Historically, the M&A markets have been a great indicator of upcoming trends in the Private Equity sector. In this article, we take a look at the parallel between the state of the M&A markets and the Private Equity sector in face of the current global COVID-19 pandemic. We also explain how the situation of exits happening in the M&A industry may trigger an increase in the importance of secondaries as 2020 valuations are being released.
• 6 min. Read •
Historically the M&A markets have been a great indicator of upcoming trends in the Private Equity industry. As it stands, deal-making activity has fallen significantly, affected by the ongoing pandemic's drag on the global economy. Remaining prudent in face of the high volatility of markets, corporations and PE funds have both limited their activity in recent months. However, PE players have shown a greater resilience and willingness to acquire. After all, private equity prides itself on making the most of market dislocations.
Data from Mergermarket for the first half of 2020 shows that global M&A was down by 49% on the previous year and value collapsed by 69% over the same period. Primary PE buyouts – that is, newly minted deals, not including those acquired from fellow fund managers – were down 23% and 28% by volume and value respectively, relatively smaller falls in the context of the broader M&A market.
However, as might be expected given the state of the economy, the drop in portfolio realizations in H1 2020 has been far more precipitous. Exits were down by 33% year on year (581 deals), value having cratered by a full 57% (US$90.1 billion). GPs have been refraining from realizations having spent the first half of the year triaging assets amid the crisis.
This lack of value being realized in 2020 is coupled with unprecedented appetite for PE. Given the success known by the asset class during the previous cycles and in an attempt to meet their target returns in a low-return environment, investors re-upped into ever larger funds. In the decade following the global financial crisis of 2008, unrealized net asset value (NAV) more than doubled from just over US$1 trillion to well in excess of US$2 trillion. For many investors in PE, this may now be looking like an overcommitment.
Private equity fund managers have had record amounts of dry powder in the past years which posed the challenge of identifying high-yield allocations as companies over-valued their assets. Buying in a seller’s market became a real struggle for GPs. But this has turned on its head.
GPs must now solve how to sell in a buyer’s market. Indeed, as LPs become more demanding for cash of the distributions they have been accustomed, GPs’ requests for exits are increasing steadily. Fund managers find themselves selling stakes at discount to earn quick liquidities to satisfy their investors.
As divergent price expectations and uncertainty over the timing of the recovery persists, secondary activity, just like the M&A market, has so far been subdued in 2020. What happens next in M&A has implications for PE secondaries. If exits are not forthcoming, this could prompt an upsurge in LPs taking their liquidity needs into their own hands by selling in the secondary market.
Early vs late funds
The rise in secondaries and the return of liquidity into the hands of LPs will of course depend on a willingness to transact among buyers and sellers, which itself depends on the firm’s valuations and appropriate pricing. The last thing LPs want is to divest from high yield stakes, only to watch a recovery and outsized returns from the funds they sold.
This is where sellers need to develop a strategy based on their liquidity needs. Given the inherent lag in quarterly NAV reporting, tail-end funds that are traditionally mostly drawn have been a tougher proposition for vendors in the first half of 2020. Determining the fair value of these assets has been fairly difficult, and so far, the outlook displays too much uncertainty to close the bid/ask spread. The performance of companies in a single late-stage fund during the crisis may also be too diverse for parties to agree on price. Investors are now looking at the future: as clarity on the economic recovery and future growth should be regained, deals for more mature fund positions may emerge in greater numbers
However, early fund interests are a highly attractive option from a seller's perspective. As they tend to be less drawn by LPs, these funds will certainly be less impacted by the pandemic. For the same reason, there is less potential to lose out when asset values rise. The divestment of earlier funds can also grant the benefit of freeing sellers from potentially large and numerous capital calls as their GPs set about deploying committed capital amid the economic disruption. From a buyer's perspective, early funds have the advantage of attractive market timing as GPs of these funds become acquisitive while valuations are down.
If M&A activity continues to remain subdued, GPs have limited options but to bide their time until confidence in the market recovery is regained. LPs invested in those funds storing a record $2 trillion-plus NAV backlog, however, have the secondary market to turn to. If exits do not pick up meaningfully in the second half of 2020, 2021 has the potential to be one of the most active years for PE secondaries to date.
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