Within the past four decades, the private equity industry has shown remarkable growth. According to the WEF, its total value is now approximately $4 trillion. During the looming economic recession, this growth curve will slow somewhat, even though the interest in private funding is increasing within companies as well as among investors. The next months will reveal considerable differences between well-positioned and weaker private equity funds. We will see that those with a strong position will remain an attractive asset class in spite of the overall economic climate. The volatile stock market, the pressure to turn profits, and challenges through policy changes will be the driving forces directing money towards private equity funds. The overall economic prospects, while a bust for many, could actually turn out to be a blessing for the private equity industry. Thanks to their diversified portfolios, funds are much less vulnerable to market fluctuations than they were during the last recession ten years ago. Further, investments in the technology sector have increased considerably and now account for a major part of the portfolio. The tech industry is much more resilient to market fluctuations than the overall economy.
During the last recession, the private equity industry – including venture capital investors – largely froze their investments. The coronavirus is now causing severe economic repercussions that will be comparable to the recessions in 2001 and 2008. At its worst, up to fifty percent of all startups will not survive this crisis. For investors, it is of the utmost importance to be prepared and take the necessary measures now. Healthy investment funds can handle this downturn much better than ten years ago. With the following strategies, investors can even find opportunity in the slowdown:
Adopt a winner-takes-all mentality
Especially now, during the slowdown, a sufficiently broad portfolio is indispensable. Like a boom, a severe recession has effects on the entire economy, no matter the specific position of any given incumbent. A less severe slowdown, however, splits the playing field. Weaker players need to shore up their balance sheets and operations, i.e. sell company stakes. Those with a more diversified portfolio can focus on strengthening their position and growth projection. One way of building industry leadership and getting ahead of competitors is by investing in strategic acquisitions, e.g. through M&A platforms. When this recession is over, weaker players may not have survived – but a relatively few strong ones will emerge with a better position than ever.
Explore new investment opportunities
Public-to-private deals have not only increased significantly in number over the last years but also in terms of the investment sums. Private equity investors are more and more willing to acquire public companies. The combination of low-interest rates and high liquidity can help them use this trend and buy underperforming companies.
Larger funds should focus on further diversifying their portfolio by not only targeting different vertical industries but also branch out geographically and in terms of different asset classes.
Drive corporate transformation processes
The powers shaping our world will not go away because of this recession. Companies need to continue to advance their digitization, environmental, social, and governance (ESG) practices as well as more diversity and inclusion. Market-leading venture capital firms will use the time ahead to bolster their competence in areas such as artificial intelligence, machine learning, and advanced digital tools. This way, they will be able to future-proof their portfolio companies and increase the overall value of their portfolio.
Considering ESG practices for the allocation of capital and management criteria is becoming more and more important. An analysis of more than 300 companies shows that those with advanced ESG practices sported higher revenues and lower risks. A similar effect is observable with regard to initiatives that drive diversity and inclusion. It has been proven that revenues in companies with diverse management are almost ten percent higher than in those where the diversity within the leadership is below average.
If they can achieve advancements in these three areas, venture capital firms and their portfolio companies can create a virtuous cycle by attracting top talent, driving innovation, and building the foundation for sustainable growth.
Building resilience to the recession
Although a focus on growth is decisive, investors cannot afford to ignore economic fundamentals. Cost optimization, a zero-based approach, and effective cash management can help private equity firms and their portfolio companies to build resilience and maintain a range of choices. The leadership needs to look closely to identify the products and services that drive profitability. Quite often, it turns out that a reduction to the most valuable assets can recalibrate management focus, make resources available, and speed up the development of new functionalities and initiatives.
The portfolio companies’ management needs to consider cost reductions. In their function as an advisory council, investors should advise the management correspondingly: Seemingly discretionary costs such as research and marketing are often the first to be cut during a recession. If they are reduced too much, this can significantly hamper a firm’s ability to jumpstart growth afterward though.
Lastly, strong cash management is always necessary, but during a downturn, it is absolutely indispensable. Founders have a tendency to neglect cash management in favor of technology, product development, growth, and revenues. During a recession, this can prove fatal. Particularly during these times, cash loss and payment default occur more frequently. At the moment, this is already happening due to supply chain disruptions. Investors should, therefore, keep a very close eye on their portfolio companies’ cash management. They may also advise the management and illustrate what to keep an eye on in their financial planning. The leadership needs the necessary data and analytics tools to have an integrated view on EBITDA, long-term investments, inventory, receivables, payables, debt repayments, and asset disposals.
Carefully consider investments and return to the fundamentals
Investment decisions need to be planned even more carefully than usual during a downturn: As a founder and investor, I actively observed the last two crises. During the entire past decade, the economy has steadily grown. Those who entered the field during this time do not know it any other way, they may not be able to imagine there not being any growth. Now, there may be financial losses on the horizon, which means that investors need to write off unprofitable investments and act with even more consideration. With the strategies described above, and a return to the fundamental principles of good investments, i.e. human ingenuity, leadership and innovation, private equity is a relatively crisis-proof asset class.
The overall economic outlook may not be promising at the moment, but the next recession could turn out to be an opportunity for venture capitalists and the private equity industry at large. The underlying economy is stronger than it was ten years ago, the portfolios are more diversified. And even though policy risks pose challenges, they also offer opportunities for those who have the necessary resilience and foresight to navigate the new context.
