This article is sponsored by EQT Partners
How best should LPs assess the risks to which they are exposed?
We have talked to lots of LPs about this. You can’t judge a portfolio purely by its pie charts, where illustrations might show X per cent in this industry, country or place in the capital structure. The only way to truly understand the risks is to go company by company, line by line.
You also have to test the manager’s style. Do the due diligence as if you are investing your own money in those companies – which in effect you are. It has been too easy, in many respects, for managers over the past few years to dress up their portfolio to look like anything they want it to.
Ultimately, LPs should be looking for managers that have the resources, the ability and the knowledge to tackle a wide variety of situations and issues. They need to be able to use their knowledge to make smart investment decisions that avoid losses. And, having avoided those losses, they must be able to show they can generate an attractive return for the risk they are taking. One indicator is to look for successful exits in a portfolio. Defensive, attractive assets are even more sought after in these times, so realisations should not dry up post covid-19.
Managers also need to have the right skillset, so LPs should look for people who have been “in the trenches” during previous downturns. Talking specifically about restructurings, it is worth remembering that these are stressful moments for any investor. Documents may need to be renegotiated, covenant breaches or cash shortfalls addressed and debt-to-equity conversions evaluated. While investment teams that don’t have that relevant skillset can certainly develop it, it takes many years and you will make mistakes along the way. We are starting to hear of managers without those capabilities selling all or part of their positions to investors with those capabilities to do the heavy lifting.
If you have a weak portfolio, it takes a minimum of one to two people to work through a full restructuring, potentially taking time and energy away from originating new deals. It adds stress to the system from a capacity standpoint, but also in terms of the team’s personal lives. People’s hair goes greyer, and the team members will endure sleepless nights. There are more unintended consequences and impacts than just the value of the challenged investment.
For LPs, what can be done to improve their position, now we are fully immersed into the pandemic? Is it too late?
If you are only repositioning the portfolio now, you are two years too late. For LPs, it means you are wedded to your manager’s asset selection at this point. You need confidence in the strategy in which you invested. Most LPs are understanding if they are in an investment that hasn’t gone to plan. But if they lose confidence in their manager’s abilities, that is when they vote with their feet and either look to sell their position or don’t invest in the next fund.
There is a secondary market for LP stakes. In 2020, we have heard of a number of transactions in Europe. Specialist managers have raised significant amounts of money to purchase secondary stakes. As the market has matured, the discount applied to net asset value had been shrinking, which is good for LPs. To get a good price, the buyer has to trust the valuations used to calculate the NAV as well as have confidence in the economic outlook. Right now, there are substantial discounts.
From a macro-economic perspective, are there any consequences yet to play out which could affect portfolios?
We are now dividing the world into potential covid and non-covid impacts. We agree that economies will heal, but it is likely to take quite a long time. We have not seen the bottom yet. If you look at the global financial crisis, it took over five years for leveraged loans to get back close to pre-GFC levels.
Furlough schemes are coming to an end and many companies are going to be left in a tough spot. Companies have had to use cash or borrowed money for non-productive purposes, just to keep the lights on. As a result, they are coming out of the first covid wave more levered than when they went in. I think it is inevitable we will see additional damage to balance sheets of governments, companies and consumers. Confidence levels will all be tied to this. We think this investment opportunity will be here for quite some time to come as stressed markets are typically great investment environments for private credit.
But my concerns are not limited to covid. Setting aside the presidential election in the US, there are a number of other global impacts, such as rising tensions between the US and China, frayed relationships between multinational organisations like OPEC and NATO, increased political polarisation in Western countries, and rising inequality and social unrest. Then, we also have Brexit. All together there are a number of headwinds to the recovery.
The question is how fast do we recover? Volatility is a good thing – not from a personal perspective, but from an investment standpoint. It always presents attractive investment opportunities. There is an opportunity to make very good money in this vintage of coming funds. Premiums will rise in corporate credit and the terms should be better. There is always a flight to quality.
What opportunities exist for LPs? Is it worth exploring these now, or waiting a little longer?
Both the primary and secondary markets are looking pretty interesting. The secondary market will likely be characterised by continued volatility and there is now a much bigger dispersion in prices for credit quality. We are moving from a strongly performing world into a less-well-performing world and this will have knock-on effects.
Banks have large portfolios of consumer and corporate credit which are going to start showing increased levels of non-performance. As a result, banks will trim their risk weighted assets. That not only offers opportunities in the secondary market but also in the primary market as there will be less appetite to put incremental risk on the books. Direct lending funds will take share in the primary LBO direct lending space because we are able to write large tickets, move faster, and be more decisive than the banks.
In the secondary market, we will see increased supply. In the whole credit opportunities space and higher risk strategies it has not been easy to find well-priced risk for the past couple of years, but that changed this year. Markets have already seen significant dislocation and we are now coming into a period where there will be a lot of stress. The investment pipeline funnel will be much broader.
What are the effects on investor asset allocation?
We expect many LPs will shift a bit back towards riskier strategies. If you think about the risk/reward curve, you’re looking at 10-13 percent plus unlevered net returns from credit opportunities and distressed strategies. The market environment is going to produce some very interesting opportunities over the coming years. People are going to want to make sure they are getting paid for the illiquidity and this is a logical place to look in the current market. I also expect LPs to continue to be highly discerning and even more focused on diligencing their investment managers. It should be a good opportunity for LPs to clearly differentiate between their managers.
At the same time, there may be some managers who won’t be able to raise their next fund because underperformance will make it difficult to attract fresh capital or retain top talent.