Perspective

Markets

Why the Covid-19 crisis is different for private assets

Investors trying to assess what the Covid-19 crisis will mean for their portfolios have started to look to previous crises – and in particular the global financial crisis (GFC) – for answers. It’s understandable, and in some cases the comparison may be instructive. However, it is important to note that the Covid-19 crisis is very different to the GFC in many ways.

Novel virus, novel crisis

Volumes have been written (and indeed, movies made) about the causes of the 2008/2009 GFC. Its essential element though, was a collapse of trust between undercapitalised/overleveraged banks. Covid-19 is not the same. Bank balance sheets are far less geared and much smaller than in 2008. Funding is also more stable.

The heart of the Covid-19 crisis is essentially an unprecedented collapse in demand in the real economy. Measures to contain the virus have hit small businesses especially hard, and unemployment has rocketed in the short-term as global governments seek to curb physical social contact. Analysts now are watching how close viable businesses are to reaching the limits of available credit lines, and whether they have enough capital to ride out the demand shock.

The implications of a “people’s crisis” versus a banking crisis are therefore very different, and will impact private markets very differently than a decade ago. Private assets are also not uniform. Drivers of return vary significantly, and not just between equity and debt based segments.

The effectiveness of government stimulus packages for different parts of the economy, the nature of cash flows in underlying businesses and duration of debt-based private investments all contribute to the variation in impact.

Private equity

Nils Rode, Chief Investment Officer, Schroder Adveq

“During the Covid-19 crisis, some companies will be mostly unaffected and others will face only a temporary decline in activity without requiring additional capital. Certain companies however, will need additional capital injections to weather the storm.

“The need for capital injection depends very much on the depth and length of the current crisis and on the ultimate size and applicability of government stimulus packages. Both of these are still highly uncertain. There are also different dynamics for buyouts on the one side and venture/growth investments on the other. For venture/growth investments for example, it is normal to have several funding rounds and fund managers typically hold certain reserves for follow-on financings.

“Taking a base case scenario - single lockdowns in most countries, with a length of several months each - we estimate the required volume for equity injection for buyout portfolios in the single digits in terms of per cent of current net asset value.

“At a high level, there are two types of reserves and follow-on financings. Defensive capital injections provide liquidity or refinancing. These typically have strong downside protection for new investors and are punitive to existing investors. The quality and strength of a company and the outlook for its specific business are key determinants for defensive follow-on financing decisions.

“Proactive capital injections aim to provide flexibility to benefit from the current situation. These might include buying competitors or add-ons at especially attractive valuations. It might be purchasing debt (in the same company) at discounts, or buying out other shareholders at discounts. 

“As external financing sources may be difficult to find in times of crisis, fund managers will use uncommitted capital in their funds, recycling provisions or credit facilities to inject capital in existing portfolio companies, if and where indicated. In some cases, fund managers might also decide to raise top-up funds to finance existing portfolio companies.

“As defensive follow-on financings typically have preferential economic terms, we believe investors should be prepared to participate in those top-up funds or additional equity rounds of direct/co-investments. This might mean reserving additional allocations in their portfolios.

“If the portfolio companies can weather the crisis, the additional financing could prove to be an exceptional source of enhanced returns for otherwise healthy portfolio companies. ”

European commercial real estate, while still an equity asset class, is typically anchored on real assets backed by longer-term leases.

European commercial real estate

Duncan Owen, Global Head of Real Estate

“In normal circumstances one of the attractions of real estate is the stable rental income. Leases are legal contracts and landlords reserve the right to evict tenants who do not pay their rent. Professional investors generally avoid letting space to weak businesses and build portfolios with diversified income streams. It has been unusual for the rental income on real estate portfolios to fall. Even in the global financial crisis, the total rental income on UK real estate portfolios only fell by 1% (source MSCI).

“The current circumstances are not normal. Except for Sweden, the only stores which are still open are banks, food stores and pharmacies and most factories and construction sites have also shut in order to protect workers.  

“Inevitably, the collapse in revenues and the intense pressure to conserve cash during the lockdown has impacted rent payments. As real estate investors, we saw the percentage of rent due actually paid vary from 60% – 90%. Perhaps not surprisingly, retailers were the most likely to defer rent and service charge payments. Most office occupiers in our experience have continued to pay in full. Industrial tenants have been somewhere in the middle.

"Another variable is geography. Occupiers in continental Europe have been less likely to defer than occupiers in the UK.  This could reflect differences in business culture and the importance of paying bills on time, although it may be also be because in some countries (e.g. Germany) landlords can charge high rates of interest on delayed payments of rent.

"As European economies start to recover, real estate investors will seek to recoup the arrears. It will not be possible to recoup 100%. Some businesses will fail and their space will have to be re-let.  As is always the case, managers will need to assess each case individually.

"In some instances it may make sense for the property owner to write-off the rent arrears if in return, the tenant agrees to extend their lease, or not to exercise a future break clause. Another option may be to agree sale and leaseback deals, depending on the quality of the asset and financial strength of the business. The retailer Next plc, for example, has put its UK headquarters and distribution warehouses up for sale.

“Obviously, the interruption of rental payments has implications for property owners, both in terms of servicing the interest on debt and paying dividends. With low interest rates and generally lower leverage than in the run up to the GFC, we do not expect the former to be a problem, at least for most institutional funds.  

“It is important that real estate funds continue to pay dividends, although some may have to be postponed, or deferred. Real estate investors need to strike a balance between paying dividends now and having capital to invest later, when prices could be very attractive.”

But what about the impact of the current Covid-19 crisis on debt asset classes? We analyse these below, starting with infrastructure, which has historically suffered less than other asset classes during crises such as that of 2008/2009. 

Infrastructure debt

Jerome Neyroud, Head of Investments, Infrastructure debt

“With countries around the world in lockdown and basic freedom of movement being (understandably) put on hold, GDP will take a severe hit. The jury is still out as to how long the lockdowns will last and how the recovery will look. As such, while we do not expect supply of financing to cause the issues it did in 2008, underperformance by business we lend to is a concern, both from a short term, liquidity perspective and mid term, solvency viewpoint.

“Liquidity supports include reserve accounts as well as undrawn facilities.  Dedicated reserve accounts are a key feature of infrastructure debt structures.  The epitome is the DSRA (Debt Service Reserve Account). The DSRA provides for some cash (enough to meet the next debt service payment, generally up to six months) to be set aside for difficult times and secured in favour of lenders.

“Having said that, there is a limit to liquidity buffers a company can live on, when or if all activity grinds to a halt. It could be three months, six months, nine months...maybe more. These are still early days and we lack a crystal ball. In a prolonged lockdown, debt restructurings are not to be ruled out. 

“In very extreme scenarios where liquidity support is not enough, there could be a postponement of interest payments or repayment rescheduling. But in such a scenario, borrowers’ solvency should pass an acid test. Indeed, with lifecycle spanning several decades, impairment in value should be less acute than industries evidencing shorter product lifecycle.  Infrastructure’s long asset life should ultimately maximise debt recoveries. 

“In a prolonged Covid-19 induced recession, infrastructure debt expertise in debt restructurings, gained on the battlefield during GFC, dotcom bubble in the 2000s, Asian crisis in the 1990s, etc may prove to be a key differentiator between the best and worst asset managers.

“Ultimately, we expect that the Covid-19 crisis will demonstrate the resilience of infrastructure as an asset class as it did during the 2008 GFC."

Microfinance

Philipp Mueller, Chief Executive Officer, BlueOrchard

“In general we have seen some very proactive measures from many of the emerging and frontier markets that we invest in. Countries like India, Georgia and Kenya have taken firm action to try and limit the spread of Covid-19, by closing schools, borders and even enforcing full lockdowns.

“Many countries have also been proactive in implementing fiscal or monetary policies to support their local economies, including reduced interest rates, investment plans and permitting credit holidays or moratoriums.

“From a microfinance perspective, many microfinance institutions (MFIs) have taken steps towards digitalisation, allowing them to continue operating and serving their clients during a lockdown. As a result, while we expect to see a slowdown of these economies over the short term, which will have a knock on effect for activity and liquidity levels, steps are undoubtedly being taken which aim to mitigate the longer-term effects.

“We have seen a number of our investee companies proactively approaching us to discuss liquidity levels. Many of them have sufficient liquidity to meet obligations over the next few months, in some cases they would prefer to extend repayment terms in order to give them more flexibility to continue their operations in the current environment.

“We assess these requests on a case by case basis, based on the credit risk assessment for the individual company – we currently do not expect these rescheduling requests to result in proportional levels of credit loss. Indeed, we expect that the vast majority of our exposures will repay in full in the normal course, if with some rescheduled payments of principal. It is our policy that all requests for accommodation will require continued payment of interest.”

Insurance-linked securities (ILS)

Dirk Lohmann, Head of ILS

“The ILS market has shown strong resilience since the outbreak of Covid-19 versus major corrections in the listed equity, commodity and debt markets. As observed during the GFC, the uncorrelated nature of ILS to the economic cycle is providing investors with some stability.

“A small spillover effect from the current crisis has affected ILS performance, but the impact was very limited. Importantly, the correction was of a technical and not fundamental nature, and performance is expected to be earned back over time. ILS deals that include a life-related risk component constitute a relative small fraction of the overall ILS market and we currently expect limited impact by Covid-19 exposure. Non-life (predominantly natural catastrophe driven) ILS is largely immune to the virus.

“Re-insurance balance sheets will be impacted on the asset side by losses in public markets. In addition, there are potentially Covid-19-related insured losses for life, health, property & casualty lines of business (e.g. extreme mortality, health expenses, business interruption, trade credit). This will lower solvency capital and hence reduce risk-taking capacity. This in turn will further accentuate the “hardening” of re/insurance rates that was already under way in certain contract renewal dates.

“Hardening rates means that the protection buyer (reinsurer) has to pay a higher premium. This means that the investor earns higher premium, which is good for the returns on ILS funds.

“In the next few months, around $5 billion of cat bond notional is scheduled to mature. While we expect redemptions, most of the cash will be available for reinvestments in renewed deals which are likely to carry better terms. With weaker balance sheets, re-insurers may have to rely more on private markets to raise capital or transfer more risks off balance sheet to strengthen their solvency. This will likely result in increased deal flow into the ILS market.

"In case of a further market corrections and/or government/central bank interventions, we believe the ILS market will remain resilient. Current yields of ILS strategies are at some of the most attractive levels seen in years and - assuming no major natural catastrophe events will occur - should generate attractive returns for investors.”

Private assets can be part of the solution

Overall, private assets portfolios are expected to be resilient, particularly relative to listed assets, through the crisis. Moreover, private assets are generally capable of supporting portfolio companies, and thereby the real economy, given dry powder and longer-term funding structures. For equity investments, this can mean capital injections at potentially attractive terms and for debt investments  there can be various degrees of debt restructuring, providing downside protection for investors.