Covid 19 and private equity – performance impact
Based on prior crises we can expect older vintages to underperform and coming vintages to outperform.
The drivers of this are
The macro economy
Pre-crisis funds may suffer, post-crisis funds may outperform
Looking at Figure 1, not least the period around the GFC, this at least is what we would expect.
The funds in the 2-3 vintage years prior to both the GFC and the Dot-com Crash underperform significantly on both IRR and TVPI. Conversely the funds in the 2-3 vintages immediately following the crises significantly outperform.
Figure 1: Historic private equity performance by vintage, Net to LPs, as of Q4 2020
Source: PE Compass, data from Cambridge Associates July 2020
Note: Past performance is not indicative of future results
The impact on pre-crisis funds will be different
These differences are due to the inherent characteristics of the various vintages. I.e. older funds will be fully deployed and under some pressure to exit. Younger funds may not be fully deployed have more time but have also on average invested at higher multiples.
Pre-2014 vintage funds have invested at lower valuations but face exit pressure
These funds may have limited flexibility on whether to sell or hold an asset. But lower entry valuations, see Figure 2, and a more developed secondary market may help them achieve decent exit multiples.
Depending on the portfolio composition and realization rate* these funds may, even as individual investments might be significantly impacted, see relatively limited impact on both IRR and TVPI.
2014-2016 vintage funds have some flexibility but face prolonged holding periods
Many of these funds will be fully invested and are only just beginning their harvesting period. Consequently they still have time and GPs can work with the portfolio companies and wait for exits.
In the case of longer holding periods, IRR is likely to be the most impacted. However, as these funds were not invested at the top of the market, and as markets and asset prices rebound over time TVPI may ultimately hold up very well.
2017-2019 vintage funds have time but have invested at very high valuations
A fast paced investment environment the last few years means the earliest of these funds may well be fully invested, and even 2019 funds are likely to have made significant deployments. All at very high entry valuations, see Figure 2. On the upside, GPs have time to work with the portfolio companies and will, in many cases, also have the option to add more capital.
A permanent market rebound could leave these funds relatively unscathed. But, in the absence of this, they will likely see significant impact on both IRR, because of longer holding periods, and TVPI, because the investments were made at the top of market and may be difficult to exit at the same elevated valuations.
Benign post-crisis valuations are the main driver of outperformance
Economic downturns / crises lead to lower valuations. This is partly due to an overall worse economic outlook and partly because leverage becomes harder and more expensive to get. The latter can be seen in Figure 2. Leverage pre-GFC was 2-3 turns more than post-GFC.
With less leverage available valuations must come down for GPs to be able to make adequate returns on their investments.
Figure 2: Median US PE buyout EV/EBITDA multiples
Source: PE Compass, data from Pitchbook Q2 2020
Note: * As of Q2 2020. Past performance is not indicative of future results
Funds with dry powder can take advantage of lower valuations
Even if Funds, in the absence of leverage, post-crisis have to put in more equity they can often invest at significantly lower valuations. And as the economy recovers and leverage again becomes available they can subsequently add leverage and sell at higher valuations.
This plain and simple multiple arbitrage or just ‘buy low, sell high’, potentially with a not insignificant upside from adding leverage, can be a significant return driver for post crisis vintages, see Figure 1.
It’s the economy stupid
It’s not all multiple arbitrage and leverage that drive returns – fundamentally, it is the macro economy and actual company performance.
GPs have little to no control over the economy, which in a downturn can significantly impact revenue. Mitigating this is mainly down to avoiding cyclical sectors, building good defensive portfolios, and managing the companies.
GPs can however do much about company performance. Ensuring that leverage is reasonable and does not overly amplify a crisis – for example because of use of pro forma EBITDAs. Good solid management, optimizing operations, and more.
If these things are in order. it is much more likely that the company will weather a crisis well. And potentially come out in a strengthened market position.
Looking at the S&P 500 index, in Figure 3, it seems that the crisis is all but over. With the Q2 rebound we would expect PE valuations, as always with a lag, to also rebound and any damage to portfolios may well be minimal.
But, no matter the disconnect the markets seemingly have from the real economy, the healthcare crisis is ongoing. And, as McKinsey notes in their latest survey on global economic sentiment, executives, in stark contrast to the sharp market recovery, remain cautious expecting a slow long-term muted recovery.
Regardless, both LPs and GPs would do well to use this respite to their advantage. GPs should be assessing their portfolios and working with their PF companies positioning them for another potential downturn. LPs should be going through their portfolios, assessing their GPs and their future investment strategies.
Figure 3: S&P 500, daily price at close, USD
Source: PE Compass, data from Yahoo Finance 27 July 2020
Note: Past performance is not indicative of future results
No market timing and vintage diversification are essential for LPs
Tempting as it may seem from the above to simply invest in private equity post crises, PE is a long term illiquid asset class. And as it is hard to predict anything with accuracy over 10-15 years PE does not lend itself well to market timing.
The above also clearly emphasizes the need for vintage diversification. Commitments made only to 2017, 2018 or 2019 fund vintages would see most or all of the capital invested in years leading up to the crisis at elevated valuations, which in the case of a deepening or extended crisis probably will lead to relatively poor vintages.
LPs should deploy over several vintages in different stages at a steady and measured pace – again simply good thoughtful portfolio construction.
These are critical takeaways which future posts will look in more detail.
#PrivateEquity #VentureCapital #PEcompass #StayIlliquid
Source: McKinsey & Company, July 2020
Note: * Realisation rate = (NAV + distributions) / commitments