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.
Our vantage point in the PE secondary market has many benefits. One is that we are able to gauge sentiment, both positive and negative. Every day that we speak to LPs, we hear common misconceptions and past truths that are keeping them away from the secondary market. We feel it is our duty to dispel these myths.
The question of whether track record is a reliable indicator of future returns is a question as old as the asset management industry itself. If all it takes to make money is backing last season’s winning horses, anyone can succeed. If only it were that simple.
Dispelling the Myth of the Distressed Seller
One of the top ten private equity funds raised last year wasn’t even a private equity fund. At least not in the traditional sense. Coming in at tenth place was Blackstone Group’s $11.1 billion raise for Strategic Partners VIII, the largest secondaries fund ever raised until it lost that distinction to Lexington Partners at the start of 2020.
Demand among investors to commit to secondary funds has never been higher. The reason for this is simple. The rise of secondaries is due, in large part, to the rapid growth of alternatives. As private equity has ballooned, it follows that some LPs would like to unlock liquidity in these closed-ended funds.
Energy funds have been notable for their absence in recent years, the commodity crash of 2014 has cast a long shadow. The strong correlation between the value of operating companies and the oil price, which has made a slow and stuttering recovery, has meant LPs have had to wait a long time for limited distributions. Naturally, the demand for new fundraisings in the sector has been lackluster.
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.
Measured against the circa $70bn private equity secondaries market, private debt secondaries are small potatoes. For now, at least. However, good sense suggests that is about to change. So far, 2019 has provided compelling evidence of what could be the coming advent of private debt secondaries.
Unlike picking stocks, private equity investing is something of a black-box exercise. Select a GP, entrust that manager with committed capital and hope that they diligently curate a portfolio of assets that reap rewards over the coming decade. Secondaries, meanwhile, put investors in a far more transactional, hands-on role. This is where it is important for investors to fully understand the dynamics between current reported value and the potential for future upside.