PE in economic recession

I did try researching this topic, but with limited explanation. I come from technology industry. So, your elucidation on this topic with a brief on this industry will be helpful. Web-links/reference materials will be a bonus for me.

How PE firms get affected during economic recession? Valuation, (distressed) business investing, LBO, Venture Capital, etc. are an affair for companies round the year (correct me if I'm wrong). While it's true that everyone is affected by the economic downturn, is PE cyclic? If yes, how does the industry tend to cope with it (apart from lay-offs, cost-cutting measures, reduced salaries, ...)?

Investopedia definition of Cyclic: http://www.investopedia.com/terms/c/cyclical_industry.asp

 

I am not an expert on your questions but I've worked in the distressed industrial segment for 13 years now. Obviously, downcycle creates a lot of opportunities for those who are poised to pounce. There is published information on zombie portfolio businesses that are not (were not) being addressed. I've seen estimates on the total size of zombie portfolio business and it's huge. I've seen funds go to great lengths to hide failures in their portfolio hoping for better times or better luck. Generally, PE managers do a better job managing the down cycle than entrepreneurs, but they still have their problems. #1 problem for PE firms is the combination of arrogance in thinking that there is no one smarter in managing a turnaround than them (which is wrong) and pride which keeps them from exposing problems - so they find clever ways to hide the problems. Also, there were articles on LP's wanting to get their money out in 2009-2010 and the pressures that created.

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Not a PE guy but I can give you the general gist.

Bottom line is, yes, PE is incredibly cyclical. PE relies heavily on a healthy debt market in order to get deals done, plus the high leverage levels on portfolio companies make them vulnerable to economic shocks, and a PE firm gets hit hard in both areas in a downturn.

The first part: Since obtaining significant debt financing is required for a buyout, a traditional buyout is very difficult to accomplish during a period like 2008-2009, when the credit markets effectively shutdown. Graph here of deal flow during this period compared to '07: http://www.zerohedge.com/sites/default/files/images/PE%20Deal%20Flow.jpg

The reason this is especially bad is because environments like 2008-2009 are when the best bargains can be had; but again, tough to get a traditional deal done. You see PE firms mitigating this in several ways. For one, most of the big PE shops now have credit investing arms, and in a downturn they can exploit opportunities in distressed credit through that part of the firm. Apollo, for example, doubled down on some of their PE investments made pre-crisis by buying up portfolio company debt that was trading at low prices. And you can also get creative and do interesting deals that aren't buyouts; for example, Leonard Green made a large growth investment in Whole Foods back in 2009 when they needed capital to continue expanding.

The second part: Portfolio companies typically have significant leverage, and need to generate a good level of cash just in order to cover debt service. This leaves them more vulnerable to shocks in the economy than your average company. To some extent, this is mitigated by the fact that buyout candidates (traditionally) are good businesses with relatively stable cash flow generation. But even if you have done your homework, you can still get screwed. That said, the portfolio companies of most of the big PE firms that I'm aware of did not fare quite as poorly as you might think. The two huge pre-crisis buyout failures that are still lingering on today (I'm thinking TXU & Caesars/Harrahs) did not fail because of the 2008-2009 crisis; they've failed because the investment thesis and the level of debt just doesn't match today's economic reality for those businesses. The lesson being, big buyouts are dangerous for reasons beyond economic cycles.

 
Extelleron:

Not a PE guy but I can give you the general gist.

Bottom line is, yes, PE is incredibly cyclical. PE relies heavily on a healthy debt market in order to get deals done, plus the high leverage levels on portfolio companies make them vulnerable to economic shocks, and a PE firm gets hit hard in both areas in a downturn.

The first part: Since obtaining significant debt financing is required for a buyout, a traditional buyout is very difficult to accomplish during a period like 2008-2009, when the credit markets effectively shutdown. Graph here of deal flow during this period compared to '07: http://www.zerohedge.com/sites/default/files/image...

The reason this is especially bad is because environments like 2008-2009 are when the best bargains can be had; but again, tough to get a traditional deal done. You see PE firms mitigating this in several ways. For one, most of the big PE shops now have credit investing arms, and in a downturn they can exploit opportunities in distressed credit through that part of the firm. Apollo, for example, doubled down on some of their PE investments made pre-crisis by buying up portfolio company debt that was trading at low prices. And you can also get creative and do interesting deals that aren't buyouts; for example, Leonard Green made a large growth investment in Whole Foods back in 2009 when they needed capital to continue expanding.

The second part: Portfolio companies typically have significant leverage, and need to generate a good level of cash just in order to cover debt service. This leaves them more vulnerable to shocks in the economy than your average company. To some extent, this is mitigated by the fact that buyout candidates (traditionally) are good businesses with relatively stable cash flow generation. But even if you have done your homework, you can still get screwed. That said, the portfolio companies of most of the big PE firms that I'm aware of did not fare quite as poorly as you might think. The two huge pre-crisis buyout failures that are still lingering on today (I'm thinking TXU & Caesars/Harrahs) did not fail because of the 2008-2009 crisis; they've failed because the investment thesis and the level of debt just doesn't match today's economic reality for those businesses. The lesson being, big buyouts are dangerous for reasons beyond economic cycles.

What's the typical leverage ratio when they make a buyout? Lehman Brothers' high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007 (source: http://www.investopedia.com/articles/economics/09/lehman-brothers-colla…), which led to bankruptcy and eventually to collapse. While I agree that Lehman was an IB and failure of Lehman was not only related to debt, how much risk PE firms typically take?

 

A scale PE firm at the GP level is really not particularly cyclical as it has contractual mgt fees coming from multiple funds which are locked up for 10 years. For that reason it is rare that a PE firm would lay off members of its deal team or back office due to an economic recession.

Dealmaking itself is extremely cyclical for the reasons the guy above stated. In vanilla LBO shops in particular, no credit means no deals in markets like '08 - '09. So the way the PE firm deals with that generally is going to be to reallocate the deal team's time to portfolio companies, where the deal guys will go in and figure out how to save the investment or otherwise improve the business.

 
RLC1:

A scale PE firm at the GP level is really not particularly cyclical as it has contractual mgt fees coming from multiple funds which are locked up for 10 years. For that reason it is rare that a PE firm would lay off members of its deal team or back office due to an economic recession.

Dealmaking itself is extremely cyclical for the reasons the guy above stated. In vanilla LBO shops in particular, no credit means no deals in markets like '08 - '09. So the way the PE firm deals with that generally is going to be to reallocate the deal team's time to portfolio companies, where the deal guys will go in and figure out how to save the investment or otherwise improve the business.

good post.

I was talking to a guy that runs a shop in Dallas.

He said in 08 to 09... You could shoot a gun at 6 pm and you wouldnt hit anyone because every one was out of the office early.

There just weren't too may available deals to be done.

 
handullz:
RLC1:

A scale PE firm at the GP level is really not particularly cyclical as it has contractual mgt fees coming from multiple funds which are locked up for 10 years. For that reason it is rare that a PE firm would lay off members of its deal team or back office due to an economic recession.

Dealmaking itself is extremely cyclical for the reasons the guy above stated. In vanilla LBO shops in particular, no credit means no deals in markets like '08 - '09. So the way the PE firm deals with that generally is going to be to reallocate the deal team's time to portfolio companies, where the deal guys will go in and figure out how to save the investment or otherwise improve the business.

good post.

I was talking to a guy that runs a shop in Dallas.

He said in 08 to 09... You could shoot a gun at 6 pm and you wouldnt hit anyone because every one was out of the office early.

There just weren't too may available deals to be done.

 

Everyone's correct above. At the GP/management co level it's just not that cyclical. Yes, deal flow ebbs and flows, leverage tightens and all that but most PE firms run pretty lean and most are smart enough to be able to easily cover their overhead with the management fee. One of the interesting thing that came out of the last downturn was its effect on the ability of people to raise their next fund. I know a couple of funds that have had or are having a tough time raising capital since '10 even though they did pretty well on their last fund, then I know guys who were flat or didn't even hit their hurdle who had no problems raising more money. Some of its the brand name but not all of it.

 
Dingdong08:

Everyone's correct above. At the GP/management co level it's just not that cyclical. Yes, deal flow ebbs and flows, leverage tightens and all that but most PE firms run pretty lean and most are smart enough to be able to easily cover their overhead with the management fee. One of the interesting thing that came out of the last downturn was its effect on the ability of people to raise their next fund. I know a couple of funds that have had or are having a tough time raising capital since '10 even though they did pretty well on their last fund, then I know guys who were flat or didn't even hit their hurdle who had no problems raising more money. Some of its the brand name but not all of it.

During 08-09, I heard stories that some of PE LPs were telling their PE funds "no calls on our commitments", as some LPs were struggling with liquidity and significant calls on their funding commitments would trigger a default.

This was more word on the street than something I actually saw in practice. However, it was consistent with the lower levels of PE deals I saw at the time.

Any views on whether this was more myth than practice?

Those who can, do. Those who can't, post threads about how to do it on WSO.
 

^Someone else can probably give you a better picture of today's market. But in general leverage will vary depending on the market environment and the asset. Back in the late 80s PE shops might put in as little as ~10% equity. The average across recent history is more like ~40% equity, trending down in frothy times and up when the debt markets are hard to access / expensive. And then the quality of the asset (in terms of cash flow predictability) and where it is in the lifecycle matter; a mature company w/ very high quality cash flows, producing a product with inelastic demand, and in a market with little competition, can support much more debt than a business in need of significant investment and/or with a lower quality cash flow stream [cyclical product, higher competition, etc]

You talked about Lehman and that brings up a few other points; it's not only about cash flow generation being able to support debt service (mostly what I'm talking about above) but you also have to think about things on a D/V basis and whether you will be reliant on the market to refinance. In Lehman's case the situation was too complex for people to wrap their heads around the value of the assets they'd be lending against and so refinancing was impossible. In GGP's case, the asset quality was more obvious and cash flow generation was strong, and yet they were still unable to refinance and went into bankruptcy as a result.

 
Best Response

I agree with AlphaGeneration. During boom periods transactions are far more likely to occur. Financing is easier to come by and buyers are willing to pay up to meet sellers' expectations. Also, portfolio companies are likely expanding and taking on new initiatives.

The other little nuance is that when times are good, it is more likely that the junior folks are invited to participate in meetings and events that require travel. Plane tickets and hotel rooms for junior folks are one of the first things to get cut when portfolio companies aren't performing well. This can be the difference between your going to a board meeting / management presentation / facility tour or simply dialing in.

On the flipside, you can learn a very different skillset in a recessionary period. Hardcore cost cutting, dealing with tripping covenants, and other "trouble" situations are more likely to happen in a recession and you'll want experience dealing with these as well.

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