For over a month, U.S. equity market performance has been driven by Covid-19 fears. The global spread of the virus has pushed the American economy to a standstill, which is by no means good news for investors. However, the significant decline in stock prices and the increasingly tightening credit market for small and medium-sized businesses might benefit private equity firms that specialize in providing financing solutions to these markets. The underlying conditions are favorable for the growth of this industry, and investors have an opportunity to benefit by investing in the shares of publicly-listed private equity firms.
How does a private equity firm operate?
Before diving deep to analyze why the current macroeconomic situation benefits the private equity industry, it’s important for an investor to understand the basics behind the operating structure of companies representing this sector.
Source: National Research University Higher School of Economics.
The business model, as illustrated above, is quite simple. The strategy is to invest in small companies with attractive growth profiles, make radical changes that improve the cash flow and earnings of such companies and divest the stake at a premium price to realize the investment return. Evidently, the ability of a private equity firm to invest in high-growth companies at fair or cheap valuation multiples is critical to its success.
Despite record low interest rates, borrowing is becoming an obstacle for some companies
An investor might assume that borrowing just got easier and cheaper for all types of businesses in the U.S. as a result of the record-low policy rates, but this is far from the truth. Small companies need credit more than ever with a nation-wide lockdown looking extremely likely within the next couple of weeks. Business activities have already gone down, but an improvement does not seem possible within the next 30 days as well. Amidst all this chaos, banks and fintech companies are all beginning to tighten the credit approval criteria in fear the imminent recession might lead to a significant rise in delinquencies. The below table consists of a few measures implemented by leading names in the financial services sector to curb lending activities.
| Company | Comments |
| JPMorgan Chase, Bank of America, Capital One Financial, Santander Consumer USA | These lenders are planning to approve fewer consumers with lower credit scores, asking for more income documentation, and placing lower spending limits on new credit cards. |
| American Express | New limits have been imposed on approving financing offers to small businesses. |
| Square Inc. | Strict criteria for approving micro-finance loans will be implemented in the coming weeks. |
| Fundera Inc. | The company has paused new extensions of credit. |
| LendingClub Corp. | The company would approve fewer loans from first-time applicants and is planning to request for more verification documents to support income and credit quality. |
| On Deck Capital | The company has stopped making new loans to movie theatres, hotels, and nightclubs and is planning to significantly tighten underwriting standards. |
| Synchrony Financial | New card applicants will face stricter eligibility criteria. |
Source: The Wall Street Journal and company filings
Multinational companies and large domestic organizations, however, will find the current interest rate environment a blessing as banks would be preferring these types of customers over their small peers amid the increasing uncertainty about a recovery of business activities. Private equity firms, on the other hand, are waiting on the sidelines to pounce on this opportunity.
A record level of liquidity
The decade-long bull market and the availability of credit at low cost forced private equity firms to hoard cash as attractive investment opportunities were hard to come by. At the beginning of 2020, many investors were skeptical of the ability of these investment managers to produce attractive returns in the future. However, the tables have turned and this record liquidity suddenly seems to be working in favor of this industry.
According to data from Preqin, the private equity industry had over $1.5 trillion of dry powder, or investable assets, at the end of 2019.
Source: Preqin/CNBC
As small businesses find it difficult to secure funding from traditional sources, private equity firms will have an opportunity to tap into high-growth companies at attractive prices. Historically, the industry has generated better returns than equity markets as a result of the ability of companies representing this industry to identify and invest in compelling growth stories.
Source: Cambridge Associates/CFA Institute
A popular criticism is that these firms were not actively investing during the financial crisis of 2008, which has led to a convergence with equity market returns in the last decade. However, the chances are that this mistake would not be repeated if the United States enters a recession in the next couple of months, especially with liquidity in excess of a trillion dollars.
A few companies to look out for
The best way an investor can gain exposure to this industry is by investing in publicly-listed private equity firms. The below table provides key information on some of the largest players on a global scale.
| Company name | Price-earnings ratio | The five-year average price-earnings ratio |
| The Blackstone Group Inc. (BX, Financial) | 15.60 | 24.04 |
| KKR & Co. Inc. (KKR, Financial) | 6.93 | 15.78 |
| Apollo Global Management Inc. (APO, Financial) | 9.56 | 24.50 |
| Ares Management Corp. (ARES, Financial) | 29.59 | 46.15 |
Source: Morningstar
As evident from the table above, all these firms are trading well below their historical earnings multiples. This creates an anomaly between the economic reality and the share price, which is an opportunity for contrarian investors.
Takeaway: private equity firms are trading at bargain prices
There’s no denying that the impact of a recession, or a significant decline in economic growth, will be felt by all businesses. However, some companies and industries will weather the storm better than others. Opportunities for private equity firms to grow will be abundant in the future as small companies find it difficult to secure funding. On the other hand, there will be opportunities to invest in equity securities of listed companies as well, primarily in travel and leisure stocks, as most of these companies are getting hammered in the market. Acting on these opportunities will lead to very attractive returns in the next decade, which should trigger a surge in stock prices of private equity firms.
Disclosure: I do not own shares of the companies mentioned in this article.
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