To say that it’s been a volatile few months for global financial markets, and for humanity, would be an understatement. Everything was going up and to the right – until it wasn’t. COVID-19 has clearly caused multiple derivatives of severe dislocations around the world, as reflected by the dramatic volatility seen in the markets. The obvious and most pressing concern is the human health crisis. The extent and magnitude of the economic ripple effects stemming from this crisis are still not certain as our new reality generates new data points by the hour. So, while it seems like ages have passed by, it is still quite early as we consider the impact of the pandemic on TIFF’s private equity (PE) program. We certainly have learned a great deal in the past few months, but TIFF and its private investment managers realize we will learn a great deal more in the coming weeks and months.
Assessing the macroeconomic environment has certainly occupied much of the TIFF private equity team’s bandwidth, but understanding the micro factors directly impacting our specific private equity managers and their underlying portfolio companies has been our key focus. As we assess our underlying managers and portfolio companies, what we know this week will be updated and enhanced by what we learn next, as the real-world ramifications of the pandemic continue to play out on Main Street. We expect certain key factors to emerge in private markets in the near term. The onset of what appears to be a deep global recession will put pressure on corporate earnings as economic deterioration persists, and thus PE sponsors and business owners will need to revise cash flow forecasts for their companies. Our sense is that most, if not all, PE-backed companies that had undrawn capacity in their credit facilities drew them down last month in a bid to maximize liquidity. Many companies will eventually need to seek new financing and/or further equity injections to stabilize their balance sheets. Most private equity managers have been unable to find a way for their portfolio companies to tap federal stimulus such as the payroll protection program, given the affiliation rule that requires counting each employee in an entire portfolio of underlying companies against the 500 employee cap (certain hospitality businesses such as restaurants are a key exception). However, we have seen a small number of our portfolio companies apply for CARES Act loans, which should provide a boost in the nearer term.
We expect PE funds of mature vintages that are heavily realized to see less of an impact on performance relative to younger funds that more recently wrapped up their investment periods, have limited follow-on capital, and are in the midst of their investment and value creation phases. These younger portfolios will likely face downward pressure on performance and could have extended hold periods as portfolio companies struggle through this market and have few viable exit opportunities in the near term. On the other hand, the more recent vintage funds in our program with most of their “powder still dry” are now in the enviable position of investing in an environment that features lower purchase prices and less competition.
In the more narrow real assets part of the PE world, the energy sector’s perfect storm of COVID-19 and a parallel oil price war set off by Saudi Arabia and Russia in March has significantly damaged the energy complex, particularly upstream and midstream assets, which will face layoffs, shutdowns, liquidity problems and bankruptcies. For the first time in history, the world witnessed oil prices dip into negative territory; in April, sellers actually paid buyers to accept their oil as near-term supplies far outstripped cratering demand.
Considering all this market stress, we are reminded that even the most challenged private equity fund vintages in the four years leading up to the Global Financial Crisis produced median net returns to LPs between 7% to 10%, while those that deployed capital in the midst of and coming out of the recession generated strong performance. Private markets proved quite resilient through that extraordinarily difficult period, although we are mindful that the current environment is unique and evolving and could play out differently.
Pandemic-related market volatility will almost certainly slow both new deal activity, particularly for traditional buyout strategies, and the pace of liquidity events since valuation multiples have contracted and uncertainty reigns. Valuations have been steadily on the rise for a decade; with assumptions on future earnings now being reformulated and a disconnect between what assets were “worth” two months ago versus what they are “worth” today, a widening bid/ask spread between buyers and sellers could result in a meaningful slow down in new investments, as we saw in the financial crisis. In addition, we expect that many sponsors are presently focused on preserving any dry powder remaining in their funds to support existing portfolio companies first. For the moment, we see that most managers have “circled the wagons,” electing to play defense first. We expect them to shift their focus to new opportunities once they have triaged their portfolios and taken actions to stabilize existing portfolio companies.
While some prognosticators have speculated that private equity capital calls may accelerate, as managers deploy new equity into existing portfolio companies, and distributions cease, as exit events through M&A and IPOs dry up, we are more circumspect. There simply is too much uncertainty and there are not enough data points at this time to have a strong view. Contrary to popular sentiment amongst many limited partners in the PE/VC world today, it’s certainly possible that capital calls and distributions dry up, as they did in the financial crisis and dotcom bust. This seems like a logical initial base case in our view, although in our internal modeling, for conservatism, we’ve slashed rest-of-year 2020 distribution forecasts while leaving expected capital calls in-line with our pre-COVID-19 estimates. All that said, TIFF’s private equity team has been working to maximize the probability that capital is deployed throughout a downturn – we would like to see our venture managers supporting great founders and innovative companies, our growth equity managers providing capital to accelerate growth coming out of a downturn and our buyout, and special situations managers finding creative ways to acquire control of stressed and distressed companies and to lead them back to health.
PE fundraising is generally expected to slow broadly, but there will likely be a flight to quality, as we saw in the years immediately following the financial crisis as LPs found opportunities to upgrade their manager rosters. We have seen some of our managers already push off their fundraising processes given an expected slowdown in new deal activity; on the other side, a handful of managers have accelerated their timelines, as they want to have significant dry powder on hand in the event new deal opportunities open up sooner than many expect.
We believe that those managers willing to take risk will find opportunities for attractive investment opportunities ahead, particularly driven by the correction in asset pricing. For example, venture capital managers, after an extended period of high entry valuations and founder-friendly terms, may now find themselves in an advantaged position where deal terms suddenly swing back in favor of the investor. The TIFF private equity team will continue to evaluate investment opportunities with new and existing managers, in co-investments and in secondaries, and we will continue to support our existing roster of managers throughout this crisis. No one alive has ever seen anything quite like the current challenges we face and none of us can predict with certainty what will happen next. Nevertheless, we’ll sing our now familiar refrain regarding PE investing: don’t be overzealous when things look good or get scared when things look bad – be disciplined and consistent in our process day in and out. Bright spots for new private investment opportunities will emerge, we do not doubt that, but we must unfortunately endure some uncertainty and economic challenges while we get there.
 PitchBook Data, Inc. private equity benchmark
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