Public market volatility offers opportunity to buy at discounts in private markets
Tarang Kumar. 26 July 2022. On behalf of AccelNorth Partners.
Last week, I wrote about volatility in public markets impacting private market valuations, and some of the ways that private market managers attempt to manage the volatility so that their portfolios reflect, at least in part, the GP’s view of fair value in a slightly more normalised way than a pure mark-to-market approach.
In a way, there is a “so what” to that short-term volatility point. Yes, LPs have to conduct stronger diligence on the fundamentals of the market, strategy, operations and people at GPs, amongst other factors, when considering new primary investments, but by and large the volatility in existing portfolios can be withered by LPs, and LPs are not desperate to sell at reduced valuations for this reason.
However, there is a second reason that is likely to lead to interesting secondary transaction opportunities in private markets, and that is what is well-known in the industry as the “denominator effect”. A number of large institutional LPs, public pension funds for example, have a maximum % of their AuM that they allocate to private markets. Say for example, an LP (“LP ANP”) has $100bn under management in December 2021, and has 15% maximum allocated to, and also fully invested in, private markets. I.e. in December 2021, $85bn exposure to public markets, $15bn to private markets.
Now we all know that public markets are down between December 2021 and June 2022 at somewhere between 21% (S&P 500) and 30% (Nasadaq 100). The $85bn of public market exposure from December 2021 from LP ANP is now therefore, ceteris paribus, valued at $60–68bn. Say over the same period of time, the private markets valuation is only down 10% (i.e. the $15bn is now valued at $13.5bn), the LP now has $13.5bn of private markets exposure vs. $60–68bn of public markets exposure. I.e. private markets now account for 16.5–18.5% of its portfolio, $1.3–2.5bn more than its maximum allowed allocation.
The LP now has three choices.
· Choice 1 is to go to its board and seek approval to increase the % allocated to private markets permanently. That process is harder than it sounds, and involves the investment team having to challenge why the initial maximum allocation is not considered good enough, how liquidity risk will be managed vis-a-vis the LP’s liabilities, and much more — usually an uphill battle.
· Choice 2 is to ask its board for a temporary increase in the maximum % exposure to private markets, with the understanding that the breach of the maximum allocation is a technical one, and will get corrected automatically once public markets recover. This may work for one or two quarters, but is harder to keep arguing if the public market downturn is more persistent. Recall that public markets were already down in Q1 2022 vs Q4 2021, and so Q2 2022 was already the second successive quarter where markets were down.
· The final Choice (literally) is to sell part of the private markets portfolio, to bring the % allocations back to what they should be. In our prior example, LP ANP would need to sell $1.3–2.5bn of its private markets exposure.
OK, I hear you say, that’s just the supply side of that capital. Surely, the $100bn+ that we read of secondary market dry power can’t wait to lap up those buying opportunities up?
Well, the answer for those secondary funds is nuanced. What many of them have promised their LPs is “J-curve mitigation”. i.e. that the value of what they acquire will increase in one or two quarters at most. Simply buying ‘relatively cheap’ is not good enough for these secondary investors; they have to more or less ‘call the bottom’ when the markets are volatile (or ask for very large discounts, so that even if fundamental portfolio value doesn’t increase next quarter, simply marking these assets to fair value will lead to a positive IRR for these secondary buyers).
We are starting to hear anecdotally that some LPs are seeking to sell some of their VC/growth portfolios at notable discounts, in the fear of these portfolios taking further valuation hits in the months to come, but by and large we are not hearing the same for buyout funds, infrastructure funds or senior lending funds, at least not at scale. Therefore, a number of these large secondary funds are likely to continue to wait before buying en masse until it is clear to them that the market is going to recover in the near term.
We witnessed a similar trend post the global financial crisis in 2008. Since traditional secondary funds require third-party LP capital to be raised, we did not see a large increase in fundraising by secondary funds really until 2012 or even 2013.
Given that the secondary funds’ capital raising activity did not substantially pick up until 2012/13, if the funds had deployed rather quickly after 2008, we would have seen a significant dip in the secondary market capital overhang, which we also did not witness, until a small dip in 2011, 3 years after the crisis, and at least two years since public market indices such as the S&P 500 and NASDAQ 100 had bottomed out.
What’s also clear, as we look at the size of secondary funds raised since 2019 (the ones with the most dry power), is that more than 80% of those funds have raised $1bn or more in fund size, meaning that smaller transactions of $25–30mm or less are likely to be of limited interest to these pools of capital, again opening up an opportunity for smaller and more nimbler capital to take advantage of.
In summary, both the very nature of a secondary funds that have raised off the premise of offering J-curve mitigation for LPs, and the size of secondary funds raised recently, combined with the denominator issue that a subset of LPs with established PE programs are facing, opens up an interesting buying opportunity in the secondaries market for more nimble pools of capital.
Interested to learn more, or want a confidential chat? Get in touch!
AccelNorth Partners is an advisor specialising in the private markets industry. Whether you’re a GP or an LP, reach out to us to discuss your strategic, operational, funding and sourcing challenges. Email us at info@accelnorthpartners.com. And follow us on Medium.
