Over the past-year, the unique situation presented by the Coronavirus has wreaked economic havoc and produced a self-evident K-shaped pattern of economic recovery. The necessity of physical distancing has resulted in remote learning and working through technologies like video- conferencing, and with it, forcing an acceleration of the digital age, sending tech-stocks soaring, and creating a new series of ‘winners and losers’. Despite record-high unemployment, desolate shops and restaurants, the S&P500 hit a new record: a crystal clear trajectory of a K-shaped recovery. However, the important yet somewhat obvious point of note is the expectedly temporary nature of the situation – with an unprecedented scale of research into a vaccine, a preventative was expected and has since been found, with mass production and administration of vaccines underway. Since restrictions are eventually expected to disappear, the temporary nature of the situation presents an unprecedented opportunity for firms able to situate their investments over a longer horizon to capitalise on the lower-bound of the K-shaped recovery. For private equity firms with a high proportion of dry powder and liquidity to AUM, or access to it, this transient drop in valuation presents a golden opportunity.
It is important to note that for private equity firms, the effect is two sided: there is a sharp distinction to be made between the effect on their AUM and the potential for new investments. In their current portfolio of businesses, PE firms remain as disadvantaged as everyone else – they too have experienced the domino effects of the virus on their existing assets, and remain vulnerable to these challenging circumstances. The structure of Limited Partnership private equity firms, where there are strictly defined divisions between different rounds of funding, and therefore restrictions on where such funds can be used, means the commonly held notion of private equity firms as being flush with cash and able to weather such storms does not hold water. This has been argued by Michael Moore of the British Private Equity and Venture Capital Association in attempting to secure eligibility of government stimulus for PE backed firms, noting that there exists a clear restriction on the usage and allocation of funds by General Partners [1]. Hence it is only in new investment rounds that PE firms can leverage the lower bound of the K-shaped recovery to their benefit – not from their existing AUM that lie on it. Thus in order to take advantage of the current situation, PE firms need excess dry powder or access to new liquidity. It is in these two opposing effects that an aggressive new investment strategy aimed at distressed firms may allow PE firms to hedge against their existing assets, which themselves are vulnerable to the very same struggles they are capitalising on.
However, the notion of capitalising on such a severe economic downturn, raking up businesses while ‘mom and pop’ outlets go bust inevitably invokes serious ethical concerns and can be compared to that of the 2008 financial crisis. For example, the reckless financing of subprime mortgages resulted in mass-defaults, shattering the housing market to record lows and allowing firms with dry powder to clean sweep the market – Blackstone itself bought 30,000 foreclosed houses as a result of the housing crisis [2]. But it is important to consider the differing context between 2008 and now, and what exactly the alternatives to PE are in this case – notably that of government support. Unlike the 2008 financial crisis, Covid-19 is not a man-made catastrophe, a symptomatic result of a reckless financial system. Rather, it is an exogenous shock to the system, an unavoidable physical virus, forcing the entire world to drastically reshape the way they live, changing consumer behaviour and productivity overnight. Infection rates that have spiralled out of control has forced governments to implement strict lockdown measures as a moral imperative to save lives – doing so has produced severe financial struggles for businesses, especially brick and mortar firms. Though now it may seem like there is a light at the end of the tunnel, the current situation has been ongoing for an entire year, and in Britain, largely as a result of inconsistent government policy, the danger of the virus seems to oscillate like a sinusoidal wave. Governments around the world have issued a broad expanse of fiscal stimuli to support those in need, induce aggregate demand and keep businesses afloat, but doing so places an obvious strain on the government budget balance. The sustainability of propping up the economy for anything more than the short term is dubious and the size of recent stimuli will likely place a severe burden on the tax- payer for a long time to come. Furthermore, in order to provide immediate and desperately needed aid to struggling businesses, government based fiscal stimulus or loans are often essentially non- discriminatory. However, this manifests a situation where the government is propping up already unsuccessful businesses that produce an inefficient allocation of resources and likely would otherwise go bust, in addition to the prevalence of rampant fraud, placing an even bigger and an inherently unjust strain on the tax-payer [3].
The entrance of private equity into the economic downturn produced in the lower-bound of the K clearly presents a lucrative opportunity for such firms, but more importantly it provides much needed aid to businesses that would otherwise go under. In this case, the moral reasoning behind PE firms entering the market is clear: without them, no one would win – in the current situation and the absence of continuous fiscal stimulus, firms on the lower-bound would otherwise go under, secondary chains would lose business and unemployment would only soar. Such a rise in unemployment would serve only to further ramp up inequality, and send a sharp increase in unemployment and benefit claims, placing a further strain on the government budget balance and thus the remaining tax-payers. Instead, private equity firms are in a position to aid flailing businesses with much-needed capital, preventing countless firms from going under. They are able to reduce unemployment from what it would otherwise be if firms did go under, meaning any number above zero would be a Pareto-improvement, while also creating value for their shareholders. When such shareholders in PE firms are institutional investors such as pension- funds, further inequality exacerbated by the K-shaped recovery can be avoided. In the case of brick and mortar firms, PE firms are able keep long-standing business alive long enough to weather the storm, producing a social surplus for customers who benefit from the continued existence of such firms. The three-fold benefit to consumers, employees and shareholders manifests at minimum a Pareto-efficient outcome relative to the other alternative of mass bankruptcies, and in actuality, the entrance of PE firms would unequivocally result in a mutually beneficial outcome for all three stakeholders.
References
[1]. “The UK and Europe-based PE and VC backed companies see stimulus options open”, S&P Global Market Intelligence, https://www.spglobal.com/marketintelligence/en/news-insights/latest-newsheadlines/u-k-and-europe-based-pe-and-vc-backed-companies-see-stimulus-optionsopen-58124863
[2]. “Blackstone Moves Out of Rental-Home Wager With a Big Gain”, Wall Street Journal, https://www.wsj.com/articles/blackstone-moves-out-of-rental-home-wager-with-a-big-gain-11574345608
[3]. “A Giant Bonfire of Taxpayer’s Money: Fraud and the UK Pandemic Loan Scheme”, Financial Times, https://www.ft.com/content/41d5fe0a-7b46-4dd7-96e3-710977dff81c
