The State of Private Equity

Jacobson: In terms of business, people like you and I, Philippe, were probably a lot less concerned about doing new deals at that point in time. What we needed to do was triage our existing portfolios, and it completely varied by industry sector. If you had a portfolio that was full of telecommunications, healthcare, and software, you might not have even noticed that anything happened. But if you had a portfolio with travel and leisure, or anything that was locked down, the impact was quite sudden and severe. The focus for the first months was making sure that those more lockdown-prone businesses had the liquidity to make it through. The good news is that our companies survived that most difficult first wave.

Ferneini: Absolutely. That was the main focus of Q2 last year—looking into the portfolio companies and making sure that the GPs [general partners] had enough support, or finding out if they needed some additional funds or assistance from us as investors. When the markets dipped in the end of March 2020, we thought that we would see a similar scenario to the great financial crisis of 2008–2009, where the financial markets took a couple of years to recover. Fortunately enough, markets rebounded sharply in April and May 2020 thanks to the governments and the central banks stepping in and providing liquidity to the markets. This led to more confidence in the market and a flurry of activity in the second half of 2020, both in terms of transactions and fundraising.

Jacobson: Fundraising should be talked about a bit more because fundraising provides the oxygen for our business. We invest other people’s capital, and the interesting thing is, we had to ask them for more capital via Zoom, which we had never done before. Investors wanted to know on an almost moment-by-moment basis how their portfolios were developing. We had to give a lot of transparency. They asked a lot of great questions. But the overall trend was that we were able to prove out the thesis of our asset class and where the investors have capital they need to make a return on, and this wound up winning the day.

Investors also asked about the new deal side, and as 2020 progressed we saw a lot of pent-up demand for deals because we had about five months of only minimal activity. Europe reopened midsummer, and the investment pipeline started to swell significantly because there’s all this uninvested capital in our industry. So for us, it was one of our busiest Q4s ever in terms of new investing.

Ferneini: A direct consequence of the COVID crisis was a flight to quality and a focus on the better performing assets and managers. This led to a K-shaped recovery whereby the star assets in COVID-resilient sectors (software, healthcare, etc.) saw a lot of demand from investors, which drove valuations up above and beyond pre-COVID levels. On the other hand, the assets that were hit by the pandemic or were low/medium quality saw valuations drop drastically as investors’ demand dried up. I’m focused on secondaries private equity investing, and as discussed previously, we definitely saw a market dislocation in Q2 2020 where we managed to acquire good quality assets at interesting discounts.

Jacobson: If you’re a private equity owner of a high-quality business that was relatively immune to the pandemic in the sectors I mentioned before, like telecom, software or healthcare, you’d be able to sell that business at a healthy multiple of profit. Even during the pandemic last year when it wasn’t clear how the broader economy was developing, the multiple of profit was higher than ever because there was so much interest in these perceived COVID-19-resilient companies and assets.

In terms of other sectors, it’s still a bit early to know about the other side. When some of the lockdown-sensitive businesses reopened—in sectors like dentistry or veterinary care—they rebounded sharply. For some of the sectors such as travel, leisure, tourism, or aviation, we’re actually still not sure how they will develop. I don’t know what the shape of that recovery will look like. We’re probably still a bit cautious on those types of sectors.

Ferneini: Absolutely. There’s still uncertainty despite being a year and a half out and almost half of the population having gotten vaccinated here in the UK. Will people go back to the office 100 percent like before? Will it be more like 30 percent, 40 percent? Investing in COVID-hit businesses will require some degree of “leap of faith”; if you are happy taking such risk, you would prefer to be conservative on the growth assumption going forward. But again, that might be perceived as an opportunity for some investors.

Jacobson: Building on that, what the pandemic is certainly making us do is rethink a lot of what we’ve known in the past. There are certain sectors that we believe are generally economically resilient. These companies do well in bad economies. However, they were not built for lockdown—gyms and pubs, for example. Unlike dentistry and veterinary care that I referred to earlier: we know how those are going to recover. But if you take a pub or a gym, we’re not sure what their new business model is exactly going to look like. For example, how many people will be allowed in a gym at the same time and what will social distancing look like there?

Ferneini: I agree with that, and on the other side, software is a rapidly growing sector that has seen tailwinds from the COVID-19 pandemic as software allowed businesses to keep running despite the lockdowns. Today, the software sector counts for around 20 percent of total private equity commitments—it was more like 2 percent in 2005 or 2008. The growth of the revenue and the profitability of the sector has been interesting to us.

Jacobson: Interest rates are also going to have a major impact on all of this. We’re seeing spikes in some inflationary indicators and never thought this conversation would happen so quickly. It’s unclear whether that will persist, but there is now a view that rates might begin to tick up. The cost of capital in the private equity industry is significantly dependent on the state of interest rates, and we’ve had basically zero percent interest rates, or close to zero, since the financial crisis more than ten years ago. If rates start to spike up, perhaps in reaction to inflationary pressures, it could have a meaningful impact on the private equity industry. There are some potential clouds out there. If we get back to 2 or 3 percent, that’s a meaningful change, and I do think that would jolt the equity markets and depress valuations.

Ferneini: I agree. From a macro perspective, what has been driving increased fundraising in private equity is the very low rates and the pursuit of yield. I am carefully watching the Fed and ECB’s monetary decisions alongside inflation indicators as macro-risk is there and could have a negative effect on markets and valuations.

That’s a good segue to talking about SPACs [special purpose acquisition companies] as a novel exit path, which kind of is good for us as private equity investors because SPACs are a direct result of the liquidity in the system. We like it because it’s repeatable. We’re seeing exits of underlying portfolio companies through SPACs, which is one of the drivers of increased liquidity and distribution to private equity LPs [limited partners]. It’s not a new idea, but SPACs have been booming over the past year as a result of the current expansionary monetary policy and ample liquidity in the markets.

Jacobson: I don’t think anyone would have predicted those trends happening so quickly. The question on SPACs will ultimately be: Where does the counterbalance end up? Will they wind up in some ways being competition for private equity and acquiring assets?

Something else that merits more discussion is how the pandemic highlighted a lot of deficiencies in our economies and our societies, and it highlighted inequalities. That’s led to an increased focus on ESG [environmental, social, and governance] considerations, and on diversity and inclusion initiatives. This is something that had already been percolating for some time in our industries, but we’ve seen a massive acceleration. This is good business and the right thing to do. It took a pandemic to really shine a light on all of it.

Ferneini: The LP community is much more aware about ESG and is asking for more ESG compliance. The GPs are recognizing that “values drive value” from an investment perspective. Before ESG was often treated like a “check-the-box” exercise. Now we are seeing general partners improving their ESG frameworks at both the fund and portfolio company level. We welcome this change, which would hopefully have an impact on building a better, safer, and more diverse society.