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Private Equity: Investing Amid Echoes of the 1970s
![Jared Pondelik](/_next/image?url=https%3A%2F%2Fassets.pinebridge.com%2Fm%2F405aae8051e895f4%2Foriginal%2FPondelik-Jared.jpg&w=128&q=75)
Jared Pondelik
Senior Vice President, Private Funds Group
![Private Equity: Investing Amid Echoes of the 1970s](/_next/image?url=https%3A%2F%2Fassets.pinebridge.com%2Fm%2F31615dc1e9472b26%2FArticle_Cover_Image_JPG-PE-1970s.jpg&w=1920&q=99)
In an April 2024 Wall Street Journal interview, JPMorgan Chase CEO Jamie Dimon noted, “It looks a little bit more like the 1970s. … Don’t get lulled into a false sense of security that because today looks okay, tomorrow is going to be okay.”
Though Mark Twain is correct that history does not repeat itself but often rhymes, the private equity industry was very different in the 1970s. Here we offer insights into how we’re positioning our private equity portfolios for a range of outcomes – some of which may echo themes of the ’70s.
As in the 1970s, today we are seeing huge and growing fiscal deficits that don’t appear to be going away anytime soon, along with quantitative easing (QE) and future inflationary tailwinds (arising from the “green economy,” remilitarization of the world, and other forces). Some may also feel a sense of déjà vu with the spike in energy prices, changing labor market dynamics, and rising geopolitical risks. Given these dynamics, we think it’s prudent to be cautious, especially when the market is pricing in a 70% chance of a soft landing.1
The future may bring slower economic growth (with US GDP at just 1.6% annualized in the first quarter, versus expectations of 2.4%),2 along with higher inflation and higher-for-longer interest rates, with the number of expected Fed rate cuts now down to one or none in 2024. This holds the potential to create headwinds for revenue growth, the prospect of margin compression, and structurally higher costs of capital.
What lessons can we learn from the 1970s that can provide a road map for making short- to intermediate-term private equity allocations?
Lesson #1: Size matters.
In the 1970s, value investments outperformed growth stocks, with respective annual returns of 12% versus just 4.1%.3 Small-cap stocks, particularly those with a focus on domestic markets, also outperformed large-cap stocks. This could be due to:
Flexibility and adaptability. Smaller companies tend to be nimbler and more adaptable to changing market conditions, which is increasingly important in an environment of economic uncertainty.
Lack of focus. Geopolitical tensions and oil crises during the 1970s could have impacted the operations and profitability of multinational corporations. Smaller companies with a primarily domestic focus may have been less affected by such external factors.
Potential for growth. Smaller companies typically have more room for growth compared to larger, more established companies. Customer acquisition costs are not as prohibitive, and small increases in market share are more meaningful.
Valuation. Investors may have favored smaller companies that were perceived to be undervalued relative to their larger counterparts.
Investors can find these characteristics in private equity through the lower middle and middle market (LMMM). The LMMM typically has lower valuations and debt multiples and has an easier time doubling revenue (see chart).
The LMMM Features Lower Valuations and Debt Multiples
Middle market versus large cap buyouts
Source: FactSet as of 24 February 2024. Represents all completed acquisitions globally with 2.5x to 30.0x EV/EBITDA multiples.
Lesson #2: Brand and pricing power are critical.
Strong brands, market leaders, and nondiscretionary businesses can still thrive in this environment. These companies can maintain their margins through price increases and grow their revenues as the market leaders.
Through the LMMM, investors can find companies that are market leaders in a niche industry. These companies have the ability to increase pricing more easily, take market share, or expand into other industries to accelerate revenue growth.
Lesson #3: Operational improvements drive value creation.
Drivers of buyout returns can vary widely but can be broadly classified into four categories: 1) revenue growth; 2) margin expansion; 3) purchase multiples; and 4) leverage. Leverage and multiple expansion are unlikely to add as much to value creation due to more restrictive credit market conditions, with persistently high interest rates and valuations trading in a tight range. As shown in the chart below, the Dow traded in a 200-point range for an 18-year period that included the 1970s.
The Dow Traded in a Tight Range in the ’70s
The 18-year, 200-point range: Dow Jones Industrial Average price
Source: BofA Research Investment Committee and Bloomberg as of 6 June 2024.
This leaves revenue growth and margin expansion as the main sources of value creation. LMMM companies often benefit from optimizing processes, enhancing supply chains, and rationalizing the workforce, which can improve margins. Buying from founders rather than financial sponsors – where most of these initiatives have been completed, as often seen in the larger end of the market – provides protection against margin compression.
Lesson #4: There have been some distinct benefits in private equity versus public markets.
While all companies are likely to face headwinds from rising interest rates, private equity has a more streamlined governance model in which a single owner makes resource allocation decisions.
Private market AUM nearly tripled between 2015 and 2022, growing from $4.5 trillion to $13.4 trillion, which enabled companies to stay private for longer rather than seeking a listing on a public exchange. Since the latter half of the 2010s, US public markets have seen a general decline in IPOs, as the chart below shows.
IPOs Are Waning in the US
2023 IPO numbers and proceeds by country versus 5-year average
Source: EY Global IPO Trends 2023, 4 December 2023.
It is increasingly difficult to access companies without private equity exposure (87% of firms in the US and 96% in Europe with revenue greater than $100 million are private)4,5 and for private equity managers to exit companies. This has led to the rise of the secondary market, which we believe could triple over the next seven years, from $114 billion in 2023 to $417 billion in 2030.6
In summary, we believe the LMMM space presents a compelling opportunity for investors to potentially generate attractive returns, even in a 1970s-style economy. These companies have typically traded at a lower valuation, were less reliant on multiple expansion to drive returns, and utilized less costly debt. We further narrow our focus to companies that are domestic market leaders with pricing power, owned by founders with a clear opportunity for operational improvements, provide nondiscretionary products or services, and have strong organic and inorganic growth opportunities. These companies can increase revenue and EBITDA to thresholds that expand the buyer universe to strategic buyers and financial sponsors, not just IPOs.
1 Jamie Dimon WSJ interview on 24 April 2024.
2 CNBC, 25 April 2024, “GDP growth slowed to a 1.6% rate in the first quarter, well below expectations.”
3 Nasdaq,15 November 2022, “1970s Flashback: History Is Starting to Rhyme, Offering a Road Map of How to Profit.”
4 Apollo Academy, 30 April 2024, “Most of the US Economy is in Private Markets.”
5 Apollo Academy, 28 April 2024, “Many More Private Firms in Europe.”
6 Evercore FY 2023 Secondary Market Survey Results - Highlights, January 2024.
Disclosure
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any republication of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
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