Denominator non-effect and faith in PE
The denominator effect, in which collapsing stocks mechanically push PE assets well above allocations and force PE cutbacks, looks like a non-event given surging stocks. If anything, we expect PE to emerge from this crisis with an enhanced reputation for creating value while minimizing risk – something that should lead investors to discount the denominator effect permanently. We also expect that PE will more energetically and effectively preserve and enhance the worth of investments than the passive and diffuse shareholder bases of public companies. The exceptional ability that sophisticated PE firms and their financial networks possess when it comes to tapping debt and equity even in the toughest market conditions should play a major role in what we believe will be the exceptional performance of PE during the crisis and its aftermath.
The prospect for great bargains despite high asset prices
As noted in our p. 2 market analysis, PE’s biggest challenge during the Covid-19 Crisis could be the gap between a bad economy and high market values. Yet auction theory points to factors that will mute the expense of PE. Bidders overpay when everyone has the same viewpoint. Among PE professionals, there’s a broader range of views today on everything from the shape of economic recovery to individual company prospects than at any time in the last decade. Surplus value is also more likely left for the winner when bidders use a wide range of yardsticks and skill sets to determine their offer. With general partners showing greater specialization than ever before, some managers will pick up incredible bargains.
When an exit drought is an opportunity to boost returns
Over the next 18 months there will be a significant uptick in fund extensions. This will be accompanied by a rise in deal structures designed to both generate liquidity for investors and give assets more time to develop. Counterintuitively, growth targets that exceed pre-crisis aims are likely to be part and parcel of these deals. Triago expects a proportionate increase in partial realizations designed to deliver liquidity to investors while also providing a longer growth runway for the assets in question, frequently paved with fresh capital from new investors (one version of these deals are single-asset secondaries, our p. 3 roundtable topic). Today’s exit drought will become an opportunity for managers to conceive and execute more ambitious plans that in many cases will surprise investors, driving better investment multiples and higher annual returns.
Opening up PE to US retirement accounts…and retail
It’s probably no accident that the three largest managers of US target-date funds, multi-asset vehicles that gradually rebalance portfolios from aggressive growth to income preservation over decades, have all announced deals with PE. Vanguard struck a February partnership with HarbourVest, while Fidelity and T. Rowe Price bought StepStone stakes in October. Given June guidance from the US Department of Labor greenlighting PE inclusion in TDFs, without any qualifying wealth threshold, Vanguard, Fidelity and T. Rowe Price take pole position – as do Pantheon and Partners Group which sought the guidance – to tap $6.2 trillion in US defined contribution pensions. Indeed, this may be the catalyst for a new form of low-fee retail PE. PE’s high fees will be diluted by the low-cost stock and bond portions of TDFs (their expense ratios are as low as 0.1 percent). Some predictions have low-cost, mixed-asset retail funds as being key to PE’s success in a decade.
Early secondaries rise, recycling falls
In a repeat of what happened during the GFC, there is a relative increase today of secondary market deals involving closed PE funds that are only 5-20 percent drawn. These early secondaries account for over a third of secondary volume initiated since mid-March, up from 5 percent in a typical year like 2019. Because discounts apply only to invested capital, early secondaries can be a painless way for sellers to free up committed but uninvested capital, and to come to terms with buyers even at major markdowns to net asset value. Some primary-minded buyers (investors of all types that have historically focused on fundraisings) are also doing early secondaries to gain exposure – or increase exposure – to specific funds they like. In contrast, recycling, where purchased vehicles liquidate so rapidly (short duration investing) that proceeds can be reinvested before being distributed to secondary fund investors, is at a standstill.