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By: Hteik Tin Min Paing, Xiao Yan
Research Head: Mrunali Doshi
Editor: Sakshi Sanganeria Abstract This article looks at how private equity firms add economic value to Europe through increased innovation, productivity and competitiveness and gives an insight into how the global pandemic (COVID-19) could affect the future of private investment in Europe. Private equity has driven innovation and boosted productivity by investing in ideas and physical capital. At the same time, it has empowered ventures with the financial capital to grow which increases competition in industries. The future outlook of private equity is uncertain with the current volatility of financial markets. However, there are opportunities present in the form of private equity firms investing in currently undervalued companies and developing exit strategies to realise higher returns.
Private equity can be defined as investment in private companies that are not publicly listed or trade (Segal, 2019). Private equity firms usually invest in small to medium enterprises. For example, The Riverside Company invested in athletic and recreational swimwear in 2010. The deregulation in the form of ‘Competition and Credit Control’ in 1971 allowed for greater flexibility of banks and their investments (Bowen, Hoggarth and Pain, 1999, p. 251). The subsequent structural and legal changes throughout Europe, for example the pension fund and insurance company regulation, further added to this flexibility (Bance, 2004, p. 4), allowing for the continual rise of private equity (Fig. 1) in Europe.
Figure 1: European Private Equity Trends (2013 - 2018) (Source: PwC Private Equity Trend 2019) 1. More innovation Private Equity firms drive innovation by allocating more funds (“dry powder”)into the research and development of new products and production processes of companies. Furthermore, private equity firms are more likely to invest in younger companies, who are more keen on innovation. The European Central Bank (2009, p. 20) found a strong association between private equity and innovation (9 times more effective than in-house development efforts). According to ‘InvestEurope’ (2018), 97.3 billion euros were raised and 80.6 billion euros were invested in mainly European SMEs. 2. Boosted productivity Private Equity firms boost productivity through two ways - investing in physical capital and its managerial expertise. According to InvestEurope (2019), Europe’s Private Equity investment increased by 7% to €80.6 billion in 2018. Such investments in physical capital like plants, buildings and equipment can help to improve labour productivity through automation. However, it is difficult to get specific data on an investee firm’s investment. This makes it
difficult to conclude that private equity investments would result in improved productivity through investments in physical capital. Nonetheless, statistics indicate that there is a link. According to Statistica (2019, p. 7), private equity firms have a heavy involvement in investing in sectors such as pharmaceuticals and healthcare (72%), technology (70%) and logistic and business services (68%). Another thing private equity firms bring is their managerial and operational expertise of firms. They can improve the management information systems and enhance the corporate governance of investee companies and introduce performance-based incentives, bring an overall improvement to companies’ productivity levels (Frontier Economics, 2013, p. 16) 3. Increased Competitiveness Competitiveness is created through empowering ventures and start-ups with more financial resources and IP assets to grow their business. When private equity firms invest in a company, it makes the process of getting IP assets such as patents and copyrights easier for the venture through its vast network of contacts in the relevant industries. As such, it removes the obstacles of long IP attainment processes and helps them focus on the more important side of running a business-which is creating better technology and commercialising it for mass use. Another contribution of private equity firms in increasing competitiveness is through creating more businesses. Businesses are created through direct capital investments and spill-over effects ("Frontier Economics", 2013). It could be seen that for every business that is funded by private equity, there is another business generated (Fig 2).
Figure 2: Spill-over effect of PE (Source: Eurostat, Frontier Estimates)
(Spill-over effect is created when private equity firms inject funds into a venture and that increases the confidence of other potential entrepreneurs to start their business. This ecosystem of private equity and ventures increases the number of businesses created as a whole.) 4. Challenges One of the challenges faced by private equity today is the regulatory framework implemented on the private equity firms. Both the investors in private equity firms and the management are now subject to disclose their environmental, social and governance (ESG) considerations for the investments made (Mendoza, 2020). Institutional investors who are the biggest investors in private markets now have to meet sustainability targets which in turn puts the pressure on the fund manager of private equity firms to report how their portfolio is allocated and how well it does in meeting such goals. As taking ESG goals into consideration comes with additional risks in terms of making investment decisions and calculating risk-to-rewards ratios, it poses a great challenge for the industry as a whole. Between 200 and 2015, the number of private equity firms more than doubled from 1453 to 3530 (Roberts &Naydenova, 2018). The funds available increase in tandem with the increase in the number of firms. As of 2018, there are 125 billion pounds of ‘dry powder’ in Europe and 1.07 trillion dollars globally available for investments-which has not yet been invested (Youle& Hannah, 2018). This translates into supply exceeding demand and makes it more difficult for the private equity firms to spot unicorns. This could be the cause of lower exit deals in Europe from 2013 to 2019. Today, point may have been reached where private equity investments are not as attractive a prospect as they used to be before. 5. Future Outlook The future outlook of private equity in the UK is full of uncertainties as well as opportunities. The foreseeable significant impacts on the private equity market could be vastly attributed to the ongoing global pandemic COVID-19. Financial markets have seen significant losses with the largest financial markets such as S&P 500 dropping by 12% and Dow Jones by 12.9% (Imbert, 2020). Investors are now allocating their investments into safe haven assets such as gold, US dollars and Japanese yen. This means that limited partners who are the private investors of private equity firms will pull out their capital due to the skittish financial market. This creates a potential challenge of having less capital available for private equities. The drop in the investors’ confidence can lead to another challenge which is the lower exit returns due to the expected fall in revenue of the invested businesses and rising cost of capital. However, opportunities arise due to the nature of marked-to-market valuation of the investment industry. This implies that since the companies are valued based on the current market conditions, it will be a good opportunity for the private equity firms to carefully look for undervalued firms and buy them out at a relatively cheap market price in the hope of exiting at a much higher valuation when everything is back to normal. All in all, opportunities present themselves in challenges brought about by COVID-19. Private equity has been perceived as an area where too many funds are chasing for too few good opportunities. However, with the current market outlook, private equity plays a very crucial role in making a positive contribution towards the slow-down economy if opportunities are identified carefully and funds are allocated carefully.
Reference
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