Departments

Investor Insight

Why economic downturns
are an opportune time
for private equity investments

R. Carter Caldwell

By R. Carter Caldwell, Principal,
Cross Atlantic Capital Partners

Many private equity investors instinctively avoid investing during recessions. For a variety of reasons, however, recessions and other economic downturns present some of the most advantageous investment opportunities for private equity.

The historical evidence regarding investing during recessions is undeniable: Private equity investments made during recessions have historically delivered the best returns, as investors take advantage of bargain company valuations. According to data from the London-based research firm Preqin, the median return for buyout vehicles in the prior recession of 2001 was 28%, while top-quartile funds that year returned at least 40%. Similar data for 1991 showed the median buyout returned at least 25%, with the top quartile starting above 35%.

Some investors recognize this, including Neeraj Agrawalm, a General Partner at Battery Ventures who was recently quoted in the Boston Business Journal as saying, “When you’re an investor, and you live in my shoes, this is the year you live for. This is once in a lifetime.”

As is the case in the current recession (2009-2010), the number of private equity and venture capital investments declines sharply (and predictably) during economic downturns. The National Venture Capital Association (NVCA) recently reported a 30% drop in the number of PE deals closed in 2009. Additionally, the total dollars invested in 2009 was the lowest since 1997. Of the investments that did close in 2009, the average amount invested plummeted by 37% versus 2008.

Comparing 2010 to 2001

Moreover, this climate failed to improve significantly in Q1 2010. The number of deals completed in Q1 2010 rose only 7% from the same period in 2009, though the dollars per deal rose by 28%. This current trend mirrors that of the 2001 recession that followed the burst of the dot-com bubble, the September 11 attacks and high-profile accounting scandals. The number of investments made in Q1 2001 dropped by 40% compared to the same period in 2000; Q2 2001’s drop was 42%; Q3 2001’s drop was 48%; and Q4’s drop was 44%.

Average dollars per deal in 2001 dipped as well, compared to the prior year’s quarters. Q1 2001 dollars per deal dropped by 25% from the same quarter a year prior; Q2 declined 30%; Q3 dipped further still — by 39%; and Q4 2001 fell 36%.

New opportunities

Of course, when economic downturns hit, the need for cash becomes more urgent. As seen during the current recession, many companies respond to the lack of capital by cutting jobs. The unemployment rate peaked at 10.4% and is at the highest point in 26 years. In many cases, the newly unemployed seize the opportunity to pursue a business idea they may have had prior to losing their job, and as a result, start a new company. The resulting startups represent a wealth of potential investment opportunities, that in most cases, would otherwise be unavailable.

Recessions also typically bring revenue declines for companies across all stages of growth: early-, middle- and later-stage. Middle- and later-stage companies are considered a safer investment opportunity because they typically have matured technologies or products, solid and seasoned management teams, and existing customer bases. However, many of these more mature companies are often in need of capital to offset the effects of lower revenue, and this presents an opportunity for a private equity firm to invest in a more mature company that otherwise might not need outside funding. According to the Venture View 2010 predictions survey conducted by the National Venture Capital Association, 55% of all VCs expect Growth Equity stage investments to increase in 2010. Fifty-three percent also see growth in later-stage investing.

Many later-stage companies in this situation have existing private equity investors with prior investments in the company. Not only is it clear that fewer private equity firms are actively investing during economic downturns, many have far less dry powder because of previous investments or difficulty in raising new funds. This situation further unveils investment opportunities that likely would not exist without the economic downturn’s influence. Given their product maturity, solid management teams and existing customer bases, these companies seeking investments could readily benefit, faster and more dramatically, than others once the economy improves. The combination of these elements presents an investment opportunity that could accelerate the process leading to an exit event, and hence, deliver a higher IRR.

Lower valuations can lead to higher profits

Finally, with more companies seeking investments and fewer being funded, those seeking investments are inclined to accept lower valuations than would otherwise be considered. For these companies, once the economy turns around and revenues increase, the resulting new valuations often increase faster than the typical year-over-year basis.

The investment consulting firm Cambridge Associates issues regular benchmark performance statistics for private equity funds. The latest results reveal that private equity vintage funds begun either in a recession year or within a year following a recession have delivered the highest returns in the past 23 years. The returns generated by a vintage fund one year following a recession year were still among the best results on record.

Although the evidence may run counter to conventional wisdom, and not many firms have adopted this mentality, there are examples of firms that have capitalized on the current economic conditions to their advantage. These market tendencies, coupled with the results delivered by funds investing during recessions, prove that economic downturns are truly advantageous times for private equity investments.

Carter Caldwell is a Principal at Cross Atlantic Capital Partners, an international venture capital firm that has delivered top-quartile results and is focused on investing in innovative technology and technology-enabled services companies. With four funds and $500 million under management, Cross Atlantic is closely engaged with an extensive network of resources to nurture and grow its portfolio companies and provide superior returns to its investors. For more information, visit www.xacp.com.