It’s time to adopt the brace position. Tough times are on the way. There are few who doubt we are now teetering on the brink of an economic downturn after one of the longest bull-runs in history.
Just under two-thirds of LPs in Preqin’s H1 2019 Alternative Asset Investor Outlook think we have reached the peak of the market.
How bad will it be?
That’s the $88trn* question, of course, and the truth is nobody knows. But with the US operating beyond full capacity; China’s crackdown on excessive credit hitting construction-based growth; trade wars; Brexit and a European economy struggling to maintain even modest momentum, the prospect of a soft landing is looking unlikely.
And while private equity has a long tradition of finding opportunity in adversity, the sheer weight of debt in the system is troubling. Global leverage loan issuance surpassed pre-crisis levels for the first time in 2017, with somewhere in the region of $1.6trn of loans currently outstanding, according to S&P Global Market Intelligence. Fitch numbers, meanwhile, put the leveraged loan default rate at the peak of the last recession at 10.5 percent. The numbers alone show the potential for fallout.
Add in unprecedented borrower-friendly terms – 85 per cent of global leverage loan issuance in 2018 was cov-lite, compared to 26 percent in the run-up to the financial crisis in 2007 – and the situation becomes more worrying still. The early warning system has been disabled. For LPs, this isn’t the time to “wait and see”. It’s the time for action.
Should I bail?
Well it depends but in any case where would you redeploy that money? We all know that LPs hit by the denominator effect and, in most cases, unnecessarily panicked by the prospect of default, attempted to offload unfunded commitments en masse just over a decade ago.
Secondaries buyers, meanwhile, struggled to price these assets which often had little or no equity value. The majority pulled back hard, pricing tanked and the secondaries market effectively went into shut down.
Interestingly, much of what was put up for sale at that time involved mega fund positions. Received wisdom was they had overpaid and over-levered, in contrast to a more restrained mid-tier.
The reality, however, was that the behemoths the mega industry was backing proved remarkably resilient, and banks more lenient in their negotiations with powerful players. Using the secondaries market to make big market bets of this nature isn’t necessarily the right way to mitigate risk – or maximise returns.
So, how are LPs using secondaries to prepare for tough times?
The secondaries industry has come a long way since the global financial crisis and few expect the market to grind to a halt in the event of another downturn.
Indeed, nothing appears to be able to shake the faith of secondary buyers. The market has weathered a number of squalls from the Greek debt crisis to nuclear threat in North Korea, without so much as a batted eyelid or dent in pricing. Meanwhile, the few secondaries firms, such as LGT, that remained active a decade ago, made – in the words of one green-eyed rival – “an absolute killing”. The market won’t be making the same mistake twice.
And so, this isn’t about panic selling while prices remain high. LPs aren’t ditching stakes to reduce overall exposure. Instead, increasingly sophisticated investors are carefully recalibrating at a manager level. Many have a far greater depth of resource at their disposal this time around and are using it to analyse individual GPs and the assets beneath them.
The secondary market offers the easiest, and fastest, route to rebalancing a portfolio and LPs are looking to offload managers that have disappointed, lack the asset management skills to navigate a downturn, or late-life funds still largely un-divested where exit prospects now look poor.
Instead, they are looking to redeploy into operationally-intensive strategies, turnarounds, and distressed debt.
The growing prominence of non-traditional secondaries players over the past ten years, means there is a rich market for multi-buyer deals, which can often command higher prices. A secondaries strategy, focused, not on macro trends, but the nuances of individual managers, can enable LPs to quickly and efficiently ready themselves for whatever type of landing lies ahead.
