As the second quarter of 2020 progresses, LPs have a multi-billion dollar question on their hands: How will all of the chaos that cascaded across the public markets in the first quarter affect their private equity asset valuations – and, by extension, the future of their overall private equity programs?
LPs, especially public pensions, usually have a specific range in which they must keep their private equity allocations. While the values of liquid public equities will rise and fall with the ebb and flow of the markets, private assets are different, increasing or decreasing in value on a lag.
Should public equities shrink suddenly due to a market shock, private asset classes can suddenly begin to take up more space in an LP’s portfolio than allowed by policy. This tension, the “denominator effect,” can play a critical role in how much an LP ends up actually committing on the market.
Should an LP’s private equity portfolio be severely overgrown as a result of the denominator effect, they may be faced with the unpleasant option of selling some private equity interests on the secondaries market at a loss.
Julien Gervaz, chief executive officer of Palico, an online marketplace for secondaries sales, says the 2020 secondaries market will face steeper discounts due to the first quarter’s market dislocation. What would have sold for 95 percent of its market value a year ago or 102 percent in February will now sell around 90 percent, he estimates. But how much a particular private equity interest drops will depend on the industry or industries in which the fund is investing.
“It’s not an across-the-board drop,” Gervaz says. “It’s a very sector-driven drop.”
Still, overall, Gervaz says LPs will need to expect a secondaries sale going forward to be less lucrative than before the dislocation.
“There’s not going to be so much froth anymore,” he says.
Wait and see
While some LPs are facing overgrown private equity allocations, that does not mean they must immediately make substantive changes to their portfolios. The lag in private equity valuations can actually work to their advantage.
“The private market allocation is going to come down as well,” says Todd Silverman, a principal and private markets consultant at Meketa Investment Group, which advises many top US-based LPs. “For those who can still afford the illiquidity, who have policy ranges that are wide enough to withstand short-term volatility in respect to exposure, all else equally, we are recommending that people stay the course for the most part.”
Indeed, the needed modifications for most LPs seem to involve, if anything, simply adjusting pacing and commitment volume for the coming year as opposed to selling off assets.
Tom Lopez, chief investment officer of Los Angeles Fire and Police Pension System, tells Buyouts he expects to see not only the denominator effect but also distributions from general partners to dry up. That may change the pension’s plans for the rest of 2020 and beyond.
“We were projecting $550 million to $650 million in terms of new commitments, but that might not happen,” Lopez says. “When the next fiscal year rolls around, we might be saying, ‘Okay, well, we’re over our private equity [allocation], so instead of investing $500 million, we invest $350 million or $400 million.”
Silverman says those sorts of adjustments are happening with a lot of LPs.
“We’ve been anticipating and are in the process of making pretty modest adjustments to commitment pacing budgets, but we are trying to model in…some amount of expected decline in private market valuations based on how private markets behaved in the first quarter,” he says. “But for most of our client programs, most of what we’re recommending is not drastic changes.”
LPs have a couple of different options for how to make those adjustments, according to another LP source. First, the LP could lessen its overall number of commitments for the year and drop its lower-rated managers in return for making its full planned commitments to higher-rated managers. But another option would be to spread the decline in commitment capital across all its managers on a pro rata basis. The LP source expects most LPs to choose the first option.
Silverman says it all has to do with where an LP’s portfolio allocation sat before the market dislocation.
“A program that was relatively less mature and below target…has more room to stay the course in terms of commitments pacing than, arguably, a program that was at or even above target before any denominator impact,” he says.
Cash is king
Many LPs have found ways to make sure they have plenty of cash on hand not only to mitigate the denominator effect and keep up with capital commitments, but also to explore opportunities.
California Public Employees’ Retirement System CIO Yu (Ben) Meng told his board that staff had created greater liquidity in the portfolio over the last year or two to mitigate the market volatility. Los Angeles City Employees’ Retirement System got approval from its board to temporarily hike the amount it can keep in its unallocated cash account to cover expenses. Lopez says LAFPP purposely kept about $1.3 billion in cash on hand, enough to cover a year’s worth of pension rolls.
GPs also appear eager to work with their LPs to make sure they are not hit too hard. One unidentified GP even told an LP source that he would try not to make capital calls for six months. California State Teachers’ Retirement System CIO Christopher Ailman recently told Bloomberg that he had not received many capital calls, and that his GPs had been depending on lines of credit for cash for the time being. Ailman also said CalSTRS planned to be pro-active with its own cash on hand, with a special focus on co-investments.
“Liquidity is important and we will make all opportunities compete for that capital,” Ailman said. “We will look at all opportunities equally.”
CalSTRS is not alone. Family offices in the US are also on the lookout for the opportunity to take equity stakes in temporarily struggling companies. Canada’s Caisse de dépôt et placement du Québec recently launched a C$4 billion ($2.8 billion; €2.6 billion) fund to help distressed companies in its home province.
In the meantime, LPs must be careful to make sure the private equity valuations they are receiving are accurate. That means a great deal of communication with GPs throughout the second quarter.
“One of the challenges we face is that there is still a fair amount of subjectivity that can be applied to the valuation process,” Silverman says. “The other challenge would be more the uncertainty and the unknowns in terms of how deep and long the impacts will persist.”
Investment advisor Duff & Phelps stresses the need for LPs to make sure they understand not only what policy a manager is using to value its assets, but how it is using it – and that there will be more due diligence than ever required in the second quarter.
“This is a great time to set up a dialogue with your GPs. They’re going to be busy, but to the extent you can get input from them, that’s certainly going to be helpful in your process,” says director Sumner Estes. “There’s certainly going to be more work involved on the LPs’ parts just making sure that they’re comfortable with the [net asset values] that they’re reporting.”
“The LP needs to know what’s going on at the GP from the start,” says Duff & Phelps managing director Steven Nebb. “They ultimately need to think about what their decision-makers need. They need accurate fair value to make appropriate fiduciary reporting and decision-making. So that’s the goal here.”
When surveyed, most participants in a recent Duff & Phelps webinar believed that come the end of 2020’s fourth quarter, private equity valuations would be higher than the close of the second quarter, but still less than the end of 2019.
That means that even while there may be a drop in valuations, and some attendant adjustments, LPs and GPs may be able to get back to business sooner than they think.