Weathering the Storm: Why Private Equity Is Better Prepared for the COVID Crisis Than the Financial Crisis
This summer, American cities are trying to navigate the reopening of shops, restaurants and parks after nearly four months of sheltering in place to halt the spread of coronavirus. Business closures created a sharp economic downturn, reversing more than 10 years of economic expansion. While the global pandemic has gripped almost all businesses, the private equity industry appears better positioned to endure a recession today than it did during the Global Financial Crisis (GFC).
Assessing the tides
The recession caused by the COVID-19 lockdown looks quite different from the Great Recession created by the GFC. First, this drop is much steeper. U.S. unemployment spiked from 4.4% to 14.7% between March and April, and GDP is projected to shrink more than 35% in Q2. In contrast, the Great Recession lasted 18 months, and then four months later, unemployment peaked at 10%. Second, fiscal and monetary policy responses have come large and fast. Within days of most shelter-in-place orders, Congress passed a record $2 trillion in aid to workers and businesses, and the Federal Reserve cut interest rates to a quarter point. These moves to limit economic damage are generating market optimism. After falling more than 1,000 points in late March, the S&P 500 index is closing at levels higher than one year ago (source: Google Finance).
A number of factors indicate the private equity industry will weather this storm. First, private equity looks very different today than 12 years ago. Assets under management (AUM) have grown to $4 trillion, and funds hold a record amount of uninvested capital. During the past 10 years, a robust secondary market developed, providing liquidity opportunities for private equity investments, and credit funds have become a source of debt capital for sponsored companies. Because equity markets quickly rebounded from initial contractions, limited partner investors (LPs) stand in a stronger financial position than during the GFC.
Steering a sturdier ship
1. Record levels of dry powder
Economic downturns often create buying opportunities, and today, North American private market funds are fortified with over $1.5 trillion in dry powder. Private equity funds alone hold over $600 billion in unspent capital, ready to invest in new companies at possibly lower valuations (source: Preqin and First Republic).
While private market dry powder has nearly tripled on an absolute basis since 2007, it has also increased relative to the size of the economy. From 2006 to 2019, dry powder volume growth outpaced increases in the U.S. economy (see Chart 1). In December 2006, North American private market funds held $625 billion in dry powder, which grew at a 7.4% compounded rate to $1.4 trillion in December 2019. Compare this to the U.S. GDP growing at a 3.3% compounded rate from $14 trillion to $21.5 trillion during the same period.
Chart 1: Dry powder growth outpaces economic expansion
A striking difference in the position of the private equity industry today, compared to 12 years ago, is its more measured pace of investment prior to the economic slowdown. A study by investment software provider eFront finds that private equity funds deployed 4.1% and 3.3% of committed capital in 2018 and 2019 respectively, compared to 16.3% in 2006 and 19.1% in 2007. The volume of investment by U.S.-based private equity funds has not reached the same heights seen during 2007 and 2008 (see Chart 2). The prudent investment pace during recent market peaks will likely mitigate any negative impact that valuation declines would have on overall fund values.
Chart 2: Investment was more measured in 2018-2019 than in 2006-2007
2. More liquidity with secondary funds
During the GFC, the secondary market was smaller and less liquid with fewer transactions. Since then, North American secondary funds have grown to almost $160 billion in AUM (source: Preqin and First Republic). Secondaries provide LPs with a means to actively manage their portfolios and give general partners (GPs) a tool for efficient fund management.
The success of secondary funds during and immediately after the GFC increased demand for this strategy and boosted its growth as a platform for private equity investors. The segment has also evolved. For instance, GP-led deals were rare during the GFC and today, they make up almost one-third of the secondary market.
Secondary fundraising rose considerably over the past few years (see Chart 3). At the end of 2019, North American funds in this segment held more than $60 billion in dry powder (source: Preqin and First Republic). Last year saw a record volume of secondary transactions during a robust economy and sellers’ market.
Chart 3: Secondary fundraising climbed post-GFC
How will the downturn impact transactions? During the GFC, wide bid-ask spreads restricted deal activity, which eventually resolved in 2009-2010. However, a recent survey indicates most LPs and GPs expect write-downs of at least 15% in Q1, indicating expectation alignment. While sellers may wait in hopes that recently depressed valuations rebound, greater importance on liquidity may prompt secondary activity. It will take time for bid-ask spreads to converge, but given the increased sophistication of market players, secondary transactions will likely pick up faster than post-GFC.
3. Opportunities for credit funds
Unlike 12 years ago, private debt capital is readily available. Credit funds have become a significant private market strategy, having tripled the amount of capital raised on an annual basis since 2009 (see Chart 4). Credit funds include direct lending and distressed debt. Many traditional buyout firms began raising credit funds after the GFC because economic conditions created compelling opportunities to invest in distressed debt. This segment continued to flourish as a growing private equity industry produced more direct lending prospects.
The COVID-19 crisis provides the first test of the booming private credit market. As borrowers take steps to ensure liquidity, some companies may require additional short-term financing from nonbank lenders for working capital. Moreover, a recent survey found that private equity professionals believe that the current crisis will also create a rise in distressed debt opportunities.
Chart 4: Fundraising by credit funds has almost doubled since pre-GFC
4. LPs have more liquidity
During the GFC, the phrases “denominator effect” and “capital crunch” entered investors’ lexicons. The denominator effect produces a percentage (assets / total portfolio x 100) over-allocation to private assets, after sharp declines in equity values shrink total portfolio values in portfolios heavily invested in public equities. Declines in stock prices also reduce LP liquidity, and during the GFC, this capital crunch prompted many LPs to voice concern about impending capital calls.
Five months into the COVID-19 crisis, LPs appear in a stronger financial position than 12 years ago. In fact, a recent Probitas survey of global investors found that few LPs were worried about their own liquidity. Instead, LPs were more focused on the liquidity needs of portfolio companies. Unlike in 2008, stock indexes today are closing at higher levels than last year, as financial markets have responded favorably to lower interest rates and fiscal stimulus.
LPs currently do not seem as capital constrained as in 2008. Nonetheless, they face real barriers to making new fund commitments. Fundraising volume dropped in Q2 as the lack of travel prevented in-person LP due diligence of new funds. LPs are showing a flight to quality, and high-performing brands have continued to fundraise from their existing LP base. However, LPs are shying away from committing to partnerships if they have not yet met in person nor conducted on-site operational due diligence.
Charting unknown waters
Although economic conditions have improved since the spring, the continuing spread of the coronavirus threatens business reopenings. It will be some time before we can confidently say the U.S. is post-pandemic. As First Republic’s Chief Investment Officer Christopher Wolfe explains, “The virus is a biological problem that requires a biological solution.”
The path of economic recovery is uncertain, but the private equity industry is better positioned to weather this storm than that of the Global Financial Crisis 12 years ago. Private equity funds hold a stockpile of unspent committed capital, and the industry has developed an active secondary market to provide liquidity to investors. In addition, the explosion of credit funds during recent years provides capital to invest in distressed assets or lend to businesses. While the recession will dampen business activity and possibly company valuations, the downturn provides opportunities for complementary private investment strategies.