According toTom Franco, Partner at CD&R, Private Equity (PE) has always thrived in challenging environments. Amid market turmoil and economic downturns, the robustness and long-term investment approach of PE firms shine through. This competitive advantage is attributed to their ability to make calculated moves, unfazed by the short-term influences that often sway other asset classes.
He believes that market turmoil tends to be favorable for generating strong returns. “The reason for this is relatively straightforward” he tells Funds Society. “For PE firms, I believe that economic downturns spell opportunity. I believe the best PE managers invest over the long-term and in disrupted periods, deploy capital at more attractive terms, and make bold, calculated moves without being inhibited by the short-termism that frequently influences so many public and family companies. I believe this ability to take a long view creates important competitive advantages”.
In his opinion, while the near-term macroeconomic environment cannot be ignored, it does not necessarily change the PE investment approach.
“The long-term view usually assumes the need to hold an investment through both good times and tougher times.” He adds.
Franco reminds us that, across portfolio companies, macros often offset in ways that are hard to predict.
As he notes, “there are portfolio businesses where inflation has been a significant headwind in 2022 because PE firms have not been able to pass on inflationary costs due to long-term contracts that typically represent an investment positive when they are making an investment decision. But there are also businesses where inflation has been a significant benefit, due to positive net price realization with largely fixed cost structures. And interestingly, these businesses with opposite reactions to the macro also exist within the same industry.”
Even within those businesses that are economically sensitive, he believes a depressed economy can create opportunities for consolidation or to take share, reset dynamics with suppliers and customers, recruit exceptional talent or reinvest at attractive levels.
“PE is focused on being a strategic partner to sellers, and I believe this fundamental approach is even more demand in tough times. In a tougher environment, there are more problems, and therefore more problems available for managers to solve.”
The PE specialist believes that the era when PE was associated with mere financial engineering is a distant memory. “After several cycles and events ranging from extraordinarily cheap capital to the credit crunch, many today argue that private equity creates value through underlying business and operational improvements.”
In his opinion, the challenge going forward is the appropriate form of operational value creation and how PE firms should evolve their skillsets.
“In the future, I believe PE will require increased industry and capability specialization to drive fundamental value creation, such as digital, supply chain and talent management. I believe it will also require much earlier operational interventions in the PE ownership life cycle. Today, PE operations teams are often brought in well after the transaction closes. I believe the rule in the future will be early engagement to ask questions, assess management talent, and ensure the capital structure will support the transformation envisioned for the business being acquired.”
Looking at the future
Environmental, Social, and Governance (ESG) factors are becoming a significant part of the PE playbook. Companies that efficiently use resources tend to be more valuable at exit. “Looking ahead, I believe we’ll see GPs transition from narratives about their ESG ambition to clear reporting frameworks with dedicated teams. I also believe that more GPs will make environmental, social and governance matters more prominent in their processes, from diligence through the holding period.”
As the PE industry continues to grow, with over 20,000 firms globally, Franco considers that the industry has to be vigilant to prevent being defined by a single bad actor, at a time when it becomes increasingly important for participants to engage on public policy issues. “Firms must proactively defend their license to operate as media, regulators, and lawmakers focus on PE’s role in stakeholder capitalism, ESG, employment, and the healthcare system.”
In conclusion, 2023 promises to be a year of opportunity for PE firms, with a focus on operational value creation, ESG excellence, and active engagement in public policy issues. Amidst the market turmoil, PE firms have the potential to thrive, leveraging their long-term investment approach, strategic partnerships, and operational improvements to generate strong returns.