With the COVID-19 pandemic causing unprecedented dislocation across all financial markets, secondary investors are searching for a roadmap to guide them through the turmoil. Many LPs have asked whether the Great Financial Crisis (GFC) of 2008-2009 might provide some relevant direction. But, comparisons between the GFC and the Coronavirus disruption remind us of the Tolstoy quote, “Each unhappy family is unhappy in its own way.” We could say the same about “unhappy” periods in the financial markets.
True, the GFC was the last time we saw a market dislocation as severe as the one we are experiencing today, and it can be helpful to analyze and understand the commonalities across downturns. However, we should acknowledge that there are different drivers this time; the key one being the chronic corporate earnings disruption under COVID-19 versus financial institution distress in the GFC. As such, the prevailing market volatility may be with us for a longer stretch this time around. Protracted volatility risk, along with a low-yield environment and lack of M&A exit opportunities, may put liquidity pressures on many investors, and that will shape the decision-making of secondaries buyers and sellers.
While certain dynamics do differ, we can learn some lessons from the GFC particularly in terms of LP behavior. The chart below published by Greenhill Secondary Market Review 2020 and Capital IQ shows secondary deal volume mapped against the S&P 500 for the period leading up to and following the GFC.
As illustrated below, there were four distinct phases of deal flow in the traditional LP market from 2007 to 2012:
The takeaway is that, while not assuming history will repeat itself, we should aggressively prepare now for a potential initial wave of distressed sellers, followed soon thereafter by a prolonged attractive period of motivated portfolio management driven sellers. Based on our insights and interactions, we believe the most likely drivers of near-term distressed secondary deal flow are:
That said, as we have spoken with potential sellers in recent weeks, our sense is that the early liquidity stress we saw in the GFC is not evident yet. However, many LPs have been asking about the pacing of future capital calls, which would imply, at the very least, that they are prioritizing liquidity planning within their portfolios at this time.
As opposed to technical stress within an investment portfolio, i.e. ‘denominator effects’ caused by falling public valuations, we believe traditional LP sale transactions will be driven more by operating stress at institutions and corporations as this crisis unfolds. At Adams Street, we are paying attention to several critical areas of operating stress where we can help provide liquidity solutions:
While holders of private equity are feeling distress, it is also clear that many underlying portfolio companies in private equity funds are feeling the impact of the pandemic. During the financial crisis, general partner-led transactions were in their infancy and were not considered by most fund managers to resolve liquidity issues within their funds. We believe there are several reasons GP-led transactions could be an important solution for fund managers in this crisis:
Indeed, due to the volume of GP-led transactions in recent years and the corresponding growth in familiarity of GPs with the potential options available to them in the secondary market, we expect GP-led activity to be a core driver of secondary volume both in the near term (liquidity focused), and in the coming years as GPs seek to manage extended portfolio duration.
We expect GP-led activity to be a core driver of secondary volume both in the near term (liquidity focused), and in the coming years as GPs seek to manage extended portfolio duration.
Whether the reason for the market turmoil is the GFC or COVID-19, Adams Street’s approach to the secondaries market remains unchanged during such periods of dislocation. We believe investors should focus on acquiring high-quality, durable businesses across economic cycles. During the GFC, we focused on best-in-class managers, low-levered assets, less cyclical companies, and segments of the economy that we determined would be most resilient. We think that sounds like the right approach for this market, too.
The other important investment philosophy is to take a long-term view. The key is to find great companies at attractive entry valuations. That means evaluating the long-term core earnings power of a business to identify an attractive entry point given the circumstances of today’s market. Those were the types of opportunities that made sense during the GFC – and, in our view, those that secondary investors should be seeking now.
1. Source: Greenhill Secondary Market Review 2020 and Capital IQ.
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