Here are four key themes from our coverage over the last three weeks of how the covid-19 crisis is affecting the secondaries market and what could come next.
Unprecedented volatility causes market shutdown
The complete shutdown of large parts of the economy has hurt the balance sheets of many PE-backed business and brought their viability into question. The promise of massive government support has helped stabilise public markets. As general partners have flexibility in how they choose to reflect coronavirus-related impacts in their December net asset values, the true damage is only likely to become clear in June. Until valuations become grounded in the new reality, the secondaries market is likely to remain on hold.
Market braces for liquidity constrained LPs and the denominator effect
Buyers are already fielding phone calls from LPs who, while not yet liquidity constrained, are considering their options in case of a prolonged downturn. Many buyers are also expecting the denominator effect to come into play, as it did after the 2008 global financial crisis. When public markets fall in value, the relative value of illiquid asset classes such as private equity comes to represent a larger proportion of a portfolio. This throws target allocations out of whack, forcing LPs to cut back on their commitments to private equity funds or sell down their exiting exposure.
“I expect we’ll see endowments, foundations and others selling off positions in some very good funds at attractive prices,” a Europe-based buyer tells Secondaries Investor.
GP-leds face their first real test
In late March, Secondaries Investor reported how Action, the 3i-owned Dutch discount retailer at the heart of one of the biggest single-asset deals of 2019, was preparing for a possible “hunker down” scenario in which all its stores are forced to close for an extended period. The story highlighted the concentration risk inherent in GP-led deals, several of which we hear are under water as a result of the crisis.
According to one New York-based buyer who focuses on GP-led deals, it is easier to plot the path to recovery of a handful of assets than it is to steer a vast, highly diversified portfolio. We envisage an increase in the number of GPs using the secondaries market to isolate hard-hit assets from the rest of the fund, the asset-management equivalent of ‘good bank, bad bank.’
How successful secondaries buyers prove in supporting their GPs and portfolio companies will prove integral to the future success of the market.]
Preferred equity takes centre stage
If there’s one winner from this crisis, it could well be preferred equity. Pref funds that are exposed to struggling sectors benefit from a more senior pocsition in the capital structure, ensuring preferential returns over common equity holders. At the same time, investors in preferred equity funds in some cases don’t have to worry as much about the huge drops in public markets as the volatility can have a more muted impact on their returns.
Preferred equity as a structuring tool is also coming into its own. According to a London-based lawyer, the only deals getting done over the last few weeks are those that offer the buyer some kind of downside protection.
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