F 2020. You read that right. I’m not a big fan of the song of the same title by Avenue Beat, but I agree with the sentiment.
Everyone’s lives have been upended by this invisible monster, COVID-19. Like at the snap of Thanos’ fingers, jobs, financial stability, health and safety, contact with family and friends, bicycles and people’s sanity disappeared in an instant. And, COVID-19 isn’t even the only problem: We have wildfires, civil unrest, social inequity — the sobering, troubling list goes on. The toll of the events over the last several months on some level is difficult even to quantify, never mind absorb.
But in the corner of the world in which we operate, we have endeavored to get a handle on the events that have transpired and the resulting shifts and impacts on the private markets – and on direct co-investments, specifically. Here’s a deeper look at where we stand today.
Given how turbulent the environment is, you’d expect not much to be happening in the private markets realm. That’s not necessarily the case. After a lull in March and April, deal flow has picked up, but volumes are still below last year. According to Pitchbook, private equity transactions fell nearly 20% in deal value in the first six months of 2020 from the same period a year before, and dropped 30% to 40% compared to Q2 2019.1 Looking at it from a different angle, our gauge of LP contribution activity shows that contributions have dropped off a bit, though not as precipitously as you might think. The average contribution rate (contributions/unfunded capital) has hovered around 40% over the last few years, and through Q3, we were on pace for 34%. Some of this could have been lines of credit being paid down, since we know new deal activity slowed during this period.
What started in the late-March/early-April period as defensive follow-on investments to address portfolio company liquidity needs and some opportunistic investments here and there, have now moved to platform deals or offensive follow-ons for add-on acquisitions. GPs have worked around logistical diligence issues by concentrating on companies they know well, and are now doing more in-person diligence.
We have still not seen many valuations come down as a whole, but private markets investors are busy. To date, the deal pipeline has been filled with the best-performing companies. GPs have been pursuing companies and management teams that are well known and were probably diligenced on some level pre-COVID. We are probably closer to the end of the pipeline of well-known, high-performing companies than the beginning. We are seeing the new post-COVID processes starting to be launched, with GPs becoming more active with diligencing. Starting in July and August, many began conducting more in-person meetings either by their deal teams or through third-party advisors. This was more prevalent in Asia and Europe than in North America, but there were examples everywhere – a lot more growth-oriented deals in the mix vis-à-vis buyout, but very little distress.
Activity has been high for direct co-investments as well. Some LPs have slowed their aggressive pre-COVID pace, leaving more allocation and opportunities for scale investors. The importance of strategic relationships between LPs and GPs has grown, and with valuations of strong-performing companies still at pre-COVID levels, the need for capital to complete deals is high. Plus, co-investors are being asked to put up their fair share to support struggling portfolio companies.
So, what’s next? Here are the 10 questions I’m pondering...
1. Another COVID Resurgence? This fall will be a little more interesting with COVID-19 and the flu. We are seeing cases tick back up, which can be partly attributed to more testing, but the rise in case levels in many areas around the world (and the announcement of more restrictive measures in the UK, continental Europe, Israel and elsewhere) has heightened concern. Thankfully, the medical community has learned a lot about treating patients with COVID-19, which is helpful in leading to better outcomes.
2. Forced Selling? Beyond the most troubled sectors, there has not been much forced selling, and therefore, very few bargains. Unlike during the GFC, there was no liquidity freeze and most companies had access to capital through credit facilities or follow-on investments from current stakeholders. The longer we go without a vaccine, the larger the universe of companies that can potentially become vulnerable to underperformance and subsequent liquidity issues. If forced sellers become more prevalent, buyers are armed and ready with large amounts of committed capital at their disposal. According to our records, total dry powder has been hovering right around $2 trillion since 2018, with buyout dry powder comprising around $800 billion, and VC/Growth dry powder slowing its upward trend at about $387 billion. Credit and natural resources are two places where dry powder is declining.2
Private Markets Unfunded Capital
USD in Billions
3. Valuations…? This is a situation related to forced sellers. Given that only the companies that have not been impacted by the virus are transacting, valuations of consummated deals are largely at pre-COVID levels. Many companies that would like to sell – but are not operating in the industries du jour or have shown some temporary softness in their financial performance – are left on the sidelines because they do not want to accept lower prices, and thus a logjam is developing. Will this continue? Will they be patient enough to wait until their prices are met?
4. Will LPs keep up the pace? LPs, like all investors, have learned lessons from past down cycles. They’ve learned that consistent investment pacing is important, and that dislocations often present good buying opportunities. We’ve seen more of a commitment to maintaining investment pacing for primary investments versus co-investments, which benefits large-scale CI players as more allocation is available.
5. Growth. Do all trees grow to the sky? I realize this is my second mention of a tree-related theme and no, I do not have an infatuation with trees. Growth has dominated the headlines and investment performance for the past 13 years pre-COVID, and that theme has not abated these last several months. Many companies with business models poised for growth in any economic environment are doing well now, and the lack of leverage gives more operational flexibility during difficult times. Value has all but been forgotten. Things cycle, but when?
6. Accelerate adoption – but will it last? COVID-19 has forced adoption of certain technologies and practices in order to facilitate business operations in a remote work environment, by helping employees adhere to social distancing and continue operations with a reduced staff, or maintain critical practices. Collaboration software, TMT, online shopping, automation, telehealth, etc. are all having a moment. As we look at different investment opportunities, we’re focused on understanding which trends will persist and which may only be benefiting from a temporary COVID bump.
7. Is the U.S. Presidential Election over yet?
- Hot Mess
- Dumpster Fire
- Train Wreck
- Sh*t Show
No, these aren’t names to describe your [ex-boss/lousy neighbors/former significant other]. These were actual descriptions of the first presidential debate that took place at the end of September. If people weren’t paying attention before, it would be hard to believe they aren’t tuned in now. In addition to worries about specific policies for either candidate, there is a growing concern about instability – which is typically unwelcome and disruptive to the markets. Over the long haul, though, investors have been able to digest different parties, and policy changes (for better or for worse), and move on, but it could be a little rocky in the interim. With the cancelling of the second debate, though, we will be spared of a repeat performance. We were, however, treated to competing town halls, on two different networks, aired at the same time, that could not have been more different in tone. I’m trying to reduce my usage of the word “unprecedented,” otherwise I would use it here – I guess I just did.
8. Who are the winners and losers? Is a “changing of the guard” occurring? There’s been tremendous bifurcation during this pandemic. In many ways it has exacerbated the inequities that already existed and created a larger gap between the haves and have-nots across many aspects of daily life. Focusing on private markets specifically, our Fund Investment Team does a tremendous job of staying on top of what’s going on at more than 1,000 GPs across the private markets, and they are noticing strong performance from some upstarts versus some of the more established and well-known firms. Is this a real changing of the guard? Many of the upstarts are experienced from the GFC, but are not chained to old school playbooks. Will their outperformance continue, or is this a temporary blip?
9. What will this mash-up of fiscal policy, monetary policy, interest rates and inflation create? Everyone, including the Fed, is hoping for a strong fiscal stimulus package to help those in need, but that appears unlikely before the election. What else can the Fed do to instill confidence in the markets? Looks like they are willing to keep rates low for as long as possible. When will we see more broad-based inflation?
10. Will I ever be able to keep the days of the week straight again? I hope so. If time is an illusion, then days and weeks and so on are just a social construct – so I guess it may not matter, anyway.
So what’s the purpose of all this? It’s important to maintain a list of what could potentially impact your investment activities and portfolio. Right now there’s a lot going on and a lot of volatility. So much has happened in the short few weeks of writing this white paper: The Dow Jones dropped by 5% and then increased by 6%; the President and a number of his aids, staffers and fellow party members contracted COVID-19, causing concern and reminding everyone how transmissible this virus is; the second Presidential debate, after much back and forth between the parties, was canceled; and fears continue to rise about a COVID resurgence. Should I keep going?
This will continue, but so will progress in how we treat this disease (which has improved a great deal already), and so will advancement toward a vaccine, and so will people finding ways to adapt their everyday lives and business activities until we come out of this. The private markets will continue to progress forward as well, and that’s a good thing. As we review opportunities, we must assess the short- and long-term risks and weigh them against the potential rewards – so while the variables may have shifted greatly, our goals have not.
2Hamilton Lane Data