How Private Equity Firms Just Might Save the Post-Pandemic Economy
The pandemic has damaged the economy, and the recovery will be difficult. To climb out of the crisis, many companies that were financially healthy before the pandemic will need more capital in order to operate.
Some industries, however, are thriving during the pandemic. Firms that support remote work, education, and entertainment, have grown sales and profits. These businesses are attractive investments in a post-pandemic environment.
Who will provide capital to businesses, given the current economic uncertainty? Private equity may be a large source of the funding.
What are Private Equity Firms?
As the term implies, private equity firms are not public companies. As a result, they have fewer restrictions and disclosure requirements than businesses that register securities with the Securities and Exchange Commission.
Private equity funds raise money from sophisticated, high net worth investors and from institutions. Once a company is purchased, private equity managers work with firm management to increase productivity and profits.
Investors must meet net worth and investment experience requirements to invest in a private equity fund. Investors are required to keep funds invested for 4-5 years, and most investors attempt to sell the company for a gain after 6-10 years.
In the years before the pandemic, low interest rates motivated some corporations to raise capital by issuing corporate debt.
The Impact of Corporate Debt
According to CNN: “Corporate debt among non-banks exploded to $75 trillion at the end of 2019, up from $48 trillion at the end of 2009, according to the Institute of International Finance.”
The pandemic has sharply reduced sales and profits for thousands of businesses, and lower profits make it more difficult to repay corporate debt. If a company can’t pay principal and interest payments on time, several events may occur:
Credit rating: The corporation’s credit rating will be cut, making it more difficult to borrow in the future.
Collateral: Company assets, including fixed assets or accounts receivable balances, may serve as collateral for a bond issue. If the borrower defaults, the lender may take possession of the collateral.
Higher interest rates: If corporations are struggling to repay debt, due to a poor economy, lenders will demand higher interest rates on new bond issues, to compensate them for the higher risk of a bond default.
Recent private equity deals have included large amounts of debt. Bain & Company reports that, in 2019, more than 75% of U.S. private equity transactions took on debt of at least six times their operational earnings.
The industry defines this type of transaction as highly leveraged, and the business must grow sales and cut expenses to finance the large debt payments.
Private equity firms have billions of dollars to invest and are looking for profitable business opportunities.
Dollars to Invest
Sophisticated investors are looking for investment vehicles that offer a high rate of return, and many turn to private equity.
The industry refers to dry powder as “the amount of committed, but unallocated capital a firm has on hand. In other words, it’s an unspent cash reserve that's waiting to be invested.” Institutional Investor reports that: “Buyout funds had $853 billion in dry powder as of the third quarter (2020).”
A new form of private equity investing has increased the dry powder available. Special purpose acquisition companies (SPACs) are formed to raise capital through an initial public offering (IPO) of common stock. The IPO proceeds are then used to acquire an existing company. As of August 2020, more than 50 SPACs have raised over $21 billion.
As interest rates remain historically low, both individuals and institutions are searching for higher rates of return through private equity investing
PitchBook, a firm that provides data for private equity markets, makes these points in its 2021 US Private Equity Outlook:
“Heading into 2021, there is ongoing uncertainty from the coronavirus pandemic as lockdowns persist in parts of the world and widespread vaccine distribution will take time.”
Private equity fundraising will surpass $330 billion, setting an all-time high.
Private equity deals will continue to be financed with large amounts of debt, taking advantage of lower interest rates.
Consider the current environment for private equity investing, and the impact on business sales.
The Impact on Business Sales
Private equity firms can provide the investment dollars to fund company sales in a post-pandemic environment. Poor economic conditions make it difficult for business buyers to secure financing through traditional lenders, and buyers may consider a purchase too risky.
As the U.S. moves into 2021, private equity firms may purchase businesses that individual investors don’t pursue. Private equity firms are willing to take on risk, and will work to improve a business over a period of years.
If the private equity market uses available dollars to purchase businesses, more owners can close sales, and companies can get the capital they need to continue operations. Private equity firms may save the post-pandemic economy.