PE investors should hold their nerve, even if mark-to-market valuations worsen in Q2
It is unlikely that the full extent of mark-to-market valuations will be known until 30 June, when Q2’s financial reports are issued. And while this might cause investors to break out into a cold sweat, the advice being offered by investment consultants is, ‘Don’t make any knee-jerk decisions and keep investing’.
“What we learnt from the ’08 financial crisis is that it took time to for valuations to be written down by GPs – and we know that for Q1 2020 valuations, some GPs don’t re-value, they wait until the Q2 valuations so it will take at least a couple of quarters to understand the full impact of this pandemic,” says Rhonda Ryan, Head of European Private Equity at Mercer, one of the world’s leading investment consultants with USD304 billion in delegated AUM and USD15 trillion in assets under advisement.
“The message we are giving clients is, ‘Don’t expect write-downs to come through right away, it will take time’.”
Towards the end of April, Blackstone reported a 21.6 per cent fall in the value of its PE funds. Apollo reported the very same losses for Q1, while the Carlyle Group recorded an 8 per cent fall in its corporate PE business; overall revenue across its private markets portfolios (including credit and real assets) was down 34 per cent year-on-year.
These are sizeable figures but those operating in the top tier of private equity have the broadest shoulders on which to bear such losses. They have the global expertise, resources, and balance sheets needed to navigate a downturn.
During the global financial crash, private equity portfolios were hit hard, just as all other asset classes were, but they bounced back quickly. I suspect the same will apply in the wake of this current crisis.
Ryan says that while it will take time to determine how long the market impact of Covid-19 will last, investors should not make any short-term decisions. “Most LPs who sold their PE investments straight the ’08 crash probably didn’t get the best returns. It wasn’t a good time to be selling. So one of the lessons investors should take from that period is not to make any knee-jerk reactions,” she says, adding:
“You can’t time the markets in this asset class, otherwise you risk missing out on returns. The best way to achieve top quartile returns in private markets is to consistently invest with the best managers, regardless of the direction of the markets.”
Mercer advises limited partners on their private market allocations and creates discretionary multi-strategy portfolios covering PE/RE, real assets and private debt. In addition, Mercer creates bespoke mandates for some of its largest institutional investors.
“In terms of the current situation, the first question we are getting from our LP clients is, ‘What is the impact of Covid-19 on private market portfolios?’ What is likely to happen to the underlying portfolio companies? And most importantly, what is going to happen to valuations? We’ve spent quite a bit of time talking to GPs to understand where we might see the biggest impact but it varies a lot, depending on geography and sector,” explains Ryan.
Importance of operating partners
Last year, the global PE industry raised USD555 billion in LP capital commitments, pushing dry powder levels to a record high.
In some ways this is a blessing, as those who have already drawn down capital to seed new investments in their portfolios now have a strong cash buffer to support operating companies who get into cash flow difficulties over the near-term.
Yes, mark-to-market valuations are going to be severe, but it doesn’t mean they will be irreversible. Now is a time for cool heads to prevail. Retail and consumer-based businesses, transport (aviation, shipping) businesses and tourism businesses have been rocked, but Ryan says that some of Mercer’s exposure to technology buyouts and healthcare funds have remained quite robust.
“In terms of performance, I’ve been expecting a market downturn for many years now,” she says.
“Investors need to be positioning themselves with the best GPs, especially those that can handle a downturn as well as an upturn. It’s easier to make money in a rising market but we want our clients to be invested with GPs that can also handle a downturn. Those GPs that have operating teams that can help portfolio companies where required, is something that we have identified as important.”
For PE-owned companies that are experiencing difficulties, GPs who actively use operating partners are now deploying operational expertise where it is most needed, to help turn things around at the individual asset level; when and where needed.
Diversification is key
Ryan confirms that some of the discussions they are having with GPs are revolving around how much cash they have in their operating companies. But until Q2’s financial figures are released, it is hard to ascertain how much worse things could get. Q1’s figures were just the starter. It remains to be seen how palatable the main course will be come end of June.
But as Ryan rightly points out, even if some investments are a write-off, provided investors have sufficient diversification they should still expect to get a good return.
“Diversifying one’s investment portfolio by strategy, by sector, etc, should help. It’s not great to find that one or two companies in a PE fund fail, but if the other companies are doing well it’s not the end of the world for returns.
“Our message to clients is simple: please don’t change your investment strategy. It’s not a time to start moving into something totally different. People talk about the opportunities in distressed debt but I’m not sure whether that is the case yet. Time will tell,” cautions Ryan.
The rationale for urging investors to remain cautious over switching their PE investment strategies is solid. After all, any PE funds that have only just started investing over the last 12 months might only have one or two assets and still have plenty of capital to draw down. Any losses incurred in those early investments will likely be countered by sourcing attractively valued assets elsewhere in the market.
Moreover, even if some early investments have gone south, the more adept the GP the more likely they will reverse those losses over the coming years.
“With regards to LPs switching investments, by the time they’ve done so the opportunity will have gone. LPs need to be positioned ahead of time – hence the importance of choosing one’s GPs wisely,” says Ryan.
She says the key message is for investors to not stop investing in this current environment:
“If you look back at ‘07/08, some GPs and LPs stopped investing and stopped allocating. If you look at those years, they are some of the strongest vintages. The main thing is for investors not to lose their nerve.”