Private equity and the ‘new normal’
Swings between deflationary and inflationary economic cycles will play havoc with private equity investments, says Nicholas Doimi de Frankopan, but also separate the men from the boys
In the past year an unprecedented amount of money has been released by central governments into the marketplace. The US almost doubled its monetary base to over $1.6trn in the last quarter of 2008 alone; the UK engaged in a quantitative easing programme that currently stands at £200bn (€223bn); and the ‘parsimonious' European Central Bank relaxed collateral criteria for banks. All countries held their interest rates at record lows.
The issuance of money does not affect the velocity of its circulation, so the increased amount might not necessarily lead to inflation. Indeed, with demand only stabilised - not rebounding - it still looks as if we are in for a bout of deflation before inflationary pressures return. One thing is sure - we are no longer going to live in the benign monetary environment that we had since the mid to late 1990s. How will the private equity industry cope with this new environment?
Deflation is a big threat to private equity. By making existing debts more expensive in real terms it strikes at the heart of a model that uses leverage to improve returns and maximise the valuation-creation component of companies. Deflation also hits consumers hard - and in recent years private equity has edged closer and closer to the high street in search of excess returns on its original ‘boring but stable' remit.
We know that, all things being equal, a deflationary environment cannot last for long. Major peaceful and free markets have an average trend line of economic growth. The problem that most analysts foresee after this post-deflationary environment - when it does come - is runaway inflation, currently estimated at anything above 5-6%.
That would be a mixed blessing for private equity. It would benefit (like borrowing governments) from historical debts getting less expensive in real terms. But far more worryingly, runaway inflation would disrupt internal rates of returns (IRRs) in real terms, contribute to worker demands for pay rises and diminish the value of long-lived assets (unless their income is inflation-linked). All of these factors would hit private equity more than the public markets.
So is the private equity model flawed if there is rapid deflation followed by runaway inflation? Firms that have raced to scale or wandered from their mandate will find it increasingly difficult to access funding from banks or from their limited partners (LPs). This, together with a reassessment of service fees (especially for uncommitted capital), is likely to result in further consolidation.
What will the survivors of this consolidation have to demonstrate to potential banks or LPs? For existing funds or new ones the most important criterion will be the ‘pricing power' of the firms owned by an old fund or proposed as targets by a new fund. If this is proved beyond any doubt, a bank or LP will always be keen to associate with a fund. A firm that produces a necessity - and can also capture the economics of that necessity - will weather the storms of the economy better than others. It is also pricing power that should ensure the much-touted counter-cyclical element of private equity. By definition, pricing power is a zero-sum game overall in the economy, which is why a private equity investor must assess which sector or business has the most pricing power in a particular macroeconomic environment.
What does pricing power look like in the ‘new normal'? The most insulated players in the economy are governments; they are the least responsive (sometimes intentionally) to the pricing mechanism. One could therefore expect opportunities in the form of buying government assets or entering ‘inflation-proofed' contracts with governments. Indeed, this is the only way that any private capital will be coaxed into long-lived infrastructure projects in a deflationary/inflationary environment. However, private equity does not have the best relationship with government, and such investments will have to be highly monitored for political risk.
Another possible response of private equity to a deflationary/inflationary scenario will be longer holding periods during deflation, as exits become more difficult, followed by a flight to investments that have a much quicker turnaround than hitherto as inflation picks up, because paying for an investment in deflationary money and receiving returns in inflationary money is not an attractive proposition. Private equity firms will have to boast about their IRR in the former case, and about their ‘long-term' play in the latter case. Of course, these are opposite sides of the same coin - but they present LPs with serious problems too: shorter turnaround results in reinvestment problems, while longer holding periods can pose liquidity problems.
The style of investing will have to change, too. Private equity has allowed itself the luxury of strategic planning and positioning over the past few years. Now everyone expects it to get more involved with its investments. This is essential because so many private equity-owned firms will require exceptional money-raising skills, as well as tighter control of the money that is tied up in the business than ever, which is the essential expertise of private equity. Private equity first came to prominence in the 1980s for its concentration on raising money and the ‘value-add' focus of a business that was bought. Private equity firms cut out diversification if it did not add value (an important check on managerial empire building) and restrained unnecessary deployment of working capital. There is much in the deflationary/inflationary scenario that means that these skills will prove useful again. In an unstable macroeconomic environment it will be doubly important to keep a close eye on ‘boring' elements of the business - such as accounts payable, account receivable and inventory management. Even if this is not done by the private equity owners themselves, they will have to incentivise management teams in this direction, as effective control of working capital could easily be the difference between firms that survive and those that do not.
It is difficult for the whole of the economy to operate under conditions of large macroeconomic change. It is much harder to account, run or measure the economic performance of any asset when there are rapid fluctuations in the value of its benchmark (in this case cash).
It is therefore likely that a less stable macroeconomic environment lies ahead of private equity than that enjoyed over the past 20 years. That means discretion and judgement on investment opportunities will be more at a premium than ever: opportunity costs as well as risks will be much greater. But well-chosen, well-managed companies and well-executed exits should carry a higher return, revitalising the distinction between private and public equity. Such developments may not be bad - and represent a return to the origin of alternative investments for private equity.
Nicholas Doimi de Frankopan is an independent consultant