It’s working from home like no one has ever worked from home before. I have learnt how to use BlueJeans, Zoom, Microsoft Teams and Google Hangout all in the space of a week. Working from home when everyone else is working from home, in fear of going out and now under instruction from our Government. These are very testing times and it is unclear how and when matters will improve. These unprecedented times bring untold challenges to our societies and to our economies and it is too early to predict what we will wake up to when it is all over. For the private equity industry, its growth over the past three decades has seen two major downturns: the dotcom bubble burst of 2001 which impacted the venture capital sector in particular and the global financial crisis of 2008. Undoubtedly this is the third such event and while we cannot predict when and how recovery might start, it is worth reflecting on the impacts such events have on private equity and why one prediction I can make is that its long term performance will continue to mark out this industry.
Looking back to the aftermath of 2008, there are some obvious flags of what might happen initially: The private equity industry will witness a marked reduction in realisations or recapitalisations which would return cash to investors and crystallise value. The larger investors in the market typically model expected cash proceeds from such events to honour commitments made to the funds of other managers. The reduction in cash will undoubtedly cause a liquidity crunch for some investors who will take several approaches: seeking to reduce commitments made to funds or selling such commitments in the market. This is where secondary funds will see opportunities, as they are likely now to be working with the affected General Partner, as well as the Limited Partners, to derive a solution. The very material increase in secondary fund ‘dry powder’ in recent years will now find a home. Secondary funds will also benefit from the sale of commitments by investors who are over-exposed to alternative assets due to the change of the denominator as a result of the decline of all markets.
Deal doing will however undoubtedly slow, though large companies in need of cash themselves might sell subsidiaries to their management and there will be some sectors that will have proven their long term value (eg. healthcare, data warehouses). A slowdown in deal doing will help those Limited Partners who have over committed to funds. As exit opportunities reduce, we will see hold periods extend. Private Equity managers will focus on supporting their portfolios as far as possible and while IRRs for the private equity fund vintage raised ahead of the 2008 crisis were materially lower than the long term average, funds did find themselves in positive territory, aided by longer hold periods where management teams worked hard to improve the performance and exit options for assets. Purchase multiples recovered relatively quickly following the dotcom and GFC crashes and portfolio management benefits from the longer term approach that can be taken . Private Equity managers can dictate the timing of liquidity of assets and this can work to the benefit of investors who see returns generated over a long period, minimising absolute losses.
Investors in the distressed side of the private equity market will see opportunities in both credit and turnaround equity. Private equity skills in improving businesses over the medium term, without the short term reporting and dividend pressures faced by public companies will come to the fore and help rebuild our economy.
It remains to be seen what will come of the COVID-19 generation of private equity funds and how indeed the secondary funds will fare. What I am certain of is that the industry will respond in a similar way, with managers working patiently to maximise value where possible rather than walking away from their assets. Firms will want to build their track record of success in adversity even where the prospect of carried interest profit sharing bonuses will have diminished. Other firms with dry powder and small portfolios will be well-placed to acquire assets at what prove to be bottom of the market prices. From this experience, funds will emerge that have outperformed the market and will be the next generation of industry giants.