As many middle market businesses struggle to stay above water, private equity firms are well-positioned to provide a lifeline. They have been preparing for this moment for years, heeding a lesson from the Great Recession that they need capital to deploy when the valuations are low and struggling companies are receptive to investment.
Some lawmakers seek to restrict the ability of private equity firms to invest in distressed companies.
Indeed, the amount of private equity capital available to invest is staggering: At the beginning of the year, the industry had built a record cash pile of almost $1.5 trillion, according to Preqin, a research firm.
Still, the path is not entirely clear for private equity firms to get to work. First, they have not been immune to the economic downturn caused by the coronavirus. A number of major private equity deals have been scuttled, and the valuations of portfolio companies have been hurt.
Second, and perhaps more significant, there is a looming threat to the way the industry operates. It is coming from the political sphere as some lawmakers seek to restrict the ability of private equity firms to invest in distressed companies.
During a recent meeting of the Open Markets Institute, a Washington-based advocacy group that focuses on antitrust issues, Sen. Elizabeth Warren, a Democrat from Massachusetts and former presidential candidate, and Rep. Alexandria Ocasio-Cortez, a Democrat from New York, proposed legislation to halt what they described as harmful mergers and acquisitions, in order to protect the public from what they said were harmful effects of consolidation.
Specifically, the legislators’ plan calls for a suspension of mergers and acquisitions involving large companies until it is determined “that small businesses, workers and consumers are no longer under severe financial distress,” according to the proposed Pandemic Anti-Monopoly Act.
The ban would apply to businesses with more than $100 million in revenue or financial firms with market capitalization of more than $100 million, and also to private equity firms and hedge funds, among others.
Already, the plan has gained traction on Capitol Hill. The House’s top Democrat on antitrust issues, Rep. David Cicilline of Rhode Island, who is chairman of the House Judiciary Antitrust, Commercial, and Administrative Law Subcommittee, came out in support of such legislation.
Opponents of the restriction
Opponents to this plan argue that private equity provides capital, expertise and active ownership that struggling companies could not access on their own. And some would say that strong private equity returns have benefited not only the deal-making Wall Street executives but also Main Street investors through public pensions and endowments.
Opponents to this plan argue that private equity provides capital, expertise and active ownership that struggling companies need.
But how the coronavirus crisis will ultimately affect the private equity industry is anyone’s guess. As the toll on human life has continued to mount, the severity and lifespan of the illness remain unknown. As an economic event, it’s uncertain how the sudden demand shock will affect business activity and long-term consumer behavior.
If the recovery from the current downturn is anything like the one that followed the Great Recession of 2008 and 2009, disciplined investors should see solid private equity returns years from now. Although private equity volume will slow in the short run as sellers become reluctant to dispose of investments with sudden drops in valuations, buyers holding uncalled capital will unearth operating challenges and move forward with their investments that they see as prudent.
According to data pulled by RSM, middle market fund launches that occurred one year after the Great Recession resulted in compounded net returns of 12.7% through fund disposition. And larger middle market firms – those with assets under management more than $500 million – fared better, with performance over 16.2%.
Regardless of whether any such legislative plans gain steam, there is a simmering tension between private equity firms and lawmakers on what role private equity plays in the American economy.
Does private equity revive struggling companies and share in the upside of profits, or does it take advantage of the most vulnerable companies and, consequently, workers, and promote executive greed? Some argue that businesses benefit by operating autonomously where others see advantages in having outside private equity control.
The takeaway
No matter how you see it, this is an important development worth following. A ban on mergers over a certain size would have far-reaching implications to any company contemplating or taking private equity ownership. And any imposed limitations on deal-making could prevent the private equity community from hitting the types of returns it had coming out of the last economic downturn.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
