Weathering the Storm
The COVID-19 pandemic has caused considerable personal and economic distress for communities and companies across the globe. With little certainty as to the duration and the severity of the crisis, private equity firms are faced with a new set of challenges for existing portfolio companies, especially in those sectors most heavily hit. However, the combination of operational expertise and record levels of dry powder may position private equity firms well to weather the storm.
The ability to put cash to work in a downturn may also play a significant role for institutional and private investors in the wake of COVID-19. Many investors in equity and debt markets have borne sizeable losses during the recent downturn, and volatility continues to be elevated. For those investors with capital to deploy, investing during these turbulent times requires expertise and a good understanding of the risks. That said, during market downturns, private equity may present particularly compelling investment opportunities for some investors.
How is private equity affected?
Private equity managers (GPs) are confronted with a variety of risks as the pandemic renders many industries vulnerable to a downturn. For private equity funds that are already deployed, the key focus will be the performance and, in particular, the resilience of existing portfolio companies. Heavily affected areas will come as no surprise to most investors: luxury goods, restaurants, tourism and aviation. Estimates from Oliver Wyman suggest that roughly one-third of deals (representing $110 billion) from 40 of the top private equity funds since 2017 were experiencing elevated risk as a result of COVID-19 by mid-March.(1) At the same time, certain other verticals have been much less affected, including, for example, technology, healthcare and financial services.
As the crisis has progressed, GPs have been laser-focused on managing risk in their portfolio companies. In some instances, this has meant helping to coordinate stakeholder management and remote working. In others, it has meant extending or drawing down available credit lines. As a whole, the private equity industry has learnt valuable lessons from the Global Financial Crisis (GFC), and firms now employ 30% larger operations teams(2) to provide specialised financial and operational expertise across target sectors and geographies. In times of turmoil, this expertise allows for acting quickly and decisively to assess risks and ensure financial viability for portfolio companies.
Many new deal opportunities are likely to arise as a result of temporary market dislocation, and private equity managers have significant capacity to investors well to deliver future performance, in particular in funds beginning their investment cycle.
With so much cash sitting idle, private equity firms are in a dramatically different position compared to the 2000 dot-com bubble or the GFC. Cash available today can be deployed across the capital structure – from minority equity stakes to distressed debt – to support companies under stress.
While volatile equity markets may present exceptional opportunities to buy, several important risk factors remain. Notably, with IPO markets stalled, exits will likely be challenging in the short term. Debt market access may prove to be an additional issue, despite spectacularly low interest rates. In the first days of March, issuers recalled $12.6 billion of leveraged loans(5) and only now do a portion of private equity firms have access to the Federal Reserve’s $2.3 trillion dollar programme, though many will be excluded due to strict rules around leverage and employee count.(6) Some private equity firms have reacted to market conditions by slowing fundraising, while others are accelerating closing schedules.
Why look to private equity now?
Investors (LPs) with exposure to private equity, or those considering deploying capital, will have numerous factors to consider, including current portfolio exposure, availability of dry powder, risk tolerance and long-term investment objectives. CNN Business’ Fear & Greed Index,(9) which seeks to quantitatively capture investor emotions driving market movements, has tracked a gradual move over the last month away from extreme trepidation towards a more sanguine attitude. However, heightened market volatility—with the CBOE Volatility Index (VIX) hitting a record closing high of 82.69 on March 16th—is likely here to stay.
Managing risk, and stemming losses in particular, has been the predominant focus of the professional investment community of late. Many investors will have seen significant degradation in their equity and debt performance. For some institutional investors, this may be triggering complications due to the possible denominator effect, as the decline in public markets (the denominator) could make the relative weighting of private markets (the numerator) exceed portfolio limits, potentially sparking sell-offs which could yield interesting secondary opportunities. Further, the global economy now faces what seems to be an unavoidable downturn, if not an outright recession in the immediate future, as the long-term economic effects of the current lockdown measures become apparent. As could be expected, investors have demonstrated a consistent flight to quality, with elevated demand for assets in resilient sectors.
Experts suggest that LPs with dry powder to invest may discover a confluence of factors supporting private equity performance in the months ahead. These factors may include discounted entry multiples, reduced competition, and potential for outperformance due to skill (alpha). Additionally, with agility and the benefit of locked-in institutional capital, private equity funds can become buyers of forced sales by other asset managers (e.g., hedge funds, banks) feeling pressure from investors or depositors to redeem capital.
Coming out of the GFC, experts noted private equity’s resilience. During the aftermath of the GFC, vintages immediately following the crisis outperformed those vintages immediately prior, as illustrated in Figure 1 below:(10)
Patient capital may once again prove extraordinarily useful during the COVID-19 crisis. The illiquid nature of private equity allows fund managers and their portfolio company management teams to take longer-term strategic bets than their public market peers, who are more likely to feel the impact of short-term swings in public market valuations. The illiquidity of private equity funds also forces patience on its LPs. The reduction in volatility, combined with the inability to readily exit investments, restricts panic-driven moves from LPs. Yu (Ben) Meng, Chief Investment Officer at CalPERS, believes the “time diversification” from delayed mark-to-markets results in risk reduction for a portfolio.(12) Note however that the illiquid nature of private equity comes with an elevated risk profile that may not be appropriate for all investors.
For suitable long-term investors, private equity investments may help enhance portfolio returns and provide diversification benefits across market cycles. Proponents have long touted private equity as a superior corporate ownership model, which better aligns managers to focus on value creation and can help deliver outsized returns. However, not all private equity is created equal, and the dispersion of returns in the private equity universe is meaningful both in absolute and relative terms.(13) Successful private equity investing involves having access to excellent managers, conducting thoughtful (and rigorous) due-diligence, as well as a disciplined investment approach. Whether private equity is appropriate for a given investor will depend on his or her risk appetite, return objectives and liquidity requirements.
In these unprecedented times, uncertainty will likely remain elevated for the foreseeable future, and markets are expected to continue to roil. If and when the current crisis gives way to a more pronounced economic contraction, the world is destined to look vastly different than it did a few months ago. For private equity firms, there may be reason for cautious optimism. With fresh capital available to invest, an inherently flexible and agile approach and significant operational knowhow, the private equity industry is arguably in a strong position to navigate the troubled waters ahead. Investors in private equity funds may find this adroitness welcome during such a turbulent time.
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