Private Equity: The Weight of the COVID-19

Crown

Massimiliano Saccone, CFA

Private equity (PE) often claims the financial crown of outperformance. But I am
referring to that other, now infamous, Latin word for crown — corona — the shape of
which lends its name to the current coronavirus pandemic. So how will it affect PE?

Introduction
PE investing is about absolute return, not outperformance, in my experience. Survey results
referenced by Paul Gompers, Steven N. Kaplan, and Vladimir Mukharlyamov back this up.
The three observe, with some surprise:

“PE investors believe that their LPs [limited partners] are most focused on absolute
performance rather than relative performance or alphas. . . . Such investments carry
significant equity risk, suggesting that equity-based benchmarks like public market
equivalents (PMEs) are appropriate.”

I would rephrase that to “should be appropriate.”

The Beta Court

So my focus is absolute return, not the legitimacy or lack thereof of PE’s outperformance
crown. The PE industry consistently does a good job. Indeed, the PE risk premium has
stochastic characteristics. PE investors do not pursue outperformance objectives.

Does that mean PE is decorrelated from equity risk and immune to market volatility?

Not at all. The scarcity of valuation data points, due to the quarterly release of net asset
values (NAVs), does not indicate the absence of volatility. Volatility and correlation are just
non-observable — so any eventual smoothing effect in the LPs’ accounts is completely
artificial. That it is not easily observed doesn’t mean it cannot be estimated.

But when it comes to correlation and valuation, from a pure practitioner’s perspective, what
happens to PE valuations when public equity markets collapse by close to 30% as they have
over the last several weeks?

In the years since the global financial crisis (GFC), the public markets have enjoyed a fairly
uninterrupted bull run, especially in the United States, which still represents the dominant
PE market. There have been hiccups potentially as significant as the current one, but
they’ve been short-lived. A similar, more slow-moving decline occurred in the third quarter
of 2018, but the market bounced back in the fourth quarter. The current downturn is
reminiscent of Black Monday 1987 and the US equity markets took over two years to
recover from that bear market as well as those of 2000 and 2006.

The latest fall of the prices due to the COVID-19 virus reminds of the 1987’s
 black Monday. It took the US equity market over two years to recover from the
bear market of 1987, 2000 and 2006. (Chart source: Yahoo! Finance)
pic.twitter.com/42mi0xDUPY

— XTAL Strategies (@XTALStrategies) March 31, 2020

The Weight of the Crown

So how will PE fare in this downturn?

Mark-to-market rules could take their toll on the asset class for the first time since the GFC.
Mark-to-market has rarely dented the profits and losses of investors. The reporting delays
associated with NAVs often exceed three months and have cushioned the blow from market
valuation drops. Quick bouncebacks have thus far shielded PE NAVs from these declines.
Why? Because typically, at the end of March, for example, the available PE NAV may refer
to the end of the third quarter of the prior year: 30 September 2019. Or the just-released
year-end 2019. A significant decline in the PE markets followed by a fast rebound the next
quarter has no effect on the to-be-released fair value statement. Not on the end of
December NAV or the subsequent March NAV.

The quick hiccups of the public equity markets over the last 10 years have had
almost no impact on secondary private equity prices, especially on buyouts.
(Chart source: Multiplicity Partners) pic.twitter.com/KaBegHowsa

— XTAL Strategies (@XTALStrategies) March 31, 2020

The preceding chart shows secondary prices have been largely unaffected as well. Post-
GFC, they have been reasonably stable for buyouts, in particular. Will this hold up under
the weight of the coronavirus crisis and the accompanying threat of severe global recession?

The Potential Beta Legacy of the Coronavirus on PE

An estimate of the theoretical impact of a public equity bear market on PE valuations can
be derived from Yardeni Research data.

Given the reported (assumed net) debt-to-equity ratio of 0.86 for the S&P 500, hence a
debt/EV ratio at 46%, against the equivalent ratio for the buyout industry of 63% on
average, a 20% contraction in the EV/EBITDA ratio would correspond to an equity shock of
approximately -37% = [-20%/(100%-46%)] and a -54% = [-20%/(100%-63%)] impact on
PE NAVs.*

The share prices of listed general partners (GPs), among them Blackstone Group, KKR, and
Apollo Global Management, are readily available and offer an easy litmus test. In the
current turmoil, their share prices, the balance sheets of which include the NAVs of the
funds they manage, have moved more dramatically than the S&P 500.

Could the price sensitivity of the largest listed private equity managers be a
litmus test? Hint: handle conclusions with care. (Chart source: Yahoo! Finance)
pic.twitter.com/TyD3FWrF6H

— XTAL Strategies (@XTALStrategies) March 31, 2020

So what if prices and implied valuations don’t quickly rebound? What if the real economy is
unrecognizable after the coronavirus epidemic?

Coronavirus’s Negative Effect on PE

There are a few potential consequences that investors should consider:

1. Implications on Fair Value: The first thought goes to the December 2019 NAVs.
How will the discounted present value of the future cash flows incorporate the new
market information? Could the secondary prices embed much higher discounts than
those shown in the buyout fund chart? Would the discount disappear when March
2020 NAVs come out?
2. Complications of the Possible Denominator Effect: In a multi-asset portfolio,
allocations come with boundaries, and a decline in the public markets (the
denominator) would make the relative weighting to PE (the numerator) exceed its
limits. This could artificially and maybe temporarily force LPs to rebalance their
portfolios by selling fund positions in the secondary market, at price and probably in
 very unfavorable conditions.
3. The Contributions-to-Distributions Ratio: During growth periods, this ratio is
usually positive, which implies that the cash produced is more than the cash invested.
During down market periods, normally characterized by less liquidity, the ratio
becomes negative, so more cash than is produced is absorbed by PE. This can add
liquidity tension to the portfolio.
4. Latent Lending Loan-to-Value Triggers: Most secondary transactions have
lending facilities that support the acquisition of the PE interest and the provision of
liquidity to the seller. The buyer normally uses lines of credit that are collateralized by
the assets purchased with a loan-to-value protection, A financing of 50, for example,
is collateralized by a NAV of 100. If the NAV suffers from devaluation, lenders might
request additional collateral or repayment. Even with diversified portfolios, a
significant slump in market valuations is exacerbated since portfolios absorb more
cash than they produce, thus increasing the risk of defaults.

The Positives

Of course, with challenges come opportunities:

1. Dry Powder Becomes More Precious. That GPs have not put their committed
capital to work — because deals were too scarce or expensive — becomes their
competitive advantage. Cash on hand during times of crisis has its benefits and is a
reasonable predictor of attractive returns.
2. There Is More Alpha to Extract. By combining the absolute return properties of
PE with innovative risk transfer tools, investors can manage PE’s beta legacy and risk-
premium stochasticity.

* This text has been corrected. An earlier draft mistakenly laid out the formula as
debt/EBITDA rather than debt/EV and listed the two 100%s as 1%s.

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All posts are the opinion of the author. As such, they should not be construed as
investment advice, nor do the opinions expressed necessarily reflect the views of CFA
Institute or the author’s employer.

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Massimiliano Saccone, CFA

Massimiliano Saccone, CFA, is the founder and CEO of XTAL Strategies, a fintech SME
developing a platform of innovative private market indices and risk-transfer solutions. He
developed and patented a private equity performance valuation methodology, is a former
member of the GIPS Alternative Strategies Working Group at CFA Institute and the author
of a Guide on Alternative Investments for CFA Society Italy. Saccone has pioneering
experience in the field of the retailization of alternatives at AIG Investments (now
Pinebridge), a global alternative investment manager, where he was a managing director
and global head of multi-alternatives strategies and, beforehand, regional head of Southern
Europe. Prior to that, he was head of institutional portfolio management at Deutsche Asset
Management Italy (now DWS). He is a CFA charterholder and a qualified accountant and
auditor in Italy, has a master's in international finance from the Collegio Borromeo and the
University of Pavia and a cum laude degree in economics from the University La Sapienza
of Rome. He is also a Lieutenant of the Reserve of the Guardia di Finanza, the Italian
financial law enforcement agency.