Winners and losers from a decade of recovery

Secondaries firms are among those who benefited from 10 years of post-crisis growth.

The 10 years since the collapse of Lehman Brothers have seen private markets grow from an industry of around $2 trillion in assets under management to more than $5 trillion, according to McKinsey. Here is a rundown of who won and lost.

Private credit
It’s little remembered now, but before the global financial crisis, private credit was already a thriving asset class. In 2008, the year the world’s foundations were shaken, it raised $125 billion globally – a figure that was not beaten until 2013. Since then, it has gone from strength to strength, raising a record $208 billion last year.

Perhaps the biggest winner in the aftermath of the crisis, in a private credit context, has been direct lending. The banks, constrained by increased regulation and by damage to their balance sheets, have not been able to provide lending on the same scale that they did in the pre-2008 days. This has created a gap which non-banks have quickly moved into, with senior debt (previously the bedrock of bank lending) rising from a mere $4 billion of fundraising by private funds in 2009 to $64 billion last year.

Big firms
Big firms are getting bigger – and taking a larger and larger share of the industry. In 2017, funds above $5 billion accounted for 42 percent of total fundraising. The average fund size so far in 2018 has hit $726.5 million. The top 10 firms in the 2018 PEI 300 – which ranks firms based on the amount they have raised in the preceding five years – accounted for 26.5 percent of the total capital raised, up from 23.8 percent in 2017 and 22.9 percent in 2016.

One thing that has played to these firms’ advantage is the swathe of regulation – and the associated costs – introduced in the wake of the global financial crisis.

For example, since chief legal officer John Finley arrived at Blackstone in 2010, the firm has more than doubled the size of its legal and compliance team. “That investment can be burdensome for the smaller firms and is a way of setting apart competitively the bigger firms,” Finley told Private Equity International earlier this year. “That investment can also be attractive for LPs in terms of a comfort level with the size and scale of our compliance effort.”

Compliance professionals
“Arguably this is the 10-year anniversary of the beginning of the largest shift in regulation of the US financial institutions since the Great Depression,” Kelly Riera, director of compliance at Boston-headquartered TA Associates, told PEI at the start of the year. In the US, the introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act – a reaction to the GFC – meant private funds had to register with the Securities and Exchange Commission. “If you didn’t hire a staff, you had to at least hire consultants that could help you figure out the rules and implement the regulations,” added Riera. In Europe, the introduction of the Alternative Investment Fund Managers Directive has had a similar effect. “Fund formation expenses are higher than they were before, as a result of increased regulation. Legal bills to form a fund before AIFMD [when US managers marketed a Cayman fund in Europe versus an AIFMD passport structure] are suddenly way more, and that is being borne by investors,” Jason Ment, StepStone general counsel and chief compliance officer, told PEI in February.

Secondaries firms
The secondaries market did not fare well in the immediate aftermath of the crisis. Annual deal volume halved to $10 billion in 2009, according to data from Greenhill, largely due to a mismatch in pricing expectations between buyers and sellers. When the dust settled around 2010, secondaries buyers capitalised. Sales from banks, which sought to exit non-core activities and stay ahead of regulations, such as the Volcker Rule and Basel III, created buying opportunities.

The recovery in public markets also boosted the performance of secondaries funds and gave them the track record to grow in size and number. Annual deal volume is now around $58 billion – almost six times that of 2009 – and the market continues to expand.The unwinding of the banks’ holdings in PE and certain other forced sellers led to great investment opportunities and ultimately high returns for secondaries funds, says Andrew Sealey, managing partner and chief executive at Campbell Lutyens. “This performance has contributed to their ability to grow and raise more capital.”

Investment banks
While secondaries buyers made hay, on the other side of those transactions were the investment banks. Dodd-Frank was signed into law in 2010 – and with it the Volcker Rule that prohibited certain activities for banks. Many of the big banks began offloading their private equity assets in anticipation, spinning out or selling their in-house direct investment arms. We have Volcker in part to thank for One Equity Partners (JPMorgan), Equistone Partners Europe (Barclays) and Graycliff Partners (HSBC).
In 2014, divestments by banks accounted for a quarter of secondaries deal volume, according to Setter Capital. If being a manager of private equity assets has been a winner’s game in the last 10 years – and it has – many investment banks have lost out.

Investors in zombie funds
There have always been ‘zombies’ – badly-performing funds that stretch beyond their agreed life with only tough-to-shift assets left, managed by GPs with no hope of raising again. The financial crisis just magnified the problem. According to Coller Capital data, 2008-vintage funds hold more unrealised net asset values than those from any other year going back to 1999 – around $220 billion-worth. For limited partners, zombies are a major headache. There’s no more upside left, yet the general partner continues to eke out a stream of fees.

The increasingly sophisticated secondaries market, while hardly a cure-all, has given LPs options. Tail-end specialists, such as Hollyport Capital, can extract value from assets that LPs are only too happy to get off their books. LPs have also become increasingly savvy sellers, throwing newer vintage funds into portfolios of tail-ends to sweeten the deal for secondaries buyers. While investors in zombie funds are certainly not winners, the feeling of loss is less profound than it was.

Distressed investors
Distressed investors – who likely view one of the longest economic expansions post-World War II with a dimmer view than most – have been fighting over relatively few corporate remains.

The current boom has seen distress in concentrated sectors, but no large-scale opportunities. Oil and gas companies saw a rout worse than the global financial crisis, and the ‘Amazon effect’ has presented plenty of opportunities in retail, but outside those main broad themes, there has not been any sustained period of economic distress.

On the distressed credit side, Hedge Fund Research’s HFRI Event Driven: Distressed/Restructuring Index shows a three-year return of 6.86 percent and a five-year return of 3.6 percent. While almost 7 percent might be better than fixed income, it hardly meets the equity-like returns distressed debt investors target.

Limited partners

Has private equity been a worthwhile asset class for limited partners since the financial crisis? The rather unsatisfying answer seems to be “it depends how you look at it”.

The almost 10-year bull run in the public markets has made for an unfavourable comparison with private equity. Data analysed by hedge fund Verdad Advisers show that over the past five years, the S&P 500 has outperformed most major asset classes – including private equity.

If the global financial crisis has taught us anything, it’s that the stock market can bust just as well as it can boom. Let’s not forget almost $7 trillion in shareholder wealth  in the US was wiped out in 2008. This is where private equity, and other illiquid asset classes, can come in, acting as a valuable diversifier when times get tough. Has private equity been worth it for LPs since the crisis? It is, as yet, unknown.But over a 25-year period, private equity has outperformed the S&P 500 by 300 basis points. What’s more, research from investment advisory firm Cliffwater shows that over the 10-year period to 30 June 2017, private equity provided state pensions with the highest asset class returns, at a 9.19 percent average return.