The opening months of 2020 have been nothing if not uncertain. We’re in a period of rapid and immense upheaval with businesses and industries pivoting quickly as they respond to emerging news and data. This applies to the private equity industry too.
GPs are having to re-evaluate operational and financial risks within their portfolios and take action by attending to vulnerable investee companies. There are also buying opportunities lying in wait for them now that valuations have slipped (albeit central bank intervention appears to be distorting risk appetite and significantly buoying markets), and have the potential to fall further as the economic consequences of the outbreak become clearer over the coming months.
LPs are under more pressure than ever to understand their asset allocations and liquidity risk, ensuring they have adequate funds to meet capital calls and, if necessary, raising cash to meet their liabilities and exploit opportunities in various markets and asset classes.
Now, as a number of countries begin to take tentative steps to lift their lockdown measures and kickstart their economies, questions are coming to the fore about future business practices and how the coronavirus will reshape markets and industries.
The past can offer lessons for the future. The global financial crisis (GFC) of 2008 was a catalyst for change in the private equity industry, and the Global Coronavirus Pandemic (GCP) will likely reinforce and accelerate some of those pre-existing trends. At the same time, many PE firms and their investors will need to adjust to new ways of thinking and operating. Below are developments that we anticipate over the coming months and years.
Business continuity and crisis management
Business continuity plans (BCPs) are well-established tools in the corporate world but less so within private equity. PE firms are naturally adept at assisting their portfolios through hard times; indeed, that is an integral part of its active ownership model. But codified and tested plans for ensuring the continuity of operations has not necessarily been something PE firms themselves have had to pay much mind. The Securities Exchange Commission proposed a rule in 2016 requiring investment advisers to put such measures in place. Expect this to become the norm across the board and in all countries and not only apply to back-up data systems and data recovery plans but — post-GCP — the health and safety of staff, who of course, are critical to a PE firm’s innate value-creation capabilities.
Remote and digital
Social distancing and lockdowns have been a mass experiment in remote working. Companies have realized that they have the connectivity and digital tools necessary to keep operations in motion even under quarantine. As sustainability and human impact on the environment have come into sharper focus both as a direct consequence (human contact with wildlife caused the pandemic) and indirect consequence (lockdown has produced measurable drops in pollution) of coronavirus, expect a large degree of remote working to remain in place as non-essential travel is scaled back permanently. Face-to-face meetings will always be integral to private equity, which is founded on partnerships, but digital communications and marketplace platforms will increasingly help to facilitate everything from fundraising roadshows and investor meetings to secondary fund trading.
We have touched on this before, but it bears repeating. After years of relative caution in deploying dry powder, GPs will finally see discounts and buying opportunities ahead. This is likely to result in higher rates of capital calls. PE funds’ widespread use of subscription credit facilities should ensure some predictability in the timing of those calls. Nevertheless, LPs will likely have to meet an increase in capital commitments over the coming 12 to 24 months. Any liquidity issues as a consequence of this are most likely to impact high-net-worths and family offices whose wealth comes from the worst affected areas of the economy.
Elevated secondary market activity
The private equity secondary market moved into a new phase following the GFC, in part spurred by regulatory pressure on banks to divest risk assets. More generally, over the past decade, investors in PE have grown accustomed to trading out of their holdings as part of their ongoing portfolio oversight and management. It does not take long for secondary activity to recover from a crisis. A case in point, in early 2010, in the early wake of the GFC, the then second-largest secondary transaction in history (AXA Private Equity acquiring $1.9bn of assets from Bank of America) was carried out. The market has continued to grow impressively since. Today, as pricing conditions improve and buyers and sellers begin to find common ground, secondary market activity will see a large push, driven by extensive portfolio reviews and asset reallocations combined with increased PE drawdown rates that LPs will need to fund (see above).
Extended holding periods and less capital realization
Another factor in the potential for an LP liquidity squeeze is the relative dearth of distributions that can be expected in the near term. PE funds will be forced to be selective in their exits, and the volume of capital returned to LPs is likely to fall and probably dramatically in the near term. This will lead to extended holding periods as funds wait for better times, and there is some evidence that weaker assets are being ring-fenced into “sub-funds,” away from better-performing assets. With distributions drying up, LPs will have to weigh their liquidity options to cover their PE fund commitments, which in turn will elevate secondary market activity (see above).
Dry powder to the roof
One of the upshots of the GFC was a ballooning of PE assets under management. Unprecedentedly dovish central bank policy meant that investors sought out higher-returning asset classes to give their overall portfolios a performance boost in the low-yield environment. With central banks ramping up their application of Modern Monetary Theory in response to the GCP, there is little sign of countries returning to the interest rates of decades past any time soon. The consequence of this is that PE dry powder will climb further and further over the long term, and as primary fundraising rises, so too will the size of the secondary market. There is one caveat, however.
The aforementioned fall in realizations in the short to medium term will mean any ballooning in dry powder is unlikely to happen in the shorter term. This will happen further down the line once exits rebound.
One prediction that came out of the GFC was of major industry consolidation. The thinking was that company insolvency, and the travails of fundraising after 2008 would claim a number of casualties, shrinking the number of PE operators. That never came to pass. Low-interest rates meant that demand for PE was higher than ever, and leveraged companies were able to refinance with ease, granting even the weakest performers extra time. More recently, there has been evidence of a modest fall in the number of PE firms as larger houses diversify their strategies, acquiring specialist firms as a shortcut. The GCP should precipitate further consolidation. Founding partners’ succession planning will motivate PE industry acquisitions as large firms have greater access to liquidity than partners of independent firms. LPs have also already shown a desire for clipping their number of GP relationships. Therefore, there may be fewer managers in the field in the years ahead, even as PE assets under management march upwards.
As always, stay safe and well out there. Do not hesitate to contact us with any questions or insights you’d like us to explore or discuss – you can reach me directly by replying to this email or at email@example.com.