Practical analysis for investment professionals
31 March 2020

Private Equity: The Weight of the COVID-19 Crown

Private equity (PE) often claims the financial crown of outperformance. But I am referring to that other, now infamous, Latin word for crown — corona — the shape of which lends its name to the current coronavirus pandemic. So how will it affect PE?


PE investing is about absolute return, not outperformance, in my experience. Survey results referenced by Paul Gompers, Steven N. Kaplan, and Vladimir Mukharlyamov back this up. The three observe, with some surprise:

“PE investors believe that their LPs [limited partners] are most focused on absolute performance rather than relative performance or alphas. . . . Such investments carry significant equity risk, suggesting that equity-based benchmarks like public market equivalents (PMEs) are appropriate.”

I would rephrase that to “should be appropriate.”  

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The Beta Court

So my focus is absolute return, not the legitimacy or lack thereof of PE’s outperformance crown. The PE industry consistently does a good job. Indeed, the PE risk premium has stochastic characteristics. PE investors do not pursue outperformance objectives.

Does that mean PE is decorrelated from equity risk and immune to market volatility?

Not at all. The scarcity of valuation data points, due to the quarterly release of net asset values (NAVs), does not indicate the absence of volatility. Volatility and correlation are just non-observable — so any eventual smoothing effect in the LPs’ accounts is completely artificial. That it is not easily observed doesn’t mean it cannot be estimated.

But when it comes to correlation and valuation, from a pure practitioner’s perspective, what happens to PE valuations when public equity markets collapse by close to 30% as they have over the last several weeks?

In the years since the global financial crisis (GFC), the public markets have enjoyed a fairly uninterrupted bull run, especially in the United States, which still represents the dominant PE market. There have been hiccups potentially as significant as the current one, but they’ve been short-lived. A similar, more slow-moving decline occurred in the third quarter of 2018, but the market bounced back in the fourth quarter. The current downturn is reminiscent of Black Monday 1987 and the US equity markets took over two years to recover from that bear market as well as those of 2000 and 2006.

The Weight of the Crown

So how will PE fare in this downturn?

Mark-to-market rules could take their toll on the asset class for the first time since the GFC. Mark-to-market has rarely dented the profits and losses of investors. The reporting delays associated with NAVs often exceed three months and have cushioned the blow from market valuation drops. Quick bouncebacks have thus far shielded PE NAVs from these declines. Why? Because typically, at the end of March, for example, the available PE NAV may refer to the end of the third quarter of the prior year: 30 September 2019. Or the just-released year-end 2019. A significant decline in the PE markets followed by a fast rebound the next quarter has no effect on the to-be-released fair value statement. Not on the end of December NAV or the subsequent March NAV.  

The preceding chart shows secondary prices have been largely unaffected as well. Post-GFC, they have been reasonably stable for buyouts, in particular. Will this hold up under the weight of the coronavirus crisis and the accompanying threat of severe global recession?

The Potential Beta Legacy of the Coronavirus on PE

An estimate of the theoretical impact of a public equity bear market on PE valuations can be derived from Yardeni Research data.

Given the reported (assumed net) debt-to-equity ratio of 0.86 for the S&P 500, hence a debt/EV ratio at 46%, against the equivalent ratio for the buyout industry of 63% on average, a 20% contraction in the EV/EBITDA ratio would correspond to an equity shock of approximately -37% = [-20%/(100%-46%)] and a -54% = [-20%/(100%-63%)] impact on PE NAVs.*

The share prices of listed general partners (GPs), among them Blackstone Group, KKR, and Apollo Global Management, are readily available and offer an easy litmus test. In the current turmoil, their share prices, the balance sheets of which include the NAVs of the funds they manage, have moved more dramatically than the S&P 500.

So what if prices and implied valuations don’t quickly rebound? What if the real economy is unrecognizable after the coronavirus epidemic?

Coronavirus’s Negative Effect on PE

There are a few potential consequences that investors should consider:

  1. Implications on Fair Value: The first thought goes to the December 2019 NAVs. How will the discounted present value of the future cash flows incorporate the new market information? Could the secondary prices embed much higher discounts than those shown in the buyout fund chart? Would the discount disappear when March 2020 NAVs come out?
  2. Complications of the Possible Denominator Effect: In a multi-asset portfolio, allocations come with boundaries, and a decline in the public markets (the denominator) would make the relative weighting to PE (the numerator) exceed its limits. This could artificially and maybe temporarily force LPs to rebalance their portfolios by selling fund positions in the secondary market, at price and probably in very unfavorable conditions.
  3. The Contributions-to-Distributions Ratio: During growth periods, this ratio is usually positive, which implies that the cash produced is more than the cash invested. During down market periods, normally characterized by less liquidity, the ratio becomes negative, so more cash than is produced is absorbed by PE. This can add liquidity tension to the portfolio.
  4. Latent Lending Loan-to-Value Triggers: Most secondary transactions have lending facilities that support the acquisition of the PE interest and the provision of liquidity to the seller. The buyer normally uses lines of credit that are collateralized by the assets purchased with a loan-to-value protection, A financing of 50, for example, is collateralized by a NAV of 100. If the NAV suffers from devaluation, lenders might request additional collateral or repayment. Even with diversified portfolios, a significant slump in market valuations is exacerbated since portfolios absorb more cash than they produce, thus increasing the risk of defaults.
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The Positives

Of course, with challenges come opportunities:

  1. Dry Powder Becomes More Precious. That GPs have not put their committed capital to work — because deals were too scarce or expensive — becomes their competitive advantage. Cash on hand during times of crisis has its benefits and is a reasonable predictor of attractive returns.
  2. There Is More Alpha to Extract. By combining the absolute return properties of PE with innovative risk transfer tools, investors can manage PE’s beta legacy and risk-premium stochasticity.

* This text has been corrected. An earlier draft mistakenly laid out the formula as debt/EBITDA rather than debt/EV and listed the two 100%s as 1%s.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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About the Author(s)
Massimiliano Saccone, CFA

Massimiliano Saccone, CFA, is the founder and CEO of XTAL Strategies, a fintech SME developing a platform of innovative private market indices and risk-transfer solutions. He developed and patented a private equity performance valuation methodology, is a former member of the GIPS Alternative Strategies Working Group at CFA Institute and the author of a Guide on Alternative Investments for CFA Society Italy. Saccone has pioneering experience in the field of the retailization of alternatives at AIG Investments (now Pinebridge), a global alternative investment manager, where he was a managing director and global head of multi-alternatives strategies and, beforehand, regional head of Southern Europe. Prior to that, he was head of institutional portfolio management at Deutsche Asset Management Italy (now DWS). He is a CFA charterholder and a qualified accountant and auditor in Italy, has a master's in international finance from the Collegio Borromeo and the University of Pavia and a cum laude degree in economics from the University La Sapienza of Rome. He is also a Lieutenant of the Reserve of the Guardia di Finanza, the Italian financial law enforcement agency.

3 thoughts on “Private Equity: The Weight of the COVID-19 Crown”

  1. Khalid says:

    Thank you for the insightful article.

    I have two comments/queries regarding the following:

    Given the reported (assumed net) debt-to-equity ratio of 0.86 for the S&P 500, hence a debt/EBITDA ratio at 46%, against the equivalent ratio for the buyout industry of 63% on average, a 20% contraction in the EV/EBITDA ratio would correspond to an equity shock of approximately -37% = [-20%/(1%-46%)] and a -54% = [-20%/(1%-63%)] impact on PE NAVs

    1-I think you meant 100% instead of 1%. Am I right?
    2- Does this formula still apply if debt/EBITDA is above 100%?


  2. Massimiliano Saccone says:

    Thanks for your interest and comments, Khalid. Your comments catch two proof-reading errors of mine and lead to the current amended version of the post. The answer to your first question is yes, you are right. The answer to the second question is probably not. But I mislead you erroneously writing Debt/EBITDA rather than Debt/EV, as the calculations imply. Debt/EBITDA is usually higher than 100%, Debt /EV higher than 100% would imply negative equity. Best regards.

    1. Khalid Shakhshir says:

      Thanks again for the great article. Stay safe.

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