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.
We all know that balancing asset allocation between liquid and illiquid assets is challenging even in good times, and even more so in challenging times. Up until recently, many investors were actually ramping up their allocation to PE as they tried to catch up with a long-running bull market. It was with that in mind that beginning in July of last year, we were already recommending that owners of private equity assets review their holdings in anticipation of a change in the market tide such as this. We did not know what would precipitate the change in sentiment or expect it to be a public health threat of this magnitude, but the denominator effect was due.
On March 12, 2020, the Dow Jones Industrial Average had its worst day since 1987 and since then the index has continued to lose all gains made since 2017. It is fair to say that the anticipated tipping point has now been reached. When the market cycle turns, it can be easy to forget that there are options and ways to reduce risk. Secondaries play an essential risk management role in private equity, allowing investors to keep their allocations in check as the value of liquid assets collapses. So it probably comes as no surprise that Palico has started to field an increasing number of calls from LPs who are starting to plan their next moves as they come to understand the long term implications of this crisis.
Exploring the pricing gap and buyer/seller dynamics during a downturn
Considering current events, it goes without saying that the par-to-premium NAV trend that we highlighted in our closely-watched Secondary Pricing Report will now be a thing of the past, at least for the time being, as countries remain in lock-down to combat the virus. PE funds have a quarterly valuation lag, thus buyers in this market must more closely scrutinize exactly what it is they are acquiring. On their end, buyers will need to perform bottom-up analyses and stress tests of the individual portfolio companies that comprise each PE fund.
Buyers will be thinking about how the lock-down will disrupt sectors in different ways. Historically, cyclical sectors such as manufacturing and discretionary consumer spending — as well as those exposed to bans and self-isolation policies such as travel and dining — will see some of the biggest discounts. Investors will have their own views on where upside value lies and the general uncertainty will be priced into sale offers. In times like this, the bid/ask spread naturally widens. Sellers should expect bids to soften as compared to just a few weeks ago.
The added scrutiny and effort from buyers will have its advantages. It’s worth noting that recent reports estimate a little over $150bn of dedicated secondary dry powder is seeking deployment. To put that into perspective, that is double the size of all transactions that took place in the secondary market in 2019. This is a conservative estimate that does not account for the swathe of opportunistic LPs who look to increase their exposure to certain managers, vintages, industry sectors and strategies by acquiring from their peers. Palico has evidenced a great amount of caution and planning amongst LPs. Given ongoing conversations, the expectation is that motivated sellers will soon start to generate listings on the secondary market as they begin to execute on reactionary plans. Some sellers will be looking to address concerns around capital calls and therefore will look to sell unfunded positions in order to minimize that exposure. Others will be looking to generate cash by selling fund stakes that have already achieved upside and just remain to be fully liquidated. This will generate some cash that investors will want to inject back into opportunities that arise in a down-cycle event such as this. Finally, investors will look to secondaries in order to quickly reposition their strategy.
To that point, a well-functioning and transparent market dictates the fair price of any given asset – in any market. In today’s environment, with less clarity around pricing, having a streamlined and competitive process ensures a clear market clearing price for sellers to feel comfortable. Ultimately time will tell, but, at least, now investors have a tool that didn’t exist before. They now have the opportunity to be proactive about generating liquidity during uncertain times and unfiltered access to almost all prominent and dedicated secondary buyers as well as an array of non-traditional secondary buyers through Palico.
We value your input more than ever during this time. Do not hesitate to contact us with any questions or insights you’d like us to explore or discuss – you can reach me directly at christopher.jeffery@palico.com.
