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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

  • Lower valuations

  • Leverage

  • Public markets

  • The macro economy

  • Company performance


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

Private equity multiples and IRR. PE outperforms post crisis.

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

PE valuations. Debt and Equity to EBITDA

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.


What crisis?

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

Covid 19 impact and market performance

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.


Stay illiquid!

Kasper


Source: McKinsey & Company, July 2020

Note: * Realisation rate = (NAV + distributions) / commitments

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4 Comments


Hi Kasper - new here, and really enjoying PE Compass!

"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." -->

Admittedly coming to this post >13 mos after it was written, but (at risk of saying 'this time is different') covid has differed from the GFC and other crises because leverage / liquidity never really…

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Hi Allyson, thank you for your comment - 13 months or not, my expectations were way off mark. You have a point on the growth of private credit, but more than that I think the vast amount of QE that was and still is being pumped into the global economy played a much bigger role, because it helps underwrite the valuations on the equity side. I will consider a follow-up post, but to be honest, with he current seeming disconnect between reality and valuations, I am not sure it would be anything but pure speculation.

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Hi Kasper, this is your best blog yet. As you note, the growth of secondaries will have an impact on returns. No doubt it will fuel GP led restructurings and provide the much sought after liquidity many LPs desire. Stay well and keep posting! Rob

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Kasper
Kasper
Mar 22, 2021
Replying to

Hi Rob, apologies for the late reply, problem with this being a hobby is that other things take precedence. Thank you for your comment, much appreciated. I think you are quite right, not least as secondary transaction volume fell last year as sellers and buyers struggled on price discovery. Thank you for reading and commenting. Stay Illiquid! Kasper

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