This article is sponsored by Landmark Partners
As we write this article, the impact of covid-19 is being felt throughout the global economy. Approximately 20.5 million Americans lost their jobs in April. As of Friday, May 8, the Russell 2000 public equities index (total return) is down 21.7 percent from its February peak, and economists widely expect that we are in a sharp global recession.
Though there is much we do not know about the future, our analyses of and experience with the past can give us helpful guidance as to the types of pressures that LPs and GPs may face in such a volatile environment and how these pressures can create opportunities in the secondaries market. We believe that the current situation can create especially compelling opportunities for structured transactions, which can provide important benefits to sellers and buyers alike and can also help to solve many of the problems created by this sort of volatility.
The denominator effect
Many of us recall the denominator effect associated with the global financial crisis. The denominator effect describes a situation in which LPs’ public market portfolios decline in value far more than reported values of their private market portfolios, leading to apparent overallocations to private markets. This can be one effect of a volatile environment with a deep market downturn and can force LPs to cut back on future commitments or sell existing ones.
There is some question as to whether the public market decline, at least as of today, has been large enough to cause a meaningful denominator effect for any large number of LPs. Additionally, some quant researchers and analysts of private markets argue that the denominator effect is largely a mirage, in that reported private market NAVs may mask more serious declines in fundamental values. However, in a market that is down sufficiently, or for investors who are sufficiently sensitive to NAVs as reported, or for investors whose portfolio construction makes them particularly sensitive to the value of their private market assets, the denominator effect can be real.
Unfortunately, just as LPs and GPs begin to feel the pressure, secondary market dynamics are likely to cause bid-ask spreads to widen. During the GFC, private market reported NAVs experienced less than half the drop of public market equivalents. In a situation like this, buyers are generally reluctant to pay much above the depressed public market levels, while sellers are generally reluctant to sell meaningfully below reported NAVs. This disconnect can present opportunities for structured transactions in which Landmark specializes, that can help to bridge these bid-ask spreads.
Many of the structures that Landmark uses are wrappers created with portfolios of LP stakes or GP interests. These structures are designed to simultaneously bridge bid-ask spreads, solve liquidity problems that LPs or GPs face, and create a compelling return profile for both parties.
Preferred structures are one example of this type of transaction. Buyers typically receive greater participation in near-term cashflows, and thereby enhance IRR and downside protection, while sellers receive greater participation in longer-term cash flows, preserving the opportunity to participate meaningfully in the upside should markets recover and assets outperform. The nominal price of a transaction becomes a less meaningful datapoint when both sides of a transaction can see how they achieve their target return goals under different forward market scenarios. Preferred structures can be applied to acquisitions of LP portfolios, but also to the financing of GP stakes in funds or even to purchase interests in GPs themselves.
“Unfortunately, just as LPs and GPs begin to feel [liquidity] pressure, secondary market dynamics are likely to cause bid-ask spreads to widen”
Joint ventures are another type of structured transaction that can be particularly compelling in volatile environments. In these transactions, the seller typically contributes existing NAV, while the buyer takes responsibility for unfunded liabilities. This type of transaction allows the seller to retain the future upside in the portfolio, while gaining immediate unfunded relief. As with structured transactions, the buyer receives a degree of downside protection and a potential IRR boost since it gains exposure to existing assets for future funding obligations. Since these transactions typically include no upfront payment to the seller, conversations focus less on where the portfolio is valued today and more on what the portfolio’s expected distributions will be in the future. Thus, these transactions can also help to bridge bid-ask spreads while giving both parties compelling return profiles. The ability to make future fund commitments can also be incorporated into the joint venture, providing an added benefit to sellers who want to preserve relationships with their core GPs.
A strip sale is a type of structured transaction that allows an LP to reduce the magnitude of its commitments to individual mangers, but to continue to maintain both its exposure to the funds and its relationships with its core managers. In these transactions, the buyer acquires a portion of an LP’s stake in a fund and assumes a portion of its unfunded obligation. Strip sales are often more attractive to sellers when commitments are younger as there is a significant amount of remaining unfunded that can be released. GPs can also use strip sales for more mature portfolios to de-risk the remaining portfolio and return capital to LPs, while still giving the GP and its LPs meaningful participation in the upside.
At Landmark Partners, much of our deal work focuses on using tools such as these transaction structures to build bespoke solutions to answer specific needs of individual LP or GP counterparties while generating attractive returns. We can mix and match tools and adjust terms, all in order to create the most compelling opportunities for our counterparties and our investors.
We think it is important to concentrate investments within alpha-producing GPs, which is why we pioneered the Direct Alpha method of measuring private market outperformance, and our quantitative research group works closely with our investment teams to identify these managers and uncover their sources of return.
Our research shows that hold periods typically extend during market downturns, and we know that GPs and their portfolio companies can face substantial challenges when economic conditions are poor. In this type of environment, it is particularly important to partner with GPs who can create value in excess of market benchmarks consistently over time and especially through difficult environments. We find that the types of structures described above can be particularly powerful tools to help us to access premium GPs, whose funds may not generally be available to secondaries buyers. We are typically not interested in buying lower quality funds, even at steep discounts. We want to invest with the highest quality GPs. Identifying them and creating structures that are useful to them and their LPs is a key part of what we do.
We are proud of our thirty-year history in the secondaries market, our track record of creating innovative structures and solutions, and our pioneering use of quantitative tools in private market investing. Volatile markets can create particularly compelling opportunities for managers who have the skills to execute on them. We aim to continue to be a leader in these areas and to position ourselves as a best-in-class GP.
The current environment may create other pressures beyond just the denominator effect
For example, certain types of LPs may have parent organizations that face meaningful cash pressures because of covid-19. If the 2020-21 academic year is delayed, universities may face declining tuition revenue and be forced to draw from endowment funds. Non-profits may similarly face declining donations.
If energy markets continue to be depressed, natural-resource-rich governments may face declining revenues and be forced to draw from sovereign wealth funds. If tax revenues are depressed, states may be forced to reduce pension contributions. If their incomes decline, high-net-worth individuals and families may also need to draw from savings.
Additionally, fund subscription lines are far more prevalent today than they were during the GFC. If a downturn is steep enough and sustained enough that GPs need to or want to call more capital than planned to repay these lines, LPs may face rising capital calls in a time of reduced distributions. Each of the scenarios described above could lead to significant liquidity pressures.
Barry M Miller is a partner in Landmark’s private equity group.
Geoffrey G Mullen, CFA, is a managing director in Landmark’s investor relations and business development group.
Avi Turetsky, PhD, is a managing director in Landmark’s quantitative research group.