To all readers: I hope you and your families are healthy and safe. My thoughts are with all who are impacted by this deadly virus.
I’ve been around for a while, and have experienced several market dislocations in my career. I had just started my career as a corporate finance attorney when the “Black Monday” stock market crash of October 19, 1987 occurred. I was a telecommunications investment banker when the dot-com crash occurred in March 2000. I was a private equity fund-of-funds manager when the Global Financial Crisis (“GFC”) hit in 2008. Because of these experiences, I have some thoughts for limited partners (“LPs”) during this crisis.
I’ve been around for a while, and have experienced several market dislocations in my career. I had just started my career as a corporate finance attorney when the “Black Monday” stock market crash of October 19, 1987 occurred. I was a telecommunications investment banker when the dot-com crash occurred in March 2000. I was a private equity fund-of-funds manager when the Global Financial Crisis (“GFC”) hit in 2008. Because of these experiences, I have some thoughts for limited partners (“LPs”) during this crisis.
Take Stock
In any recession or other financial crisis, it’s important to take stock of your entire portfolio and to work with your advisers to understand your current, short-term and long-term cash and cash flow needs, and how your portfolio is positioned to meet these needs. Do some scenario planning (using various scenarios such as how long the crisis might last and how deep portfolio valuations may fall) to understand how to best position your portfolio during this crisis.
Capital Calls Will Continue
It’s important to understand that during crises, general partners (“GPs”) will continue to make capital calls. Because of this, it is really important to forecast these future portfolio fund capital calls. Speak with your GPs and ask them to provide you with some guidance on this. A component of this is how the GP plans to use subscription lines of credit, if they have them. GPs that have subscription lines of credit may be able to manage capital calls to reduce the frequency of them. Once you have created a capital call forecast, this can then be integrated into your overall crisis planning.
Distributions Will Dry Up
Another important aspect is to understand that distributions from GPs will dry up. Many LPs during the GFC got into trouble because they did not have enough liquidity to meet their capital calls. This led to some LPs being forced to sell some of their fund investments at significant discounts. These sales did two things: provide the LP with some much-needed cash and removed a liability from their balance sheet.
Distributions will dry up for a two primary reasons: first, portfolio company exits will slow significantly; and second, GPs may elect to hold on to cash received from portfolio exits to invest in their portfolio companies (depending on whether the fund’s limited partnership agreement permits this). Portfolio company exits slow significantly for two main reasons. First, during times of crisis, public markets experience significant volatility, and as a result, the window for initial public offerings (“IPOs”) generally shuts for all but the very strongest and most compelling companies. In addition, because of dropping valuations, many existing and planned portfolio company sales processes are terminated. Another source of liquidity for buyout funds is dividend recapitalizations (aka dividend recaps), but these also stall as banks are much less willing to lend in crises.
Fund NAVs Will Decline
LPs must also plan for declines in the reported net asset values (“NAVs”) for their portfolio funds. What drives a fund’s NAV to decline is the decline in reported values for the fund’s portfolio companies. Buyout and growth equity funds typically value their portfolio companies based on comparable public companies (called “public comps analysis” or simply “comps”) and discounted cash flow analysis (“DCF”). As public company valuations decline, the public comps analysis drives declines in private portfolio calculations. Also, as a portfolio company’s revenue projections are adjusted downward, the DCF analysis will also yield a lower valuation for that company. Early stage venture capital funds don’t typically use public comps or DCF analysis to value their portfolio companies, as the companies are usually too early in their lifecycle for these valuation methods to be applicable. Early-stage venture capital companies can be especially hit hard in financial crises, as many of these companies are cash flow negative and have only limited amounts of cash on their balance sheets. Some of these companies will fold if they are unable to raise follow-on financing to keep them alive. Others will experience delayed customer acquisition, rising customer acquisition costs and higher customer churn, which in turn result in lower revenue and higher expenses. In addition, new deals will be priced at much lower valuations or with much greater preferences, which impacts the valuations of existing portfolio companies. Venture capital GPs will evaluate all of the foregoing and incorporate these into their portfolio company valuations.
Consider the Denominator Effect
As discussed above, private equity (buyout, growth, venture) fund valuations will decline in recessions. However, unlike public markets which are valued daily, PE fund valuations are only calculated quarterly. Moreover, PE fund valuations aren’t reported to LPs for typically 45 days after the close of a quarter. This means that PE fund valuations lag those of public markets. As a result, this can lead to the denominator effect, where an LP’s allocation to Private Equity can exceed the policy range. This needs to be considered as LPs consider rebalancing their portfolios. For more on the denominator effect, see my post “LP Corner: The Denominator Effect and Reverse Denominator Effect.”
Take Advantage of PE Investment Opportunities
There are many investment opportunities during a financial crisis. One of these is fund secondaries. Fund secondary transactions occur when an existing LP of a fund sells its interest in the fund to a purchaser. These transactions are priced as a percentage of the NAV of the LP’s interest in the fund. In normal markets, these percentages typically range from a small discount (for example 95% of NAV) to a small premium (for example 105% of NAV) depending on a variety of factors, including the quality of the fund’s portfolio, how much capital has been called (and conversely how much capital is there left to call), the reputation of the GP, and so forth. However, in times of distress, these discounts can become very large. In the GFC, I recall fund secondary transactions being conducted at discounts of over 50% to NAV. This means that there may be some very good opportunities for LPs to buy fund secondaries from distressed LPs.
There is also some research that suggests that funds that are formed in the two years after a recession tend to be strong performers. This supports my view that LPs should continue to make commitments to private equity funds during recessions. It’s very hard to time markets, and most successful LPs continue to make fund commitments during downturns.
Communicate with your GPs
Regular communication with your GPs is a key during times of crisis. Already, I have had many calls with GPs and I have also attended several GP webinars where they talk about the steps they are taking to work with their portfolio companies during this crisis. LPs should also communicate with GPs if the LP sees that it is going to have problems meeting capital calls. A GP might be able to facilitate a quick secondary sale of the LPs interest in the fund to another LP in the fund or to an LP that is not in the fund but the GP would like to bring in. The worst thing an LP can do is to default on a capital call and so getting in front of any problems and communicating with your GPs is critical.
Communicate with Other LPs and Service Providers
I find it useful to speak with other LPs and service providers during times of economic uncertainty, as obtaining their insights can be very valuable. Also many service providers (attorneys, accountants, valuation firms) will likely have helpful resources that they can share with you.
Finally, take a breath and remember that there will be a day where we can again be with our loved ones, friends and colleagues, and this horrible crisis will pass.
© 2020 Allen J. Latta. All rights reserved.
In any recession or other financial crisis, it’s important to take stock of your entire portfolio and to work with your advisers to understand your current, short-term and long-term cash and cash flow needs, and how your portfolio is positioned to meet these needs. Do some scenario planning (using various scenarios such as how long the crisis might last and how deep portfolio valuations may fall) to understand how to best position your portfolio during this crisis.
Capital Calls Will Continue
It’s important to understand that during crises, general partners (“GPs”) will continue to make capital calls. Because of this, it is really important to forecast these future portfolio fund capital calls. Speak with your GPs and ask them to provide you with some guidance on this. A component of this is how the GP plans to use subscription lines of credit, if they have them. GPs that have subscription lines of credit may be able to manage capital calls to reduce the frequency of them. Once you have created a capital call forecast, this can then be integrated into your overall crisis planning.
Distributions Will Dry Up
Another important aspect is to understand that distributions from GPs will dry up. Many LPs during the GFC got into trouble because they did not have enough liquidity to meet their capital calls. This led to some LPs being forced to sell some of their fund investments at significant discounts. These sales did two things: provide the LP with some much-needed cash and removed a liability from their balance sheet.
Distributions will dry up for a two primary reasons: first, portfolio company exits will slow significantly; and second, GPs may elect to hold on to cash received from portfolio exits to invest in their portfolio companies (depending on whether the fund’s limited partnership agreement permits this). Portfolio company exits slow significantly for two main reasons. First, during times of crisis, public markets experience significant volatility, and as a result, the window for initial public offerings (“IPOs”) generally shuts for all but the very strongest and most compelling companies. In addition, because of dropping valuations, many existing and planned portfolio company sales processes are terminated. Another source of liquidity for buyout funds is dividend recapitalizations (aka dividend recaps), but these also stall as banks are much less willing to lend in crises.
Fund NAVs Will Decline
LPs must also plan for declines in the reported net asset values (“NAVs”) for their portfolio funds. What drives a fund’s NAV to decline is the decline in reported values for the fund’s portfolio companies. Buyout and growth equity funds typically value their portfolio companies based on comparable public companies (called “public comps analysis” or simply “comps”) and discounted cash flow analysis (“DCF”). As public company valuations decline, the public comps analysis drives declines in private portfolio calculations. Also, as a portfolio company’s revenue projections are adjusted downward, the DCF analysis will also yield a lower valuation for that company. Early stage venture capital funds don’t typically use public comps or DCF analysis to value their portfolio companies, as the companies are usually too early in their lifecycle for these valuation methods to be applicable. Early-stage venture capital companies can be especially hit hard in financial crises, as many of these companies are cash flow negative and have only limited amounts of cash on their balance sheets. Some of these companies will fold if they are unable to raise follow-on financing to keep them alive. Others will experience delayed customer acquisition, rising customer acquisition costs and higher customer churn, which in turn result in lower revenue and higher expenses. In addition, new deals will be priced at much lower valuations or with much greater preferences, which impacts the valuations of existing portfolio companies. Venture capital GPs will evaluate all of the foregoing and incorporate these into their portfolio company valuations.
Consider the Denominator Effect
As discussed above, private equity (buyout, growth, venture) fund valuations will decline in recessions. However, unlike public markets which are valued daily, PE fund valuations are only calculated quarterly. Moreover, PE fund valuations aren’t reported to LPs for typically 45 days after the close of a quarter. This means that PE fund valuations lag those of public markets. As a result, this can lead to the denominator effect, where an LP’s allocation to Private Equity can exceed the policy range. This needs to be considered as LPs consider rebalancing their portfolios. For more on the denominator effect, see my post “LP Corner: The Denominator Effect and Reverse Denominator Effect.”
Take Advantage of PE Investment Opportunities
There are many investment opportunities during a financial crisis. One of these is fund secondaries. Fund secondary transactions occur when an existing LP of a fund sells its interest in the fund to a purchaser. These transactions are priced as a percentage of the NAV of the LP’s interest in the fund. In normal markets, these percentages typically range from a small discount (for example 95% of NAV) to a small premium (for example 105% of NAV) depending on a variety of factors, including the quality of the fund’s portfolio, how much capital has been called (and conversely how much capital is there left to call), the reputation of the GP, and so forth. However, in times of distress, these discounts can become very large. In the GFC, I recall fund secondary transactions being conducted at discounts of over 50% to NAV. This means that there may be some very good opportunities for LPs to buy fund secondaries from distressed LPs.
There is also some research that suggests that funds that are formed in the two years after a recession tend to be strong performers. This supports my view that LPs should continue to make commitments to private equity funds during recessions. It’s very hard to time markets, and most successful LPs continue to make fund commitments during downturns.
Communicate with your GPs
Regular communication with your GPs is a key during times of crisis. Already, I have had many calls with GPs and I have also attended several GP webinars where they talk about the steps they are taking to work with their portfolio companies during this crisis. LPs should also communicate with GPs if the LP sees that it is going to have problems meeting capital calls. A GP might be able to facilitate a quick secondary sale of the LPs interest in the fund to another LP in the fund or to an LP that is not in the fund but the GP would like to bring in. The worst thing an LP can do is to default on a capital call and so getting in front of any problems and communicating with your GPs is critical.
Communicate with Other LPs and Service Providers
I find it useful to speak with other LPs and service providers during times of economic uncertainty, as obtaining their insights can be very valuable. Also many service providers (attorneys, accountants, valuation firms) will likely have helpful resources that they can share with you.
Finally, take a breath and remember that there will be a day where we can again be with our loved ones, friends and colleagues, and this horrible crisis will pass.
© 2020 Allen J. Latta. All rights reserved.
