Private Equity: Investing Amid Echoes of the 1970s

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.