Unwanted Company – Private Markets and COVID-19
Global economies are in a constant state of change, with current events having the potential to drastically influence the behavior of local, national and regional markets. The most direct example that can be given is the oil industry, where the decisions of a single country about their production rates can cause a plunge in selling prices, which negatively impacts the economy of almost every oil producing country.
These changes in large scale trading then causes disruptions in lesser economic activities, which later have consequences on the general population that work in these activities for a living. To combat this situation, governments tend to apply measures that help mitigate the consequences towards the general population, including subsidizing certain costs that increase suddenly, enforcing the freeze of debts and payments or taking action to avoid a rise in unemployment.
However, there are certain scenarios that threaten the stability from both fronts and disrupt the international and local economies. And the situation we are currently dealing with the rapid, worldwide spread of COVID-19 is affecting workers from every sector and industry, which has severely impacted production and consumption to incredibly harmful degrees.
But there is another layer that needs insight in this dire situation: the one that does not rely in any company and is composed of investments that do not trade publicly or in exchanges, the called Private Markets. Given their apparent isolation from the traditional market and economy, they are expected to be affected differently by a pandemic, which is why we will look at the report made by PitchBook Data to discover the short-term effects of COVID-19 on Private Markets.
Can Run, Can’t Hide
Since the majority of PitchBook’s clients are oriented towards Private Equity and Venture Capital, it makes sense that this is the first topic they discuss. They explain that, since PE is not traded in public markets, it may be safe from drops in stock prices, but a reduction in earning profiles generated by said drops would indeed become a risk to PE investors. According to their view of PE relying on GDP, the evident decline in production, consumer spending and business investment will slow down PE transaction volume as a reaction to this movement.
Another big sector that will be affected is high-yield bonds, that have launched upwards as investors are selling their most risky assets. They also mentioned the drastic decline in leveraged loan volume, from $81 billion at the end of January to $860 million at the beginning of March, which is another reflection of the decrease in demand for high-risk assets.
They also briefly discuss the potential state of well-funded PE vehicles, as they might gain the responsibility to inject liquidity into portfolio-oriented companies, sacrificing the leverage that causes the enhanced returns of LBO (leverage buy-out) market. They argue that this may cause the underwriting of deals by firms and, as consequence, reduce the number of viable target companies in a very short amount of time.
Private Assets Under Siege
The second big topic they cover in the analysis is how the performance of private assets will be directly affected by the situation, by analyzing both short- and long-term scenarios and possible changes in the fundraising environment. First, they explain that private markets have a history with strong evidence of being less volatile against public markets, comparing its performance since 2001 against S&P 500 TR, and defending that this pattern will be held during this situation.
Later, they highlight that their research has shown how PE and VC funds raised in the early stages of downward trends tend to underperform, while pointing that the best-performing examples were started at the lowest points of the downturn or towards the beginning of the recovery stage. However, they also explain that each market cycle is different, and use the terrible performance of VC during the dot-com era as an example, as there was no considerable rebound for the market after this, but they say it does not necessarily mean that this situation will be repeated this time.
Regarding fundraising, they argue that a reduction in sell prices for public equities would in turn reduce the asset pool available for future investments, referred to as the “denominator effect”, and they say that the risk of this phenomenon will be mitigated to a certain degree because Limited Partners are currently underallocated to private markets, which reduces the concerns about illiquidity.
Overall, PitchBook offers a very objective look at how the environment of private markets is most likely to behave in the upcoming months, given the projections on how will it take for the pandemic to be controlled or a vaccine to be developed, demonstrating their points with solid examples of similar situations in the past, while never forgetting that this cycle might act in a significantly different way given the generalized nature of the infection and the measures that have been taken up to this point.
This could be the first of a series that will cover how the spread of COVID-19 is affecting different sectors of the economy, which might span numerous articles as the situation evolves, so stay in touch!
