Private Equity Helped Firms Weather the Great Recession
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Finance & Accounting Jan 4, 2018

Pri­vate Equi­ty Helped Firms Weath­er the Great Recession

A new study shows that debt isn’t always a lia­bil­i­ty dur­ing a finan­cial crisis.

Does private equity backing make firms stronger or weaker?

Yevgenia Nayberg

Based on the research of

Shai Bernstein

Josh Lerner

Filippo Mezzanotti

There are myr­i­ad rea­sons why the 2008 finan­cial cri­sis was so dev­as­tat­ing. But the intu­ition behind most of them seems sim­ple enough: the more debt you have, the worse shape you’re in. 

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Whether it is home­own­ers sign­ing mort­gages they can­not afford or invest­ment banks buy­ing and sell­ing loans they know are going to default, if you have more debt in a cri­sis, that’s not a good thing to have in gen­er­al. This is just a log­i­cal fact,” says Fil­ip­po Mez­zan­ot­ti, an assis­tant pro­fes­sor of finance at Kellogg.

But what about com­pa­nies sup­port­ed by pri­vate equi­ty funds — a form of invest­ment that usu­al­ly involves adding debt to the company’s bal­ance sheet? Is that debt a lia­bil­i­ty in a cri­sis, too? 

There’s a debate in the reg­u­la­tion area about this idea that pri­vate-equi­ty activ­i­ty may have exac­er­bat­ed the cri­sis,” Mez­zan­ot­ti says. And there are good rea­sons to think that.” 

Mez­zan­ot­ti set out to under­stand what was tru­ly going on. In a new study, he and col­leagues exam­ined pri­vate-equi­ty-backed firms in the Unit­ed King­dom and found a dif­fer­ent sto­ry. Pri­vate-equi­ty-backed firms actu­al­ly fared bet­ter dur­ing the Great Reces­sion than com­pa­ra­ble com­pa­nies not backed by pri­vate equity. 

The rea­son? Pri­vate-equi­ty-backed firms may car­ry more debt, but they also enjoy priv­i­leged access to financ­ing via their pri­vate-equi­ty investors.

It’s like if you have rich par­ents and you lose your job, you can kind of iso­late your­self from some of these costs in the short run because you can get mon­ey from them and they can help you fig­ure a way out of your issue,” Mez­zan­ot­ti says.

Does Pri­vate-Equi­ty Back­ing Make a Firm Weak­er or Stronger?

Pre­vi­ous research has demon­strat­ed the pos­i­tive effects of pri­vate-equi­ty (PE) financ­ing on the per­for­mance of firms in PE portfolios.

Essen­tial­ly, once a com­pa­ny gets bought by a pri­vate-equi­ty fund, we see improve­ment in their finan­cial per­for­mance and their growth pat­tern,” he says. But a lot of these stud­ies focused on the 1990s or the pre-cri­sis 2000s. The ques­tion that comes nat­u­ral­ly is, Okay, maybe they’re tak­ing cer­tain actions that may be good in nor­mal times — but what hap­pens when things turn ugly?’”

The sim­plest way to deter­mine whether PE-backed firms con­tribute to over­all finan­cial fragili­ty dur­ing an eco­nom­ic cri­sis is to com­pare infor­ma­tion about their per­for­mance to that of sim­i­lar com­pa­nies with­out PE backing.

It’s def­i­nite­ly some­thing that peo­ple haven’t thought about before — this idea that when there is this major finan­cial shock, hav­ing pri­vate equi­ty as a source of cap­i­tal could be real­ly precious.”

This data can be hard to come by. But Mez­zan­ot­ti and his coau­thors, Shai Bern­stein of Stan­ford Uni­ver­si­ty and Josh Lern­er of Har­vard Uni­ver­si­ty, were able to gath­er it by exam­in­ing firms in the Unit­ed King­dom, where finan­cial report­ing require­ments are more expan­sive than in the Unit­ed States.

The researchers ana­lyzed detailed income reports and bal­ance sheets of near­ly 500 PE-backed firms in and around the time of the glob­al finan­cial cri­sis; they also assem­bled a match­ing sam­ple of non-PE com­pa­nies that were sim­i­lar in size and finan­cial profiles. 

By com­par­ing these two sam­ples, Mez­zan­ot­ti and his col­leagues could empir­i­cal­ly observe whether PE-backed firms were more or less eco­nom­i­cal­ly frag­ile than com­pa­nies not backed by pri­vate equity. 

They found that while all the firms in both of their sam­ples cut their invest­ments sharply dur­ing the cri­sis, PE-backed firms did so much less than non-PE firms. In fact, the PE firms spent 5.9 per­cent more than the non-PE ones. 

If they were more frag­ile, we should expect that they’re cut­ting invest­ment more” than non-PE-backed firms, Mez­zan­ot­ti says. This activ­i­ty hap­pened right away in 2008, and it seems to be rel­a­tive­ly per­sis­tent in the fol­low­ing years.” 

This pri­ma­ry find­ing, the researchers write, sug­gest that com­pa­nies backed by pri­vate-equi­ty firms were more resilient in the face of the finan­cial cri­sis” com­pared to their coun­ter­parts in the match­ing sample. 

Dry Pow­der

Where is this resilience com­ing from? 

The researchers hypoth­e­sized that the pri­vate-equi­ty funds back­ing these com­pa­nies sim­ply had more finan­cial resources at their dis­pos­al to spend on the firms in their port­fo­lios. Addi­tion­al­ly, PE-backed firms have good rela­tion­ships with the finan­cial indus­try, which could become valu­able resources in peri­ods of eco­nom­ic distress. 

If their hypoth­e­sis was cor­rect, then the researchers expect­ed that these effects would be stronger when the PE funds had more mon­ey avail­able. To get at this, they tal­lied the amount of mon­ey that PE funds had raised but not yet spent on acquir­ing firms as of 2007. Mez­zan­ot­ti refers to this as dry pow­der” that these funds had at their dis­pos­al to apply to com­pa­nies in their port­fo­lios, thus help­ing them bet­ter weath­er the crisis. 

The researchers found that com­pa­nies whose pri­vate-equi­ty back­ers were in the top quar­tile of dry pow­der” pos­ses­sion in 2007 expe­ri­enced 10 per­cent more invest­ment than non-PE-backed firms. 

Anoth­er way to test the hypoth­e­sis was to see if being PE-backed was par­tic­u­lar­ly help­ful for com­pa­nies that were more like­ly to suf­fer from the finan­cial cri­sis. Indeed, they found that the pos­i­tive effect of being PE-backed was larg­er for small­er firms, firms with more debt in 2007, and firms oper­at­ing in indus­tries that are more depen­dent on exter­nal funding. 

The researchers also found that PE-backed firms were no more like­ly to go bank­rupt in the years fol­low­ing the cri­sis — an out­come one might expect if pri­vate equi­ty were mak­ing the com­pa­nies less resilient to finan­cial tur­moil. On the con­trary, these firms were actu­al­ly more like­ly to expe­ri­ence a pos­i­tive kind of exit in a prof­itable acqui­si­tion” than com­pa­nies in the match­ing sam­ple, Mez­zan­ot­ti says. 

Mez­zan­ot­ti cau­tions that these find­ings, while seem­ing to exon­er­ate pri­vate equi­ty from play­ing any nefar­i­ous role in the glob­al finan­cial cri­sis, should not be inter­pret­ed as any­thing more than one data point to form fur­ther pol­i­cy discussion.” 

Efforts by finan­cial reg­u­la­tors in the Unit­ed States and Europe to cap the amount of debt financ­ing that pri­vate-equi­ty investors apply to firms in their port­fo­lio may have their mer­its, but they may not do much to stave off anoth­er finan­cial crisis. 

I don’t think we have the evi­dence in gen­er­al to say, Okay, [pri­vate equi­ty] is just always bet­ter or always worse for the econ­o­my,” Mez­zan­ot­ti says. But it’s def­i­nite­ly some­thing that peo­ple haven’t thought about before — this idea that when there is this major finan­cial shock, hav­ing pri­vate equi­ty as a source of cap­i­tal could be real­ly precious.” 

About the Writer

John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.

About the Research

Bernstein, Shai, Josh Lerner, and Filippo Mezzanotti. 2017. “Private Equity and Financial Fragility During the Crisis.” Working paper.

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