Is there a liquidity crunch heading LPs' way?
For a number of years now GPs have wrestled with a conundrum. On the one hand, they have a wall of committed capital at their disposal; on the other hand, the unprecedented demand for deals combined with liquid debt markets has meant accepting nail-bitingly high earnings multiples. This is the gift and the curse of dry powder hovering at an aggregate of $1.45trn, a historic high.
As the world comes to terms with the new realities of “social distancing” and “self-isolation”, and anxiously awaits the peak of this novel coronavirus, the deal outlook has quickly reversed. Stock markets have tanked and private valuations will follow.
As Warren Buffett once said: “Be fearful when others are greedy and greedy when others are fearful.” Certainly, everybody is fearful right now, with their loved ones being the first concern. But investors have a job to do and those who have seen a business cycle or two in their time know that an opportunity awaits. Private equity has long prided itself on its ability to turn market dislocations to their advantage, taking action when others are frozen by uncertainty and ultimately being rewarded for their bravery.
In the PIPEline
A look at China may presage what is to come in Europe and the US. Amid the protracted – and ongoing – trade war between the US and China, buyout funds focused on Asia's largest market raised a meager $1.3bn in 2019. Preqin data cited by Thomson Reuters show that the figure stood at $6bn before the end of Q1 of this year. Correlation does not mean causation, but as China swiftly rebounds following a strict lockdown, it would appear that the country has become a far more appealing prospect for buyouts than it was only a few months ago.
It may be naïve to assume that funds will pile into deals at this stage with so much uncertainty around. However, one likely trend, which was already in play throughout last year, is PIPE (private investments in public equity) transactions. Bar a few select beneficiaries of the current scenario – video conferencing company Zoom, for one, has seen its share price skyrocket – countless industries have been battered by the evaporation of consumer demand.
Companies with limited liquidity on their balance sheets are in an impossible position. They need capital but the markets don't want their debt or their equity. This is where private equity funds can play the role of the white knight, putting up the equity financing the market is not currently willing to. Not only have stock markets tumbled by circa 25%, representing immediate opportunities, PIPEs allow PE to acquire publicly traded common or preferred shares at a discounted rate relative to the market price.
Compound this with another fact: the gap between public and private company valuations has narrowed in recent times (read Bain's analysis on this for more), with private EBITDA multiples looking less enticing than their public counterparts, a reversal of the norm. This makes for a compelling case that PE will go on a stock market buying spree.
Testing the market
We may have further to fall. Further significant shocks would certainly cause some hesitation among GPs. In any case, whether it be public or private deal targets, a wave of deals is looming. It could be three months from now, it could be six. Perhaps 2021 will be the industry's next golden vintage.
The implication of all this for forward looking LPs is that they should be paying close attention to their own liquidity, now that drawdowns become more and more likely. Some investors will be confident they have adequate cash reserves to cover forthcoming PE capital calls. Few will be certain they can meet every last call if their managers draw down en masse. Potentially, they risk heading into that liquidity crunch. One resolving option that is always on the table for LPs is to see how much they can raise from divesting existing fund holdings. Those LPs who test the secondary market today to gauge what they are able to raise from selling these positions, should they choose to transact, will be at a distinct advantage.
As always, stay safe and well out there. Do not hesitate to contact us with any questions or insights you’d like us to explore or discuss - you can reach me directly by replying to this email or at firstname.lastname@example.org.
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.