While the economic effects of the coronavirus pandemic have been devastating to most investors, the timing is fortuitous for private equity funds that are finishing up their fundraising and looking to deploy capital.
Before the pandemic hit, forecasts suggested that 2018/19 vintage funds would likely struggle to make decent returns this year as they faced record high asset pricing and intense competition. But once the markets settle down from the current volatility, vintage funds will be ideally placed to acquire portfolio companies at the bottom of the pricing curve, according to research from financial data and information provider Preqin and risk management consulting firm FRG.
At the same time, the firms said funds with vintage years 2012 through 2017 are likely to see their returns hurt by the pandemic.
“Those funds looking to make exits in the next 12 to 24 months will be facing a lower pricing environment,” Preqin said in a release, “while vehicles currently operating their portfolios will see disruption to their holdings’ industries.”
The 2016/17 vintage funds are likely to be most affected, having bought at the pricing peak and may face being unable to recoup their investments through exits. Collectively, vintage years 2012 through 2017 hold 77% of the unrealized capital invested in private equity, according to Preqin.
“In the coming months, investors will have to look at the disruption in financial markets and ask if they are ideally positioned to achieve their investment goals,” Dmitri Sedov, Preqin’s chief product and marketing officer, said in a statement. “Many have looked to private equity to help provide returns through good times and bad, and so the need to accurately predict their cash flows in this area is critical.”
The research also found that market upheaval will reduce capital calls and distributions in 2020 as fund managers delay making acquisitions or exits. Preqin and FRG analyzed the impact of a pandemic-triggered recession on capital calls, distributions, and net cash flows.
To model the impact, FRG created a “pandemic scenario,” which assumes a 25% contraction in US real gross domestic product (GDP) in the second quarter of this year, followed by a sharp rebound through the rest of 2020. The firms focused their analysis on 2017-2019 vintage funds, which represent 72% of the $2.63 trillion in callable dry powder that the private capital industry has raised since 2000.
The research said that for the 12 months ending June 2021, 2017-2019 vintage funds will likely reduce capital calls by 38% and reduce distributions by 19%.
“This is because we expect deal activity to be muted and distributions delayed as GPs [general partners] looking to buy wait for valuations to fall and greater economic certainty,” Jonathon Furer, Preqin’s head of strategy, wrote in a blog post. “At the same time, GPs that would otherwise look for an exit hold onto their assets to avoid selling in a downturn.”
Furer noted a sharp reduction in capital calls for funds with the highest amounts of dry powder, saying this should offer some relief to limited partners who will need to figure out how to meet their obligations in a more challenging environment. He said investors should plan for how they will meet outsized capital calls in 2021, as fund managers ramp up capital calls to capitalize on the lower asset prices.
“Since the global financial crisis, fund managers have had to contend with rising prices and increased competition as they try to make outsized returns for their investors,” Furer said. “While a recession certainly poses material risk to portfolio companies and exits today, it also represents a record opportunity for fund managers to buy at low prices after the longest bull market in history.”