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Private equity may be more resilient thanks to active ownership and long-term focus. What else makes the asset class well-equipped to potentially thrive in times of recession?

Markets have suffered in this year’s downturn, driven by rising inflation, stock market volatility and the prospect of recession in many developed economies. «We have seen a steep drop in valuations and prices in public markets, but the decline has not yet been fully diffused to private market valuations,» says Pavel Ermoline, Investment Manager at Moonfare.

These tend to follow suit eventually but often in only a limited capacity. The current valuation reset, therefore, offers attractive opportunities for recently and newly launched funds, as these will evolve in a healthier valuation environment.

In Better Shape

But despite a potentially beneficial valuation reset, investment managers still need to navigate inflationary pressures, rising interest rates and geopolitical disruptions, placing a cloud over the longer-term outlook. However, for Ermoline, private equity firms as a whole are in better shape to meet these challenges than before.

Fund managers, for example, are much better positioned to face the increased cost of capital than a decade ago. «For existing investments, fixed-rate financing will provide some room to revisit capital structure before refinancing. For new investments, rate hikes will be priced into entry valuations with likely lower leverage.»

Focus on Operational Improvements

This positioning is helped by the industry’s overall shift from one that is primarily debt focused to one that now prioritizes operational improvements to add value. Indeed, McKinsey's research shows that firms with value-creation capacities outperformed during the Global Financial Crisis (GFC). Importantly, in 2008, only the larger PE firms had operating expertise. Today, most portfolio companies can receive such support to overcome challenges and grow more quickly.

Moreover, private market funds’ tendency to deploy capital over three to five years mitigates exposure to a single entry point and valuation environment. We have seen this before in the GFC, with private equity’s 2008 and 2009 vintages delivering solid performances at a time of an incredibly volatile and uncertain environment.

Record Dry Powder Prepares Soft Landing

Private equity firms today are also awash with an unprecedented amount of capital to deploy. By the end of the first half year of 2022, they were sitting on $1.8 trillion which the firms will need to deploy within a typical four to five-year investment period.

This, says Ermoline, adds an extra layer of comfort. «A similar situation happened during the early days of the pandemic when lockdowns and supply chain chaos generated a wave of panic on public markets. The significant amount of dry powder back then proved vital, as managers benefitted from valuable capital to support existing portfolio companies and avoid any liquidity shortfall.»

Well Placed to Capitalise on Downturns

Not only can top-tier funds help companies survive downturns, they may also have the skills, tools and expertise to navigate and capitalize on volatility. «Markets are cyclical and diversifying entry points is the best hedge to generate stable long-term returns. Current market conditions appear pretty favorable for investors and managers deploying capital.»

This doesn’t mean, however, that private investors should get into the business of trying to predict volatility, he says. «The statistics tell us that timing the market is never a good idea in private markets. The best strategy remains discipline and consistency, which means regular and long term commitments to the asset class.»

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