Thought Leadership

Crisis accelerates changes already underway in PE space

By Audrey Nangle

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What happens when you take a part of the investment industry that was already changing and subject it to a profound shock? That’s the question that will challenge private markets for the foreseeable future.

The landscape was already in flux when the novel coronavirus came onto the scene. Now, some funds are experiencing or anticipating major financial disruption, while others are finding unexpected gains and opportunities. 

Even before the coronavirus outbreak, there were numerous drivers in motion. The playing field had become more competitive and returns had become harder to achieve, particularly for some hedge funds. New regulations, a push for more transparency and investors’ demands for more involvement were already having a strong impact. Cost-consciousness and fee scrutiny were also well underway. 

In response to the complex forces at work, managers and investors have become more creative and flexible in their approach to investment. As the turmoil continues, a few trends in private markets stand out:   

Funds and investors are fluid

Even before the current sea change, funds and investors were stepping out of their traditional lanes to expand the pool of opportunities. The evolution continues. Hedge fund managers, for example, are launching private equity and debt funds. Smaller investors are moving into venture capital that allow more modest commitments. 

Hybrid funds, with characteristics of both hedge and private equity funds, are also on the rise. Many investors expect hybrid funds to offer more predictable liquidity and better cash flow, helping to boost the probability of long-term success even in the midst of a crisis. 

This crossover, however, is likely to be impacted by shifts in fundraising and dealmaking. With so much uncertainty, many funds are anticipating a decline in dealmaking, given the higher scrutiny, increased due diligence and difficulty in determining valuations. Financing could also become more tenuous although the stockpile of capital, particularly in private equity, provides a substantial cushion.

Global instability and its impacts are also likely to accelerate another trend. If fundraising lags, some smaller funds could close, paving the way for megafunds to continue the massive growth that has occurred over time. 

In these times of change and uncertainty, there is great opportunity for some fund managers, particularly for private funds with unused committed capital. An example of this would be debt funds, which are expected to see rapid growth in the volume of distressed loans over the next few months.

Investors seek greater involvement

Investors of all types are demanding more transparency and information. In some cases, general partners and limited partners are having conversations at a fund’s inception. There is more and earlier negotiation over fees. 

Co-investments are also becoming more common, with insurance companies and pension funds among the leaders in seeking these opportunities. In some cases, institutional investors will be among just a small group in the co-investment, giving them more say and influence over what happens in the fund.

Limited partners of all types are looking to further diversify their portfolios, whether that means new sectors, geographies or strategies, and are seeking more information as they expand into less familiar areas. 

On the regulatory front, Alternative Investment Fund Managers Directive (AIFMD) is mandating greater transparency. That may be reassuring to investors but it comes with a literal cost, as both time and monetary resources are being used to meet the requirements. As these expenses are paid for by the funds, ultimately the limited partners are picking up the bill.

In addition, the IRR of the fund is being hit, which results in lower carried interest. This, in turn, has an adverse effect on the fund managers and their cash flows. All of this is exacerbated by the fact that AIFMD and other regulatory schemes are not always written to accommodate the complexity of private investments. 

Private equity firms are branching out

To lower their risk of exposure and find new sources of returns, some PE firms are broadening their investment strategies. They may be launching venture or debt funds, or pursuing themes that are outside their traditional areas. To help drive success, they are seeking thematic experts to direct their strategy. This has led to demand for sector experts and even the acquisition of firms with particular expertise.

With the pummelling the world economy is taking, some firms are looking at distressed debt and others private debt and credit strategies. The focus is on entire industries that are now struggling, including energy, travel, non-streaming entertainment, retail and restaurants. In these cases, the closed ended nature of the private investment structure should give comfort to fund managers as they wait out this difficult time.

There is often opportunity in down cycles and firms are also considering industries that have gotten an economic boost from the coronavirus. The changes in how people are living now – working from home is the new normal, students are immersed in online learning and tele-health has become a necessity – could persist even after the pandemic is contained and boost related sectors.

As funds and investors struggle to find opportunity and minimise undue risk, they are taking new paths and building new relationships. It’s difficult to predict what will happen in three or six or twelve months. One thing is clear, though: the private markets industry was already in flux and those changes will only accelerate and reshape the industry in new and indelible ways.

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