PE’s big opportunity in the mid- and small-cap sectors
Purchase price averages expressed as a multiple of corporate cash flow are at all-time peaks, according to data providers. But averages in the Covid-19 era mask stunning diversity, especially among mid- and small-cap companies starved of government largesse. Recent studies from the Bank for International Settlements and others indicate that the loan and bond guarantee programs driving today’s credit boom disproportionately benefit large firms with revenues of $1 billion or more and access to syndicated credits. Mid-sized and small companies – frequently not adequately serviced by banks – increasingly face a credit crunch, creating opportunities for private capital to provide equity and debt at attractive terms. Indeed, many companies are finding that to negotiate the complexities of cov-lite loans from private credit funds, it helps to have a PE firm in their share capital. The prospect of exceptional PE deals should help drive record fund commitments in 2021.
Diversity across sectors and regions comes to the fore
One of the lessons of Covid-19 is that diversity in portfolio construction pays. As Rainer Ender, Head of Private Equity at Schroder Adveq, says in our roundtable on the crises’ impact (see p. 3), “the days of investing two-thirds of your portfolio in North American buyout are over.” Investment volumes and values have arguably never shown greater variety across industries and geographies than they have this year, with some sectors like venture capital experiencing record fundraising, and others like real assets seeing decades-long lows. If fundraising builds to the record heights we expect in 2021, one of the biggest eneficiaries may well be Asia, which came out of Covid-19’s darkest days early, and where regional powerhouse China is the only major economy in the world projected to end the year with a bigger economy than the one it started with.
Distributions and relative plenty
Don’t put too much faith in averages. While the mean distribution returned to investors in 2020 from realized PE investments dropped to 13 percent of total committed capital (see fourth graph on p. 1), from a five-year annual average of 23 percent, quite a few managers returned record sums to investors, notably those focused on the broad sectors of healthcare and technology (underlining the importance of portfolio construction diversity). And 2020 wasn’t really so terrible for distributions. In the global financial crisis and its wake, when virtually all asset categories were slammed, distributions dropped to just 2 percent in 2009 from a pre-GFC 5-year annual average of 19 percent. Distributions post-GFC returned to double-digits only in 2012 when 12 percent of investor commitments were generated by asset sales, producing the first cash surplus for PE programs since 2007.
Early secondaries nipped in the bud
In our June report, we noted an uptick in secondaries involving closed PE funds that were only 5-20 percent drawn. Because discounts apply only to invested capital, these early secondaries could be a relatively painless way to close with buyers, even at steep markdowns. Well, despite the blip, early secondaries volume never became significant (though post-GFC such deals amounted to 45 percent of 2009’s $9 billion in secondary volume – the latter, half the previous year’s turnover). With the economy supported by massive monetary and fiscal stimulus, net asset values dipped for only one quarter before bouncing back and hauling up secondary prices. Lower levels of distributions relative to calls have set the stage for a strong rise in secondary sales, but in a normal rather than a dislocated market, and notably, so that investors can stay allocated (and allocate more) to what we expect will be some very good PE vintages.
The appetite for LP stakes is stoked by shortage
Annual volume in the secondary market for limited partner stakes fell 36 percent, while volume for GP-led transactions actually rose by 23 percent in 2020, according to Triago’s preliminary estimates. As we note in our market analysis commentary on p. 2 (more on pricing and volume there), GP-leds allowed investors this year to put large sums to work in a market characterized by few LP-stake offerings. Heightened competition has seen exceptionally tight pricing for GP-leds (frequently par or better) and a hankering among buyers for the lower risk and shorter duration of LP-stake offerings. As one major secondary buyer recently told us: “our appetite for classic limited partner stake deals has never been higher.” This should be music to the ears of limited partners looking to make up distribution shortfalls with some secondary market portfolio pruning.