As public capital markets roil in the turbulence caused by the coronavirus pandemic, private markets aren’t immune from challenges, said a recent report from PitchBook Data Inc.
“As we enter into the most significant market drawdown and economic shock we’ve seen since the financial crisis, PE is equipped to help alleviate pressures, but it will also certainly be challenged,” the report said.
As many businesses face a cash crunch, it remains to be seen how effective efforts by the U.S. Federal Reserve will be in alleviating liquidity concerns, the report said. “As consumer spending and business investment are set to decline, we believe we will undoubtedly see a slowdown in PE transaction volume to follow the expected economic contraction.”
Given the great need for liquidity, coupled with economic uncertainty, there will likely be a flight to quality where private debt is concerned. However, there remain many distressed and special situation funds seeking to find assets at especially depressed prices, the report said.
Meanwhile, 75 per cent of private equity deals in 2019 included debt multiples of six times greater than earnings before interest, taxes, and amortization. “While leverage ratios have become consistently high, we believe they are bound for a reversal from that sustained trend,” the report said. “With tighter lending, PE firms will be forced to enter transactions with more conservative capital structures that include a larger equity proportion.”
Asset prices are set to decline across the board, the report said, which will compress exit multiples. “As economic activity subsides, we still expect to see an enhanced risk premium in the types of leverage and debt solutions used by PE, which will drive yields in those pockets higher despite the Fed’s actions to depress overall rates.”
Private equity funds will also likely hold onto struggling assets for longer. But historically, private equity funds have outperformed public security peers in periods of extreme market stress, the report noted.
As well, in the past fundraising has proven trickier during periods where institutional investors saw significant losses in public markets, but Pitchbook doesn’t expect to see a dramatic downturn this time around. Indeed, during the 2008 financial crisis private markets saw a trend of limited partners struggling to make capital calls and even selling assets in the secondaries market at deep discounts.
The report suggested the current period of economic distress could prove different than the 2008 financial crisis, as many investors were over-allocated to private investments at that time. While some institutional investors may prove more cash-strapped than usual in today’s market, that over-allocation has since diminished.
“Today, while illiquidity remains a concern and will be an issue for some [limited partners], we think the risk of the denominator effect is somewhat mitigated because many LPs are currently underallocated to private markets. . . . We also do not foresee panic-selling on the secondaries market, as was the case in the [great financial crisis]. For those LPs who do need liquidity, the secondaries market is deeper and more developed than it’s ever been—even if transactions may take longer in a challenging environment.”