The Opportunity of a Generation
The world is currently experiencing a humanitarian crisis on an unprecedented scale, which is expected to worsen over the coming weeks and months. The effect on global GDP is already apparent, and Schroder Adveq expect the ensuing recession to be longer and deeper than that of 2008/2009.
The world is currently experiencing a humanitarian crisis on an unprecedented scale. The effect on global GDP is already apparent, and Schroder Adveq expect the ensuing recession to be longer and deeper than that of 2008/2009.
This pandemic clearly affects the way that private equity will be conducted over the next economic cycle, and in particular the way capital is invested over the next 3-4 years. Whilst the humanitarian aspect should not be ignored, any form of acute downturn or dislocation will provide opportunities for investors who have both access to capital and who are able to navigate the new environment. When compared to other asset classes such as listed investments, private equity is well positioned to deal with shocks such as the current one for a number of reasons:
- Locked-in capital can be used to pursue new investments or for supporting existing portfolio companies. A long term investment horizon means that investors and managers can remain calm in the face of turbulence;
- A variety of ways of accessing private equity (primary and secondary fund investments, GP-led restructurings, coinvestments, staple transactions etc.) give managers a higher degree of flexibility;
- Active portfolio management means private equity managers can intervene in the operations of their portfolio companies in times of crisis, rather than being passive stakeholders;
- Managers of private equity investments during economic turbulence are often more able to negotiate favourable terms;
- Private equity allows for flexibility with regards timing of portfolio company exit.
The evidence of this can be seen in returns of private equity compared to other asset classes during the last crisis in 2008/2009, where returns far outperformed public markets. 2008, 2009 and 2010 were three of the highest performing vintage years of Schroder Adveq’s history, and we expect this to be replicated over the coming 3-4 years. To achieve this it is important to strike the optimal balance of fund investments and direct company investments. This will balance the amount of committed capital and invested capital. A longer recession will require a heavier weighting to funds that will be deployed over several years, and less into businesses that will need to endure an extended period of low or negative growth. Strategies such as club funds are well suited to this as LPs are able to better influence the deployment of capital. A shorter recession will call for capital to be invested sooner, and therefore direct investments into businesses are more suitable.
During the upcoming period of uncertainty, Schroder Adveq expects to see particularly interesting opportunities emerge in certain areas of the three strategies that we pursue (primary fund investments, secondary fund investments and direct company investments). Many of these are similar to investments that performed well during the previous recession, and which can be replicated.
Primary fund investments
Schroder Adveq expects opportunity in primary investments to come through three principal avenues:
- Ultra high-quality, difficult-to-access managers
As was the case during the previous financial crisis, we expect the coming period to provide opportunities to increase commitments to managers who are extremely strict on allocation. This is due to some investors being unwilling or unable to deploy capital.
- Late primaries
Conventional wisdom would suggest that private equity funds that are currently raising which have already deployed part of their capital in a small number of deals should be avoided when a shock occurs. For the most part this is good practice, however in times of crisis it is always worth seeking out those that can still yield excellent returns. At the smaller end of the market, which is less affected by public asset prices, entry valuations have remained stable at moderate levels. Therefore a transaction based on LTM figures can still be attractive. As an example, during the 08/09 crisis, Schroder Adveq evaluated over 50 late primary opportunities. In the end only 2 investments were carried out, however they proved to be top performers:
o UK-based manager – sold one asset for 10x MOIC 18 months following Schroder Adveq’s investment
o Nordic manager – sold one asset for 9.5x MOIC following the crisis, with another significantly valued up.
We therefore expect similar opportunities to occur in funds that are already in fundraising and who are working towards a final close, provided managers remain highly selective.
- Strategy shift
During the previous recession, Schroder Adveq deployed approximately 30% of capital into turnaround funds, which performed extremely well through 2008-2010. Following that period, many investors stopped investing in turnaround strategies, and are therefore now not able to invest again in a sector that will be attractive for the next cycle. Schroder Adveq reduced allocation, to 15%, whilst still maintaining GP relationships that allow us to now increase commitments to top GPs in this strategy.
Secondary fund investments
During the previous crisis, the best secondary investment opportunities were characterised by large portfolios of brand name funds being sold at deep discounts. Since 2008 the secondary market has evolved and grown beyond recognition. Looking forward to the next 2-3 years there are now more secondary funds with enormous amounts of dry powder, in a market which is increasingly intermediated.
The opportunity therefore lies in GP-led transactions, where portfolios are concentrated and there is an ability to be more targeted than in a portfolio sale with a large number of underlying company holdings. There is far more scope for negotiation in these more complex transactions that attract less competitive tension, at a time when GPs are seeking assistance.
The key to being able to source and evaluate these transactions is number and quality of GP relationships. Schroder Adveq’s primary fund investment capability means that we are very well placed to access this market. Furthermore, as a consistent backer of early-vintage and first-time funds (Schroder Adveq is an early institutional LP in 88% of commitments, and one of the top 3 LPs in terms of size in 89% of commitments) our GP relationships are also of high quality.
Direct investments
As M&A activity sees a sharp decrease, logic would suggest that private equity deals would also witness a decline. However we are already seeing that this is not necessarily the case when it comes to coinvestments. The main reason for this is that when a crisis hits, private equity GPs tend to want to prolong the life of the funds that they are currently investing from. They therefore reduce the size of the equity investment into each deal, with the remainder being offered to coinvestors. As with the GP-led transactions, however, they are only likely to do this with trusted LP partners. Schroder Adveq’s deep GP relationships therefore provide an opportunity to deploy capital into good quality companies on attractive terms.
As an example of direct investments which can be sourced and executed through this uncertain period, within the last month Schroder Adveq has closed a €20m investment into a fast-growing global technology business. The company grew 100% last year and has continued to grow at approximately 10% per month from January to mid-March. This performance has been global in nature, with growth continuing in countries such as China, Italy and the US in the current environment.
Overall, Schroder Adveq has focused investment on non-cyclical sectors such as healthcare, IT and business services and avoided investments into businesses exposed to commodities, oil and gas, infrastructure or real estate. In addition, our focus on smaller businesses means debt levels are maintained at a moderate level. With the above areas of focus, we believe our strategy to be uniquely well-placed to capitalise on investment opportunities over the coming period.
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