As the novel Coronavirus pandemic continues to unfold across the globe, it has shut down and frozen large parts of the economy and presented private and public markets their biggest survival test to date. The global lockdown of businesses, employees and consumers represents an unprecedented material risk as well as a significant opportunity for private markets.
Over the last 40+ years, private equity (“PE”) has transformed into a growing array of multi-asset “private markets” strategies. These include buyouts, venture capital, debt and real assets representing over $5 trillion in assets under management [Preqin]. As a technology provider for the industry for over 20 years, Dynamo Software has had a ringside seat in the transformation of private markets and the relentless advance of new technology solutions across the front-to-back office.
While the attractiveness of private markets is recognized increasingly (market indices-beating returns, diversification, and a growing lineup of investment opportunities), the fact that the asset class tends to fare better than others during economic downturns is often less well known. During the 2008 global financial crisis (GFC), many commentators predicted the industry would severely contract. On the contrary, it bounced back even stronger and in better shape. A study by the Private Equity Council (now the American Investment Council) found that private-equity backed businesses during the crisis defaulted at less than one-half the rate of comparable companies.
Correctly predicting when and how the economy returns to normal is impossible, but it is possible to point to attributes of private markets that likely are to favor private multi-asset strategies in weathering the present economic crisis. Here are our top five reasons for optimism, plus our views on technology’s supporting role in PE firms’ continued success:
1. Proven and Resilient Business Model
Although PE has continued to evolve, adapt and transform across industries and geographies, at its core, the business remains centered on the limited partnership structure that aligns limited partner (LP) and general partner (GP) interests over a long investment horizon. By concentrating equity and aligning GP and LP interests, the structure creates powerful incentives for GPs to not only drive growth opportunities in expansionary markets but anticipate and mitigate downside market risks.
The continuous development and implementation of new technologies, processes, and tools across the back-to-front office has been a critical enabler of the model’s resiliency and thus the asset class’ rapid growth.
2. Greater Diversification by Strategy, Industry, and Geographic Region
Driven by an intense competition and success that has attracted more and more capital, GPs have continued to diversify their strategy offerings. Investors today can invest across the capital structure, and throughout industries, regions and company lifecycles. In addition to providing a high level of safety through greater risk diversification, investors can be matched with strategies that better fit their risk-return profiles. Private credit, which includes distressed and special situations lending, is one of the fastest-growing new strategies and is likely to play a critical, countercyclical role in today’s severe downturn by providing capital and restructuring expertise to companies in financial turmoil.
Ongoing diversification by strategy, industry and geographic region raises significant platform complexity, integration and scaling challenges that put a premium on staying ahead of technology and operational best practices.
3. Maturity of Fund Managers and Investors
As a relatively new asset class, many of the original founders of private markets firms are still around or just beginning to hand over the reins to new leadership teams. Consequently, firms generally have partners who have experienced earlier market contractions and have the hands-on capabilities to navigate through today’s market dislocations. Similarly, LPs have gained significant investing experience to the point that some have become highly respected direct investors. The rapidly evolving secondary market is an indicator of growing GP and LP maturity, and will become an invaluable source of liquidity and risk mitigation. Last year the value of traded LP stakes reached near $90 billion—up from the $72 billion record total in 2018—and six times the value in 2008 [Coller Capital].
Particularly after the GFC, investor demands for timely reporting, customization, advanced analytics, and higher standards of cybersecurity helped to drive industry adoption of best practice operations and technology, and spurred the emergence of new solutions providers.
4. Rise of Permanent Capital
An important hallmark of private equity is that it represents patient, long-term capital. Yet, over the past ten years, GPs have taken the next step to seek permanent capital by going public, selling minority interests, launching longer-term or perpetual funds, and acquiring insurance companies with stable annuity streams. As an equity cushion, this capital becomes especially valuable during times like today when financial distress is acute and liquidity is in short supply. Unlike “temporary capital” that is locked in closed-end funds, permanent capital can be used strategically to seed new investment ideas, facilitate succession, enter new markets, and harness new technology.
Technology development and adoption are likely to benefit from the increasing flow of permanent capital into private markets. In turn, this should help build stronger and more resilient multi-asset platforms.
5. Growing Amount of Dry Powder
Today, approximately $2.5 trillion of the industry’s $5 trillion+ of AUM represents dry powder, that is capital raised but not yet invested. The amount of unused capital has been rising given record fundraising and slow deal activity as a result of elevated pricing. This high level of unused capital also indicates that GPs are exercising discipline. Moreover, during the present downturn as liquidity dries up, this capital can act as an equity cushion for portfolio companies in need of support, and enable fund managers to take advantage of fire-sale opportunities of top-flight assets.
Rising dry powder across a growing array of strategies points to the value of ever-evolving technology solutions that help GPs and LPs address data, reporting, and complexity challenges.
Private equity races to spend record $2.5tn cash pile, Javier Espinoza, FT, JUNE 27 2019
Private markets have the resources, expertise, and experience to weather the present downturn. Equally as important, they are likely to ultimately thrive given the opportunity to put highly flexible, disciplined, long-term capital to work when asset prices are at a low point.
This is not to say that the unprecedented financial turmoil caused by the pandemic will not cause damage to the asset class. Today, however, with more capital, experience, and innovative technology, plus the same incentives to perform, private markets are in a stronger position to mitigate the severe downside risks and take advantage of upside opportunities.
The industry’s significant expansion in products, strategies, investor base, and geographic footprint has been largely made possible by the equally significant deployment of operational and technology infrastructure. Aligned with its GP and LP partners in addressing reporting, data, security, and compliance challenges, Dynamo Software is positioned to do its best to ensure that industry comes out ahead of this cycle in stronger operational and financial conditions.
This article is written in partnership with David Haarmeyer, a Boston-based independent, private markets content and marketing specialist.