In times of crisis, many pension plan sponsors pull back on investing in private equity, including the secondary market, because they’re trying to assess their liquidity needs, says Joseph Marks, global head of secondaries at Capital Dynamics.
But this pulling back often happens at a time when they should be putting their foot on the gas, he adds.
Historically, crises and volatility have generated some of the most attractive purchasing opportunities, especially for secondary buyers with both fundamental underwriting capabilities and deep negotiation and structuring capabilities, according to a report by Capital Dynamics. “Secondaries funds demonstrated resilience during previous periods of market dislocation and can offer an attractive investment opportunity for limited partners looking to take advantage of these dynamics.”
Because private equity reporting lags the public markets, buyers and sellers typically pause when a crisis occurs, as they assess the situation and wait for valuations to come through, Marks notes.
Further, deals are being repriced or falling apart entirely, the report said, noting 2020 will likely see fewer deals by both count and value. “However, over the coming quarters, we expect to see a rebound in activity driven by an increase in acute liquidity needs of sellers, declining fund net asset values and distress at both the fund and company level resulting in restructuring opportunities.”
As well, the smaller end of the secondary market may bring attractive opportunities, the report added, noting this part of the market is underserved because large institutional investment funds have a concentration of dry powder and need to deploy significant pools of capital. “Buyers are well-positioned to avoid this heightened competition by focusing on the small end of the market, where there is a far larger opportunity set of deals (by count) and an increased need for leadership, especially for more complex deals, such as fund restructurings and preferred securities.”
It’s likely that activity in the secondary market will pick up at different times for different types of deals, Marks adds. For instance, purchases of limited partnership stakes will probably pick up sooner than more complex deals like general partner restructurings. “I think the complex end of the market may take further time because they tend to be more concentrated portfolios, they tend to involve a higher degree of underwriting than a highly diversified portfolio on each individual asset.”
For more complex deals, due diligence concerns also exist if an investor is unable to physically visit a company, he notes.
Sellers active in the secondary asset class will have to reset their expectations, which is challenging, Marks adds. “First of all, the outlook on a number of businesses are very uncertain and the dispersion is wide in potential outcomes. That naturally leads to a gap in pricing expectations, what we call a spread between the bid and the ask.”
During the 2008 global financial crisis, a gap also existed between seller expectations and what buyers were willing to offer. “You have to find a new normal and a price with which both sides are willing to transact.”
In the past, during times of market dislocation, the private equity secondary market has had strong countercyclical tendencies, Marks says. “It’s pretty well established that when you’re able to acquire quality assets all of a sudden, at pricing that’s substantially lower than before, that when you come out of this at the other end, you end up with nice returns.”