Private Market Strategies During COVID-19
The spread of COVID-19 has vastly impacted our economy during the last two months. These impacts can potentially be felt for many more months to come. This article highlights how COVID-19 has and will continue to influence different private market strategies including limited partners, secondaries, private equity, venture capital, and private debt.
One issue that will occur with limited partners during this time is the denominator effect. Public markets are more volatile than private markets. When the stock market falls dramatically, like it had during the beginning of the COVID-19 outbreak, public market investments fall immediately, but private market investments do not reflect this for another quarter or two due to a manual valuation process. As a result, the private equity stake can quickly be overallocated. Recently, private equity investments have been under allocated, so this effect should not be as drastic as it was during the 2008 financial crisis. Strategies to manage asset allocation in the provide markets allow for two solutions. One solution is to allow a certain time period for market valuations to settle overtime allowing the private market portfolio to reset to the new normal valuation or investors could allow the investment policy to be more flexible.
The secondary market has willing buyers that will purchase at discounted valuations. On the other hand, most sellers are not going to want to sell unless they are forced and do not see their company making it past the next couple of months. Buyers are anticipating a recession, a drop in fundraising, and lower deal volumes due to the current environment. The past several years has been a seller’s market where a record amount of money has been being thrown at a limited number of sellers, but that is no longer the case now with the discounted valuations. Many firms and analysts believe that it could possibly take the whole year for transaction volume to rebound given the need for recalibration from both buyers and sellers. Looking at IRR numbers from funds with vintage years around the time of the great financial crisis, you can see that funds opening right before the financial crisis experienced the greatest negative impact. The funds that were able to open at the nadir of the recession at distressed prices experienced the highest rate of returns.
Due to the current environment, less capital is projected to be raised throughout the rest of the year. The projected lower capital raised mixed with the continued fears of COVID-19 will lead to worse performance of private equity funds. Larger private equity funds with extra capital should not be affected as much due to the use that capital to invest in distressed assets; however, they will be more focused on their current portfolio of investments and will need to insure all their current companies and investments have cash before deploying that into new projects. Putting this capital to work during a crisis can be risky, but the best performing funds coming out of these situations are the ones that took chances and successfully invested capital in distressed companies and assets. Private equity funds with some of the best metrics are ones with vintages in 2001 and 2009 that were active towards the end of these crises. Private equity performance tends to be like that of public market performance in the long run; however, private equity tends to slightly underperform when the stock market is accelerating and tends to outperform when the stock market is struggling.
Venture capital funds had been the best performing private market strategy when looking at IRR over the past several periods. Coming into 2020, there were anticipations of high venture capital fundraising, and strong first quarter stats back up this fact. Fundraising has been challenging the last month, especially for newer funds. There are two main reasons why this is the case. First, the difficulty of in-person meetings has and can delay the approval process needed to consummate a fund commitment. Secondly, just like private equity, these funds will put their focus on supporting existing portfolio companies and adjusting their reserve capital accordingly. Venture capital funds are similar to private equity funds in looking at performance during crises. Venture capital funds with the best performances are ones with vintages that started at the trough of a downturn, and the worst performers are the ones with vintages in the years right before a downturn.
Private debt fundraising had experienced its best three-year period in history coming into 2020 having raised $388.9 billion globally since 2017. Dry powder has also increased reaching $276.5 billion as of quarter two of 2019. Both of these statistics point to the fact that private debt funds have plenty of capital to employ during these struggling times. Direct lending funds, or nonbank lenders, had been the standout strategy of the last decade accounting for 56.9% of capital raised in 2019. This should continue to be the case as banks have stopped giving out as many loans. Distressed debt is likely to see more investment opportunities in the coming months. Covenant-lite loans have become popular over the last couple of years. With that said, they have not been used heavily during times of distress. These can be helpful during this time since they allow borrowers more flexibility, but on the other hand, issuers will have greater ability to steer cash away from creditors if they sense that the company is no longer a going concern.
Sources: Gelfer, James, et al. “COVID-19’s Influence on Private Market Strategies and Allocators.” www.pitchbook.com.