Over the last three months, we have been fielding questions from buyers and sellers and comparing notes with clients, as everyone attempts to gauge the temperature of the secondary market. Since this crisis hit, there has been a degree of paralysis on the part of vendors as they have attempted to understand the valuation environment.
The opening months of 2020 have been nothing if not uncertain. We're in a period of rapid and immense upheaval with businesses and industries pivoting quickly as they respond to emerging news and data. This applies to the private equity industry too.
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.
It can be difficult to make sense of the social, economic, and financial disruption unfolding in response to the spread of the novel coronavirus, otherwise known as Covid-19. What is certain is that stock markets have tanked by circa 25% over the past month, with some of the largest single-day drops in history. This has obvious implications for the valuation of private equity assets and will need to be woven into pricing calculations in the secondary market.
These are unprecedented times. We’ve faced recessions before, but we’ve never experienced a coordinated lock-down such as this. Investors will, understandably, be shaken by current events, but we want to offer some words of reassurance. At times like this, it is important to keep a cool head and make smart decisions that lead to well-reasoned actions. Here we take a look at what we are seeing in a secondary market that has seen LP-led deals in particular, become more sophisticated since the last recession of 2008/09.
Private equity is an inherently long-term play, though that longevity has been chipped away over recent years. The median hold in the US ticked down once again in 2019 and now clocks in at 4.9 years, continuing a trend that began in 2014. At that time the average holding was 6.2 years, according to data from Pitchbook’s US PE Breakdown report. The M&A boom of the past five years has provided funds with ample opportunities to exit their deals, compressing hold times.
This trend has been driven by top-quartile holding periods (that is, top quartile by duration, not performance), which were down to 7.1 years in 2019 from almost nine years as recently as 2016, but other quartiles have also shown falls.
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.