For decades, private equity (PE) firms made money by focusing on the microeconomics of businesses and letting the macro conditions take care of themselves. While investors focused on industry dynamics and company performance, macro factors such as currency movements, monetary policy, technological changes and demographics faded into the background.
The global financial crisis marked an emphatic end to that era. As we explain in Bain & Company’s latest Global Private Equity Report, macro now matters. The economic upheaval of the past several years vividly demonstrated how a PE fund could own a great company in a great industry, but when the macro environment shifts, macro trumps all.
A recent Bain & Company analysis of the factors that spelled success or failure across deals done by a range of PE firms disclosed that firms are vulnerable to two common macro-fundamental errors. First, firms misread the timing or sensitivity of deals to economic cycles. Second, firms overlook disruptive competitive, technological or other important shifts affecting their portfolio company’s industry.
PE firms have undervalued the need for macro analytical capabilities in due diligence and portfolio management, because, until recently, they were of minor importance. The PE industry came of age during a period of steady growth, long economic cycles and largely stable interest and exchange rates. While it is still uncertain how the next global cycle will evolve, key factors that sustained that moderate growth will no longer be in play. The nearly three-decade decline in long-term real interest rates is finding a bottom. China’s one-time jolt to the global supply of labour dampened inflation and supported corporate profit margins; it is now done. The declining consumption by the giant demographic wave of aging Baby Boomers will drag on growth for years to come in many markets.
In the place of these key factors, powerful new forces are shaping the global economy. Large-scale asset purchases by the world’s central banks are contributing to the already highly inflationary, bubble-prone environment brought about by decades of financial sector innovation. Global ties of finance and trade that formerly held inflation in check now transmit instability as the effects of national interest rate and foreign exchange management policies ricochet from one region to another.
PE firms cannot play and win in these new arenas by adhering to past decades’ practices. In this environment, good macro due diligence is critical. But the art and science of macro-focused diligence is to filter out the distracting and misleading headline information and home in on the short list of factors that truly influence deal theses and returns.
To navigate the macro environment, leading PE investors should, at a minimum, do the following:
Macro forces will remain among the most important factors affecting PE returns over the economic cycle. PE firms that can best identify which ones will matter most, monitor them appropriately and understand their potential impact will best be able to achieve market-beating returns.
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