PE Key Trends Blog

The Big Correction: It is High Time for PE Allocation Reviews

Feb 28, 2020 3:36:51 PM

Tags: Private Equity KeyTrends, Secondary Market

With such an extended bull market, it can feel like we've been due up for a correction for a while now. In July of last year, we published an article titled ‘When the denominator effect comes calling’ not because we can read runes but because all markets are cyclical. In that previous piece, we discussed the nature of allocation targets and how PE secondaries provided a platform for executing on those plans to stay on target. As we all know, it is a matter of ‘when’ and not ‘if’ economies will fall into recession with asset prices following. In the following, we review previous recessions, PE performance, and LP sentiment to date to put some perspective on the current situation.

In the last week of February 2020, stock markets the world over registered their worst week since the global financial crisis 12 years prior; the mass sell-off prompted by the coronavirus spreading from China. On Thursday 27th, the Dow Jones recorded its biggest daily points drop in history. Five months of gains in the S&P 500 since Halloween were wiped off the books in a few days.

At the time of writing, investors are attempting to digest whether this is a short-lived check to their exuberance (the S&P 500 gained a staggering 29% in 2019, nearly three times the historical average) or whether it represents a deeper, lasting shock to the global economy.

There’s little doubt PE’s strong performance has contributed to the alternatives mega-trend of recent years that has seen dry powder amass to $1.45tn. However, as we said in July, the denominator effect has also been playing out in reverse for an extended period. Stock markets have been inflated by dovish monetary policy, and LPs have had little option but to increase their private equity holdings just to keep their target allocations in balance.


The main challenges are knowing what we’re looking at, whether it is a correction or the beginnings of a bear market, and the inherent lag between stocks and alternative asset quarterly revaluations. Will markets continue their descent, dragging PE NAVs down with them? Or is this a blip, albeit a very large one, that will have a limited impact on PE portfolio company valuations?

 

Research from Goldman Sachs shows that there have been 26 market corrections since World War II, with an average decline of 13.7% over four months. Recovery from these upsets has lasted an average of four months. February's big correction saw the S&P 500 and Dow Jones each down more than 10%, but in record time. These losses were made in a single week, not four months. There could be a big rebound around the corner. However, assuming there is more downside to come and we are entering a more long-term situation, LPs have little choice but to address the unprecedented level of PE interests they now hold.


Research suggests this has already been playing on the minds of LPs. Secondary firm Coller Capital’s most recent market survey shows that 65% of LPs believe their PE portfolios need modification against the next economic downturn. This rises to 80% of North American LPs who said the same.

Not only does this signal that LPs are well aware of the impact the denominator effect has on their private equity allocations but also suggests that their PE portfolios are not prepared for the economic tide turning. Prescient LPs will be asking themselves the same question and tending to their allocations targets accordingly.

 

About Palico

Palico is the leading digital marketplace for private equity secondaries. Our digital platform is designed for LPs, from single Family Offices to large Pension Funds, to streamline the secondary sales process, and maximize price with an array of both traditional and non-traditional PE buyers on the platform.

 

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