What makes a private company recession-proof?

While the current climate of high inflation and possible recession could hamper private equity investors’ ability to generate returns, they can still do so with the right companies in their portfolio. And according to one PE industry insider, there are certain must-have criteria to consider.

“You’ve got to be profitable. Because if you have to raise money today, you’re going to take a haircut, and you have to put up with some pretty draconian terms,” said Marcus New, Founder and Chief Executive Officer at Vancouver-based InvestX, a leading private equity marketplace that empowers sell-side firms to invest in and trade late-stage private companies through its state-of-the-art platform InvestX GEM (Growth Equity Marketplace).

Historically, many of the companies InvestX has invested in – including the likes of Airbnb, DocuSign, Spotify, and SpaceX – have been global leaders that are headed by entrepreneurs who have been one of the top five in the world in their respective domains. That gives those businesses the leverage to raise capital and thrive in practically any environment.

The current climate of inflation and bearish market sentiment has altered the math of investment. In analyzing public companies, New says InvestX has found valuations that were highly correlated with growth rates – a link that makes sense given the operating leverage businesses in certain sectors could draw on. But today, they’re finding a company’s valuation is more highly correlated with its efficiency score, which incorporates its revenue growth rate and its EBITDA margin.

“Certain sectors are less impacted by recessions,” New adds. “For example, putting aside healthcare spend or staffing, companies in the medical space are going to be in demand all the time, so you have a reasonable expectation that they can keep growth rates up.”

Given the current inflationary environment with the potential for a recession ahead, he expects the ability of PE managers in general to deliver outsized returns for clients relative to the public markets will be impaired. Some of it may depend on the vintage of the funds they raise; for example, those that launch during a recessionary period tend to do very well as they’re able to make investments in companies that participate in the subsequent recovery.

Of course, the flip side to that applies to managers that have funds from previous vintages that run into a recessionary period midway through their projected investment horizon. Because companies’ growth rates wind up being lower than initially expected, New says, the funds likely have to push out their liquidity period – possibly by several years – in order to get to a more ideal valuation for their portfolio companies.

“If you think about a five-year fund that’s now going to take seven years to make its expected return on investment, it will have a lower internal rate of return,” New says. “It's not going to be zero, as long as the fund is holding good, high-quality companies. But you’re adding on a couple of ‘dead years’ into the growth profile of the business to be able to capture the returns.”

Theoretically, some high-conviction PE fund managers could still end up as winners. Because there’s always a bull market somewhere, some sectors can be expected to maintain lofty growth rates even as the broader market experiences a slowdown. That means managers who stake positions in those areas could win big – assuming they went all in, which is a major assumption.

“The other issue is if you think about the long-term nature of those private funds, you have to wonder if the cycle is still going to be in place when they go to liquidity,” New says.