good time to be a cashed-up private equity fund.
"On the other hand, it's not the time for companies to be doing IPOs because the appetite from investors is more limited.
"People are more nervous and more risk-averse," he adds.
"For cashed-up private equity firms with a long-term view, there will be an increasing number of opportunities as the economy softens and as other investors get a little bit more spooked."
Tough times ahead?
Nigel Bingham, the managing partner at private equity firm Pencarrow, says the economy looks to be in for tough two or three years.
"It's always hard to tell, but we have almost the perfect storm at the moment with the situation in Ukraine, which is forcing up energy and food prices, and supply chain issues, particularly with China adopting a zero Covid policy.
"All of that is driving inflation and interest rates up.
"Of course, capital markets don't like rising interest rates — it raises the discount rate at which you rate future cash flows and most asset prices tend to fall in that environment.
"Some will fall more than others, and we are seeing that a bit at the moment," he says.
The "profit-less" tech stocks have fallen dramatically on Nasdaq.
"From a private equity perspective, we have been here before," observes Bingham. "The Global Financial Crisis was not easy on anyone, but it was a time when private equity performed well. It is an active type of asset management.
"You roll up your sleeves when things get hard. You dig deep and you work hard on the assets."
Private equity, particularly in Australasia, tends to focus on robust assets — the likes of healthcare, consumer staples, and business-to-business service companies, which are often backed by long-term contracts.
Most private equity firms have stuck to the same types of assets.
Bingham warns, 'while we are very conscious that we will probably see some downturn in valuations, that can present a two-edged sword for private equity."
In a downturn, exiting a private equity portfolio might not be as good.
On other hand, for those with "dry powder" — uninvested capital — there is a real opportunity to buy businesses at lower valuations.
The style of private equity in New Zealand is very much more growth-oriented as opposed to leverage-oriented.
Bingham says the right type of assets may require some bank debt.
"You don't want to have too lazy a balance sheet.
"We are really looking for underlying growth in revenue and earnings over time."
Bingham expects to see a switch in the way that private equity conducts itself during the downturn. "Venture capital is going to struggle a bit in this kind of environment.
"The very large leveraged buyouts will also struggle a bit".
New Zealand private equity is largely in growth — the small to a mid-cap area that tends to perform slightly better in these environments.
"Overall, and we have seen the trend in New Zealand, if you look at asset managers as a whole, they have tended to allocate a bit more over time to private equity alternative assets away from some of the traditional assets list listed equities and bonds as they have become more comfortable with the asset class."
He says private equity has become a more conventional investment alternative over the last 15 years.
IPOs v private equity
Private equity owners of companies are now either selling to trade buyers or increasingly to other private equity buyers rather than go down the IPO route.
Bingham says that is because it such a large asset class now, private equity firms can sell up to larger private equity firms.
"That's increasingly the case for us."
Asked if there will there be fewer IPOs and more private equity deals in the future, he replies: "That would be my sense.
"Every now and then you get waves of IPOs and we have seen a little bit of that, particularly in the tech sector — over the last 12 to 18 months until recently.
"You get these almost boom-bust cycles in the public markets and obviously the private equity and venture capital firms tend to take advantage of high prices when they are there, but the windows close and then it stops.
"What you will need to find is that because of high levels of regulation, higher disclosure requirements, higher costs of listing, a lot more firms will tend to stay in private hands or with private equity firms, particularly as there are so many more private equity firms with so much more capital these days."
Typical equity clients are iwi groups, community trust, some institutions and high net worth individuals usually through aggregate vehicles put together by brokers.
Pencarrow had a stake in Christchurch-based software company Seequent, which was sold to Nasdaq-listed engineering software company Bentley Systems for US$1.05b in March last year.
Not many Seequent-sized deals come along every day, Bingham says.
"We are in a more difficult environment now and the big question will be how much worse does it get and how long will it last.
"But we have been through these cycles before and it's about investing in high-quality assets that will be robust throughout the cycle, which is what we are focused on."
It seems certain that the current downturn will not impede the rise and rise of private equity.
"From our perspective, I can see us doing pretty much the same level of deals that we have tended to do."
Obviously, the pricing will change a bit.
"As the GFC showed, it was a good time to be investing."
Steady is better
Gavin Lonergan, a director at the private equity firm Direct Capital, says the company is in some ways "a bit indifferent" to the economic cycle.
"Generally, we have been around for 28 years so we have been here many times before — at different parts of the cycle.
"Periods like last year felt a bit like 2006-7 all over again but without the levels of debt that existed during that period.
"The use of debt has been a lot more sense this time around but nonetheless valuations appeared to get quite toppy and the level of transactions reflected that.
"This year we are seeing that reverse back to more normal times and that's better from our perspective.
Lonergan said nobody likes the peaks and the troughs. Steady is better.
"It's in the tougher times that equity gets more recognised.
"Our busiest times have been in periods like this."
Companies wanting to make acquisitions are sometimes better off doing that in partnership with somebody who has the capital.
"For us, typically, this is a good time simply because there are more uses for our equity during tough times — it gives companies more certainty over debt."
Private equity has gone from being an unknown two decades ago to be a viable alternative for many.
Lonergan said private equity is now seen as a real option over an IPO and listing.
One of the advantages of taking the private equity route is that the sale of a business takes place privately and not in a public environment.
Private equity is a lot more flexible than a listing and is not so encumbered with the rules that typically surround going public.
"In private equity, you can invest with a much longer time frame in mind without having to worry about what the next quarter's earnings are going to do," he said.
Lonergan says downturns always turn up interesting opportunities.
"Generally, in our experience, this has been a time to invest."
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