In the last eight years, investors have ploughed considerable sums of money into private markets, in particular in Private Equity ("PE"), where assets, in terms of fundraising globally, have surged from a low of $178.3billion in 2010 to $591.8billion in 20181; in terms of assets under management, the PE market has doubled over the same period reaching $4.2 trillion in 20181. PE has risen in popularity with institutional investors, who appear unfettered by the inherent liquidity risks of a strategy where it can take in excess of ten years to make and realise investments; in fact, many institutional investors like the long-term nature of the asset class.
However, the number of good deals available at any given time is finite and, therefore, an increase in the capital available tends to drive up valuations and reduce returns, as has been observed in recent years. This, coupled with market perception that we are nearing the end of the cycle, means that any PE fund being raised now or any which is early through its investment period, will likely be subjected to the next economic downturn, posing both a threat and an opportunity. As such, there are some areas where we have observed a change in approach or shift in focus by General Partners (GPs) and therefore there are a number of considerations that investors or Limited Partners (LPs) need to pay greater attention to, in order to ensure they are prepared to navigate a substantially less favourable market environment.
How are GPs preparing?
Despite record levels of dry powder, whereby a peak of $1.4trillion was reached in 2018 (after almost doubling from 2010 and has already been surpassed in 20191), many GPs are returning to market to raise successor funds earlier than initially expected. This is driven by a wish to take advantage of the buoyant fundraising market, as well as in anticipation of a less favourable climate on the horizon; GPs fear they may struggle to raise their next fund once hit by an economic downturn. As deals continue to increase in size, GPs are generally also seeking to raise much larger amounts of capital, with fund size targets often increasing by considerable amounts compared to the previous vintages. Indeed, in Q1 2019 the average fund size across PE funds of all kinds in the US alone increased by around 70% compared to the whole of 20182, although this figure is undoubtedly amplified by a handful of so-called "mega-funds3" launched by more established GPs, particularly in the mega-buyout space.
At this point in the cycle, it is important that GPs are able to demonstrate how they are finding value in a market which is overstretched and overvalued, to instil LPs with confidence in their ability to produce strong returns in a more challenging climate. This is particularly important when considering investments with newer GPs who have yet to invest through a crisis. During our recent due diligence efforts, we have observed GPs preparing and making adjustments to their strategy/approach in several ways, including the areas of the market in which they source target companies and the way that they negotiate their deals, as detailed below:
Focus on defensive sectors
When posed with the question of what they are doing to position their investment strategies for the end of the cycle, we have heard numerous GPs highlighting the importance of targeting non-cyclical or defensive industries in an effort to "recession-proof" their portfolios. Sectors such as healthcare and technology, which have incidentally offered some of the strongest returns in recent years (specialist healthcare and technology funds in the US delivered multiples of invested capital of 2.7x and 2.4x and IRRs of 34.4% and 23%, respectively, on investments initiated between 2001 and 20144), have become increasingly popular; this has led to the launch of many new dedicated strategies by both new entrants and existing generalists looking to specialise. Indeed, the proportion of buyout managers targeting the healthcare and technology sectors increased by 11% and 20%, respectively, between 2014 and 20185. The trend towards specialism is a growing theme more generally, resulting from the increasingly competitive landscape in which it has become ever more necessary to be able to demonstrate strong differentiation and expertise versus peers in order to secure deals.
Looking at healthcare specifically: in 2018, global deal value reached record levels, increasing by approximately 50% compared to 2017, whilst deal volume increased by around 19%6. In Europe, the sector is also on track to record its highest full-year percentage as a share of overall exit count, currently standing at 8.9%7. Within the healthcare industry, top performing sub-sectors globally include healthcare technology and biopharma, which have led to an emergence of even more niche strategies, such as medical technology and/or biotechnology focused funds, as well as an increase in deal flow within these sub-sectors; for example, in 2018 PE deals involving medical devices increased by approximately 40.5% compared to the previous year, standing at a total value of $11.6billion8. On a global basis, healthcare companies with a strong technology component are now valued at an average of 17.1 times earnings, with some specific healthcare technology companies being exited at between 23X and 25X EBITDA9. These are impressive multiples compared to an industry average of approximately 15X9.
Negotiation of deal terms
GPs are also seeking to protect themselves against a downturn by becoming stricter in the deal terms they negotiate with their investee companies. Terms they seek to negotiate for downside protection include but are not limited to:
Drag and tag rights: These are provisions which either enable a majority shareholder to force minority shareholders to join in the sale of a company or enable a minority shareholder to join in the sale of a company initiated by a majority shareholder, respectively. Having such rights can provide a GP with more of a say over how an investee company is exited, which will be vital if realisation opportunities arise when valuations are depressed during a downturn.
Liquidity preference: These terms define the division of proceeds upon liquidation of an investee company and could be critical during a climate where liquidations become more common.
Stronger board participation rights or representation: This allows a GP to have better oversight of a portfolio company's business, thereby enabling it to set stricter performance targets and milestones for the management team to meet. This provides recession-experienced GPs with the opportunity to provide a company with greater guidance or the ability to identify potential weaknesses more quickly.
Rights of first refusal provisions: These give existing shareholders rights to control the entry of new shareholders or force investors seeking to sell their positions to offer them to minority investors holding such rights first. This again provides greater control over exit strategies.
One point to note is that GP sponsors have been taking advantage of the availability of cheap credit in the last few years to leverage their deals and been able to negotiate covenant-lite and even covenant-zero debt terms (that is looser credit terms), to finance their investments. Indeed, covenant-lite loans represented an estimated 80% of deals in the over $1 trillion US leveraged loan market in 201810.
When considering new PE allocations, LPs should ensure that their GPs are skilled negotiators who seek to secure strong ownership rights from their portfolio companies. This can be established during thorough investment and operational due diligence of a manager.
What we believe LPs should be thinking about
In addition to the above observations, as almost 90% of institutional investors continue to allocate to PE11, we believe there are additional considerations for LPs to include in their PE due diligence process, as detailed below. Where there are broader liquidity or portfolio construction concerns, investors should also consider potentially reviewing their strategic asset allocation (SAA).
Valuations and exit – "Longer and lower"
Typically, PE managers value their portfolio companies using the "fair value" accounting approach, whereby the objective is to estimate the price at which a transaction would take place between willing market participants at the measurement date12. It is usually estimated with reference to valuation multiples for comparable public equities, which are commonly marked-to-market, or rather valued at their current market value, often taken to be the latest closing price. Therefore, a decline in public market valuations has repercussions for valuations in the private market. In an economic downturn, less favourable exit conditions and valuations may encourage GPs to hold on to assets longer to allow them more time to add significant value or wait for the market to rebound before seeking exit opportunities. This preference has led to a rise in the number of GPs raising funds with fund terms far in excess of the typical ten years13. Indeed, in recent years large well-known managers have launched vehicles with terms which allow them to hold portfolio companies for over 15 years14. This means that LPs will need to become comfortable with the likelihood that their capital may well be tied-up for far longer than in prior fund vintages or longer than a given fund's originally defined term, as possible extensions are more likely to be exercised. This could have repercussions for an investor's long-term allocation plans and, as such, we'd suggest a potential rethink of their SAA.
Furthermore, valuations are currently at record high levels as mentioned previously, with 79% of investors confirming that asset valuations are a growing concern11. During a downturn, GPs will be unable to continue to rely on multiple arbitrage (whereby the value of a company increases due to improving market multiples without any operational improvement) as a source of return as they have been able to in the preceding bull market. As mentioned above, this is because the estimated valuations of portfolio companies, are likely to be disappointing compared to the inflated highs we are currently experiencing as well as subject to greater volatility. Thus, average exit multiples in the private sector are also likely to decline in response to a bear market. These two topics combined could lead to a future where PE terms are longer and returns are lower.
Liquidity in a downturn
In a downturn, various factors that impact a portfolio will likely be subject to significant change and volatility, and thus understanding the sensitivity of a portfolio to these factors enables investors to take steps towards reducing the potential for adverse impacts. Scenario and stress analyses are simulation techniques used to evaluate the resilience of a portfolio under defined scenarios or in response to changes in specific factors, respectively. Given the current point in the market cycle, it is even more important now, after a sustained period of benign market conditions, that investors consider subjecting their portfolios to a broader, more pessimistic set of stress and scenario tests in order to analyse their ability to withstand significant market corrections in the future.
Although the secondaries market has evolved dramatically over the last decade, with the rise of dedicated secondaries managers/funds and a diversification in terms of the type and complexity of secondary deals, any sales of LP positions during a market downturn could nonetheless be subject to heavy discounts. Furthermore, in the event that a stock market decline weighs heavily on an LP's public market allocations, there is a possibility they will find themselves in breach of their investment guidelines and/or SAA at least in the short and/or medium term. This can pose a particularly significant risk for institutional investors, who often have strict limits on their maximum allocations to alternative assets, which could easily be breached if their traditional public investments, which are typically more volatile given their frequent mark-to-market valuations (versus typically quarterly valuations for private markets), decline considerably. Moreover, for pension funds in particular, the additional challenges related to low interest rates and maturing schemes closed to new members, means that many are already cash flow negative, i.e. needing to sell assets to fund outgoings. Some institutional investors could therefore become "forced sellers," leaving them in a difficult negotiating position in a more hostile secondaries market.
Extended Operational Due Diligence
As the old saying goes "when the tide goes out..." and if we are indeed heading into a more difficult economic environment, it is likely that there will be more pressure on GPs and their organisations. Thus, LPs should consider running a more thorough due diligence process covering a GP's operations. Operational risk15 is the risk of loss resulting from inadequate or failed internal processes, people and systems supporting the organisation or from external events16. Although transparency in the industry is generally improving, even today many funds offer limited transparency to investors, and as such, it is far more difficult to ascertain the level of operational risk present. This in turn means that the chances of operational risks occurring are typically higher than in other asset classes where regulation or investor demand has resulted in more robust operational infrastructure. An example of the potential impact of limited transparency is the ability of GPs to inflate valuations to hide significant potential write-downs within the portfolio and give the illusion of strong or stable performance. In our prior publication "Key Risks in Private Equity From an LPs Perspective16," we highlighted the importance of thorough operational due diligence, particularly regarding valuation policy, transparency and legal terms.
Investors are accustomed to accounting for PE as a long-term asset class within their SAA. We have tried to highlight some of the concerns that we believe should be at the forefront of investors' minds as the end of cycle approaches. Planning and navigating through the next recession may be more complex than for previous recessions, as the popularity of the strategy has led to more competition for deals, elevated valuations, potential over-specialisation of managers, and an increase in fund sizes. Thus, the need for thorough due diligence is now even more prevalent. Investors need to consider a multitude of factors in their assessment of both the PE funds and the GPs, such as change of control terms and flexibility of the investment strategy in a rapidly changing environment. Furthermore, as liquidity becomes less certain in the already illiquid PE market, we believe that LPs should also consider additional stress and scenario testing, and if in doubt, a full review of their SAA could be key to successfully navigating PE through the next recession.
1. Source: Preqin.
2. Source: PitchBook, News & Analysis, "The average PE fund size is skyrocketing in 2019" article, April 2019. https://pitchbook.com/news/articles/the-average-pe-fund-size-is-skyrocketing-in-2019
3. In PE, mega funds are defined as vehicles with pooled capital of $5billion or more and are typically, though not exclusively, run by large "household name" managers. Source: Pitchbook, https://pitchbook.com/blog/what-are-mega-funds
4. Source: Cambridge Associates. https://www.privateequityinternational.com/sector-delivering-higher-returns-tech-youre-specialist/
5. Source: Preqin Global Private Equity and Venture Capital Report 2019, fig. 3.7.
6. Source: Bain & Company Global Healthcare Private Equity and Corporate M&A Report 2019.
7. Source: Pitchbook, European PE Breakdown 2Q 2019.
8. Source: Medical Device Network, https://www.medicaldevice-network.com/deals-analysis/medical-devices-industry-private-equity-deals-in-q4-2018/
10. Source: Financial Times, https://www.ft.com/content/7f80d354-311b-11e9-8744-e7016697f225
11. Source: Preqin Investor Update: Alternative Assets H2 2019.
12. The International Private Equity and Venture Capital Valuation Guidelines define "fair value" as the price that would be received to sell an asset in an Orderly Transaction between Market Participants at the Measurement Date, whereby for unquoted investments the measurement of Fair Value requires the Valuer to assume the Investment is realised or sold at the Measurement Date whether or not the instrument or the Investee Company is prepared for sale or whether its shareholders intend to sell in the near future.
13. Source: Insead Business School, "The Emergence of Long-Term Capital in Private Equity," June 2018.
14. Sources: The Wall Street Journal, article "Private-Equity Firms Create Funds That Are Built to Last," January 2019, https://www.wsj.com/articles/private-equity-firms-create-funds-that-are-built-to-last-11546362000; S&P Global Market Intelligence, article "Long-term fund strategies gaining ground in private equity," March 2019, Sources: The Wall Street Journal, article "Private-Equity Firms Create Funds That Are Built to Last," January 2019, https://www.wsj.com/articles/private-equity-firms-create-funds-that-are-built-to-last-11546362000; S&P Global Market Intelligence, article "Long-term fund strategies gaining ground in private equity," March 2019, https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/50645295.
15. Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk but excludes strategic and reputational risk. Basel Committee on Banking Supervision, (June 2004), International Convergence of Capital Measurement and Capital Standards, section 644 on Operational Risk.
16. Source: MJ Hudson, "Key risks in private equity investing from an LPs perspective," October 2018.