The likelihood of a recession in the coming 12 months rather depends on which economist you speak to, and whether their glass is half full or half empty. One question on the minds of PE investors is, assuming there is an economic moment of reckoning on the horizon, what this will mean for their private equity portfolio and asset allocation. Regular readers of Palico's blog will already know that we have discussed the potential for the 'denominator effect' to throw portfolios out of whack, forcing investors to seek liquidity in the secondary market in order to downsize their PE exposure relative to other, more fluctuating asset classes.
History doesn't repeat itself, but it rhymes and there's little doubt that appetite to divest fund positions will surge in such a downmarket scenario. But what lessons can be learned from the past? And what, if anything, is different this time around?
For all the expectations of a secondaries bonanza in 2008 to 2009, this transpired to be a mirage. The bid-ask spread was so wide that deal flow trickled until stock markets recovered and buyers were confident enough to pay the prices expected of sellers. Indeed, this valuation gap saw volume fall by more than 21% in 2009 to $12.7bn worth of transactions. It’s fair to assume this dynamic will play out again – but with an important caveat.
At the end of 2008 there was an estimated $23bn worth of uncalled secondaries capital. By March 2018 that had nearly quadrupled to $88bn, and this says nothing of the record-breaking war chests being accumulated by marquee names like Ardian and Lexington Partners. Today's unprecedented wall of secondaries dry powder has been applying upward demand pressure and indicates that buyers and sellers will be better able to bridge the pricing gap in a forthcoming recession.
Savvy LPs have already been capitalizing on the opportunity; price premiums have become a common sight in the last two years, particularly for in-demand funds. Secondaries are now a prudent liquidity management tool, not a last resort for investors in distress.
Australia's Future Fund takes a highly proactive approach that offers lessons for fellow LPs. Close to half of the AUS $200bn scheme's assets are allocated to alternatives, with 16% in private equity specifically, so the sovereign wealth fund knows a thing or two about the intricacies of the asset class. In the last two years alone it has exited AUS $5bn worth of private markets investments, citing the “increasing maturity” of the secondary market for making this possible.
What is most revealing, and instructive, about this divestive approach is the rationale behind it. Since PE funds offer less forward-looking return potential in their later years, this LP taps the secondary market for liquidity that can be re-deployed on a primary basis, since new funds offer more headroom for value gains.
This strategy makes sound sense, even more so in the lead-up to a potential recession. Sellers can offload PE assets today at attractive prices and at a point where there may be limited or negative earnings growth for underlying portfolio companies in these funds over the next 12 to 24 months. That capital can then be recycled back into primary fundraisings, equipping GPs with capital to sow through the bottom of the market.
A further consideration here is that, if GPs exploit a looming buyout opportunity en masse when company valuations are depressed, this will result in an industry-wide increase in capital calls. This, in turn, is likely to motivate LPs to sell fund positions in the secondary market to meet these higher drawdown rates.
Preparation, Preparation, Preparation
Looking past the next recession, whenever it does eventually strike, the sky really is the limit. Secondaries are now an accepted feature of any sensible private equity strategy and, widening the net to other private assets including direct lending funds and even co-investments, it is not unfeasible to imagine a $250bn market five years from now. But before we reach that milestone the economy will take a turn for the worse, and logic says that any major recession in this day and age will be global in nature, affecting all investors.
No seller wants to find themselves rushing into a crowded market. Those who see the sense in capital efficiency will tend to their portfolios now. LPs still have an opportunity to sell their existing PE assets while pricing remains attractive. This can free up liquidity for primary commitments in preparation for 2020, which may be remembered as one of private equity's best vintages.