Private equity valuations face deep discounts amid virus outbreak

Pandemic is causing falls in prices and more bankruptcies, but the true impact on private markets will not be known for months

Many private equity companies sent out their December quarter valuation reports to investors last week. But limited partners may be tempted to hit the delete button, as the coronavirus rendered these lagging reports practically useless.

While March was one of the worst months for listed stocks around the world, private equity-backed companies have been protected from daily volatility in prices. But they can’t escape the fallout from the widespread lockdown of the global economy even if the true impact will not be known until later in the year.

“At the end of December, the virus was still considered a local Chinese problem and not a global problem,” says Peter Gale, CIO at Hermes GPE. “The extent of the pandemic has really only come out in the last month or six weeks, so the GPs will be in a dilemma. Obviously they’ll be publishing data that is definitely out of date.”

Here’s what might lie ahead:

Fall in value

MSCI, the investment research firm, estimates that as of March 18, the valuations for private equity portfolios may be down 31% in Europe and 35% in the US, from their recent highpoint earlier in the first quarter.

“Private equity’s valuations might give it the appearance of a safe haven during the Covid-19 crisis, but portfolio companies may now be struggling under high levels of leverage. While the world has watched the crisis ripple through public markets day after day, private assets are out of view,” MSCI said.

Investec issued a similar warning. According to the investment bank, most fund of funds it has spoken to expect an aggregate of a 30% decrease in value. One manager said that a 50% write-down was possible.

“Many GPs are beginning to run scenarios and valuations for March numbers. However, at this stage GPs are warning LPs that any attempt to currently value assets are most likely to move in the weeks ahead, leading to possible delays in Q1 fund reports and even December reports given the challenges of widespread working from home.”

According to MSCI’s figures, during the financial crisis the decline was more gradual, with significant drawdowns spread out over a year. December 2007 to December 2008, private equity valuations fell from 62% to 8%.

The denominator effect

One of the dangers now for investors is the denominator effect – where a limited partner’s private equity portfolio value exceeds its target allocation because of a fall in value in public markets, resulting in an unbalanced LP portfolio.

The rapid fall in listed stocks means many institutional investors such as pension funds will become overweight private assets, forcing them to rebalance their portfolios. One way to do this is halting any further commitments to private equity funds, or, selling holdings on the secondary market, says Peter Shepard at MSCI. But selling those holdings now may mean locking in low prices. To make matters worse, the lag in private market valuations means the rebalancing might just be a matter of bad timing.

Ainun Ayub, alternative fund servicing product head for Europe and Asia at Brown Brothers Harriman says: “Some of these funds that are much more tightly regulated whether internally through their own governance rules or externally by regulators, they may have broken those rules as a result of these extreme circumstances. There may be some relief regulators can provide with regards to these rules. Or they may have the leeway but feel the need to act now.”

During the global financial crisis, many LPs were already over-allocated to private markets. Due to the stock market crash and the ensuing liquidity issues, investors struggled to make capital calls. In addition, some institutions were forced to sell their fund interests at steep discounts on the secondaries market.

Get real

BBH’s Ayub says independent valuers have entered disclaimers and added major valuation uncertainty clauses into their quarterly reports. But the effect of the coronavirus pandemic on portfolio companies might not be known for months.

Hermes GPE’s Gale says his firm, which invests in funds and makes co-investments, is trying to get real valuations from its GPs and find out what the impact is as of now. For its own investors – institutions, such as pension funds, that have committed capital to Hermes GPE’s funds – the firm is taking them through what’s happening at the moment and trying to make sure they understand the long-term strategy.

“We genuinely don’t know how badly we will be impacted against the valuations end of last year,” he says.

“We are currently investigating in granular detail exactly what’s happening in our underlying investments.”

Gale says less than 20% of the firm’s portfolio will be negatively affected by the “cash-flow hiatus” caused by coronavirus. But they still have to consider crisis measures.

“We are monitoring and we are worried and we are having to organise potentially follow on funding through emergency funding ahead of where we thought we would have to be. Our response short term has been to increase the level of scrutiny and prepare remedial action in the small minority that are extremely impacted.”

Vulnerable sectors

Experts expect to see bankruptcies at companies that have both high levels of leverage and operational gearing. The retail, leisure, travel and hospitality spaces look especially vulnerable.

But long term outcomes are hard to predict. Stefan Brunnschweiler, head of corporate/M&A at global law firm CMS, says the speed of the current crisis makes it very difficult, but there are certain industries that will take a hit.

“It comes natural that certain businesses now are suffering quite a bit if you have assets in the area of hotel and leisure, retail, automotive, for obvious reasons these assets will suffer and therefore their valuation will inevitably go down.”

The Corporate Finance Network has predicted that in the next four weeks 18% of all small and medium enterprises in the UK will collapse as a result of the Covid-19 lockdown. There have already been several businesses closing their doors permanently, including UK rent-to-own retail chain

BrightHouse, backed by Apollo Global Management, which collapsed into administration on March 30. Apollo, alongside Alteri Investors and other undisclosed investors acquired the business for £220m in December 2017 as part of a restructuring deal.

Secondaries and exits

With portfolio companies short on cash, investors should brace for a pause in distributions. And as GPs look to provide follow-on funding to portfolio companies, they will be calling capital more frequently. One California pension scheme, the Orange County Employees Retirement System, said that it received three capital calls in the last two weeks of March from general partners, according to WSJ Pro.

“They’re not getting their distributions back up and they’re being asked to pay down money faster than they expected. Then the question is can they do it?” says Ayub.

Exiting underlying investments in such an environment, especially when it is difficult to accurately value holdings, will also be a challenge. Selling now, particularly in the hardest hit sectors of consumer goods, travel and leisure, will be at a significant discount. In addition, with both corporations and private equity firms currently focused on fighting fires, there aren’t that many buyers that will be interested.

According to a recent analyst note by PitchBook, secondary buyouts, strategic sales and IPOs will all be off the table for the foreseeable future.

“GPs loathe to see years of growth during an economic boom disappear in a few weeks’ time and are unlikely to commit to an exit process at current pricing levels. Potential buyers are also hitting snags. With so many GPs in “wait and see” mode, exits via sponsor-to-sponsor transactions are likely to slow to a dribble. This impact will be outsized because currently more than half of all PE exits are to other PE firms,” the company said.

Source: Financial News

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