Private markets: calm in a crisis?

03 April 2020

5 minute read

By Gerald Moser, London UK, Chief Market Strategist

We wrote about the benefit of being invested in private markets in a period of volatility for public markets in March’s Market Perspectives. While the situation has worsened in the last month and a global recession is likely, this should mainly affect private debt deals involved with so-called covenant-lite loans.

Covenant-lite loan covenants are less protective than typically seen with traditional loans and the borrowers have more flexibility regarding their obligations. But other areas of the private debt markets, such as special opportunities or distressed debt, are likely to thrive in the current environment.

Although private market funds are likely to see their net asset value (NAV) shrink, the reassessment of their investments’ value does not happen daily, like occurs in most public markets, but rather quarterly or semi-annually. Considering the speed of the current sell-off, and our expectations of an equally fast bounce once the outbreak is under control, some of the funds may not see much write-down to their NAV. This crisis, though extremely violent in magnitude, is likely to be much shorter than a typical structural recession such as the global financial crisis of 2007-2009.

Outperformance during a crisis

Corrections and recessions are not only great investment opportunities for public markets investors. Private market funds also benefit from the lower valuations and dislocation opportunities that a crisis creates.

Data suggests that private markets tend to outperform public markets the most during a period of crisis. Cambridge Analytics’ data, using internal rate of returns as the key metric, shows that private equity vintages from 2001, 2003, 2009 or 2011, which correspond to a bottom in equities, have outperformed public markets by more than 11 percentage points on average.

Secondary funds

Secondary funds reduce some of the negative factors usually attached to investing in private markets. Investing in secondaries limits the “blind pool” effect as most of, if not all, the capital has already been called and invested.

As most of the funds are already invested, the “J-curve” is mitigated. Distributions to investors start to match and even outpace capital calls. The return on investment is more certain than for primary fund investment. But those lower risk features, typical from a secondary fund, usually come at a cost.

The return multiple on secondary funds is traditionally lower than it is for primary ones. However, in a period of crisis, secondary funds are often available at a deeper discount to their NAV. This means that the overall multiple return is similar to what primary funds usually achieve, while still providing all the benefits from secondary investing, notably the mitigation of the J-curve.

J-curve chart

Market Perspectives April 2020

Financial market sell-offs, in the face of unprecedented policy measures to fight the effects of the Covid-19 outbreak, suggest any rebound may be a few months away.


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