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Lessons for private equity from the last downturn

 showed that during the 2008 financial crisis, one of the ways that PE firms were able to mitigate the downturn was by focusing on value creation.

‘Value creation’ in this context means looking for opportunities to increase the value of a portfolio firm - for example, by improving the efficiency of a company’s operations.

Logically, companies that improve their operations during lean times are more likely to survive. They also gain a competitive advantage over less efficient competitors, thus increasing their relative value.

This ability to innovate swiftly in the face of rapidly changing circumstances is one of the advantages that private equity - and private markets in general - have as an asset class.

Whereas investors in public stocks typically have little or no influence over the strategy of the firm, private equity investors have the opportunity, as well as the ability, to make beneficial changes to secure a company’s long-term future.

Source: Data as of April 30, 2024. U.S. and NAM Buyout EBITDA margin based on median data from Pitchbook. Russell 2000 and S&P 600 EBITDA margins are as per Bloomberg. 

https://www.kkr.com/insights/private-equity-vs-public-market-returns

In the end, the COVID-19 pandemic recession lasted only two months - the shortest on record.

 Despite many dire predictions over the past few years, we have still not seen another recession (as of the time of writing in November 2024). The world, however, has continued to change.

In addition to digitalization, deglobalization, and decarbonization

, the most impactful trend for the world of investments has been the relatively swift return of high interest rates. These higher rates place a greater burden on companies that are in debt, as well as increasing the required rate of return they are expected to deliver to shareholders.

This has affected private equity firms as it has everyone else. Much as was the case during the Great Financial Crisis, it has become more expensive for PE funds to make acquisitions, and passive ‘buy and hold’ strategies are not an option.

Private Equity’s response has been to double down on value creation.

Rather than being a way to mitigate crises, firms with the expertise to do so now incorporate value creation into the deal-screening process itself. For example, by critically examining the opportunities for improvement in a target company, and laying plans to implement such strategies post-acquisition.

In a follow-up report this year, McKinsey revealed the results of an analysis of PE firms who have taken this approach, confirming the efficacy of this approach, and the findings of the original report in 2020.

Furthermore, the scope of value creation is also widening beyond efficiency alone, with revenue growth and talent management increasingly core to the remit. A study by KPMG showed that firms who incorporated both cost-saving and revenue growth measures saw higher EBITDA growth (15%) compared to those focusing simply on cost savings (5%).

We know from 20 years of experience in the private investments market that some forces are outside the control of a deal team, such as inflation, regulation, and economic growth. However, the ability to add value through focus, experience, and a network of expertise is always both feasible and effective.

We would add that value creation is not just for the "bad times." It is equally essential during times of market euphoria, when the ability to discern which assets are overvalued and undervalued is key to surviving the next 

[2] National Bureau of Economic Research (NBER) 

Value Creation: Private Equity’s Secret Weapon

Without question, the most momentous development since the last meeting has been the victory of Republican candidate Donald J. Trump. The ‘Red Sweep’, which saw the president take all seven of the contested ‘swing states’, has handed Republicans control not only of the White House but also the other two major branches of government.

While still early days, it is reasonable to speculate that the coming administration will effect major changes, and that these changes will have knock-on effects for investors at home and abroad. Already announced policies include steep tariffs on major importers, including China

, and stricter enforcement of immigration policy.

 More generally, many are expecting deregulation

If any or all of these changes materialize, commentators have observed that the probable effect would be inflationary

, and hence, likely to slow, halt, or even reverse the current policy of monetary easing. However, until the president has officially taken office and the policies are enacted, nothing is certain.

The published minutes for the Fed’s November meeting, which took place directly after the election results, make no direct reference to Trump’s victory or its implications.

The focus of the discussion was, as usual, the available economic data. While the decision to cut was unanimous, the notes imply a lack of consensus about the future path. This is due to the ambiguous nature of the data.

In spite of highly restrictive monetary policy, economic growth has been strong

. Furthermore, inflation is down but not quite ‘out’, with Core Personal Consumption Expenditure Price Index (“Core PCE”), the key target measure, showing a sideward, rather than downward trajectory, and still elevated in comparison to its target of 2.0% (see chart below).

On the other hand, the impact of interest rates takes time to work its way through the system. This means it is important to keep an eye on the road ahead as well as the rear-view mirror. Employment, the Fed’s second mandate alongside controlling inflation, showed a slight weakening in October

, which could be a sign that rates are beginning to bite.

Powell’s press conference after the meeting put a positive spin on the above. Rather than framing it as a ‘rock and a hard place’ scenario, he reiterated his previous view that the Fed is ideally poised to move in either direction as more data becomes available.

The latest inflation reading released on November 27, showing a slight uptick in PCE inflation, adds to the nuanced economic outlook facing the Fed.

Chairman Jerome Powell commented in a public appearance on November 14 that there is ‘no rush’ to cut rates

, implying that the best guess currently is a gradual decline rather than a steep one. Some commentators have even speculated that 2025 might be a year of no cuts at all, if the Trump policies are implemented as proposed.

The markets have fluctuated in their response, but currently reflect a 71% probability of a cut in December.

What are we to make of the above? Rather than try to guess a move that the Federal Reserve itself has not yet decided, we think that the disparity of opinions points to the need for caution rather than false certainty. Instead of going all-in on either side of the debate, maintaining a position of agility, allowing movement in either direction - as Chairman Powell aims to do himself - is a wiser move.

To Cut or Not to Cut: The Fed’s Final Conundrum for 2024

Understanding Time-Weighted Return (“TWR”)

Time-Weighted Return (“TWR”) measures an investment’s performance by neutralizing the impact of cash flows, such as contributions and withdrawals. This approach ensures that TWR captures the core performance of the underlying assets by calculating returns across sub-periods without reflecting cash flow timing. TWR is often recommended for assessing the performance of an overall portfolio, especially in cases where cash flows vary due to client decisions or market timing.

By providing a consistent measure across varying time frames, TWR allows for a clearer view of how investments perform over time, unaffected by cash flow influences.

Internal Rate of Return (“IRR”) and Its Applications

The Internal Rate of Return (“IRR”) measures the growth rate of an investment, considering the timing and size of cash flows. This makes IRR particularly valuable when assessing the return on a single investment or a specific deal, where the timing and amount of cash flows are critical factors in measuring growth.

However, IRR may sometimes reflect the influence of cash flow events more than the underlying asset performance, which can be misleading in long-term assessments. For instance, significant deposits or withdrawals can create fluctuations in IRR that may not represent the portfolio’s core growth.

Balancing TWR and IRR for Comprehensive Reporting

At The Family Office, both TWR and IRR are used, depending on individual portfolio characteristics and financial goals. Here’s how each metric serves different purposes:

Scenario Analysis: How to Use TWR and IRR

To illustrate the practical applications of TWR and IRR, consider three hypothetical scenarios:

These examples demonstrate that TWR and IRR provide complementary insights, with TWR offering stability unaffected by cash flow timing and IRR capturing cash flow impacts.

Choosing the Right Metric for Your Financial Goals

In helping clients achieve long-term financial goals, The Family Office utilizes both TWR and IRR to ensure a comprehensive view of their portfolio performance. While TWR may be favored for its consistency over time, IRR also adds value when assessing specific deals or investments, where cash flow timing and size are crucial to understanding growth. By leveraging both metrics, The Family Office provides clients with a holistic perspective on how their investments perform.

Choosing the right metric to evaluate investment and portfolio performance can help investors make well-informed decisions. While IRR plays a crucial role in assessing the impact of individual cash flow events or specific investments, TWR provides a broader view of overall portfolio performance. For The Family Office’s clients, both metrics offer valuable insights, enabling effective tracking of investments and supporting confident, future-focused decisions.

To learn more about how TWR and IRR can enhance your understanding of your portfolio performance, connect with The Family Office for a personalized consultation on our approach to wealth management.

The results shown in the above case study, such as the potential doubling of a $100,000 investment, are hypothetical examples and are subject to market risks and fluctuations that may affect outcomes.

The scenarios shown assume specific cash flow patterns, reinvestment rates, and market conditions. These factors can vary in real-world situations, and deviations may significantly impact the returns.

Investments are subject to risk and volatility and returns like those in the scenarios provided also carry an associated level of risk. Positive returns shown here may not always align with real-world results, especially in volatile markets.

Past performance is not indicative of and does not guarantee future performance. Exit timelines, prices and related projections are estimates only, and exits could happen sooner or later than expected, or at a higher or lower valuation than expected, and are conditional, among other things, on certain assumptions and future performance relating to the financial and operational health of each business and macroeconomic conditions.

The Rise of Private Debt: A New Era for Capital Markets and Portfolios

Wednesday, November 8, 2023

4:00 pm (GMT+3)

Language: English

Shahab Rashid discusses the rise of private debt, marking a new era for capital markets and portfolios, including:

Speaker

Shahab Rashid

Moderator

Naji Nehme, CFA

Register Now

Keep watching

Value Creation: Private Equity’s Secret Weapon

To Cut or Not to Cut: The Fed’s Final Conundrum for 2024

TWR vs IRR: Choosing the Right Measure for Portfolio Performance