This article is sponsored by Goldman Sachs
Given private equity’s long investment horizons, LPs have always had to keep their eyes firmly on the future to ensure their exposure captures emerging trends that will play out over the next decade and that the GPs they back will last the distance.
The arrival of covid-19 has made this evaluation that much harder, and with so much expectation of seismic change across economies and behaviours stemming from the pandemic – overlaid with uncertainty around how long it will continue to be a threat to life – identifying where LPs can create value for their stakeholders has become more complex than ever. Against this backdrop, we spoke to Chris Kojima, co-head of Goldman Sachs Alternatives Capital Markets and Strategy, to hear his take on how LPs can navigate the current crisis and beyond.
How will the pandemic affect the investment performance?
Experienced LPs are well aware of the challenges of manager selection. But the coronavirus outbreak is likely to exacerbate dispersion in performance, making the job of finding the right manager even harder. This is different than 2008 for a few reasons.
First, this is a healthcare crisis impacting people. The unique opportunity in private equity comes from investing in the best companies, managed by the best CEOs, aligned with the best GPs. But these employees, CEOs, and GPs are all human. It’s hard to be objectively confident on things like revenue, burn rates, and liquidity when you are subjectively anxious about a pandemic in your neighborhood.
Second, this crisis affects strong and vulnerable businesses alike. Unlike a conventional industrial recession or the 2008 financial crisis, the current disruption comes as a result of governments deliberately and swiftly putting the economy into a recession to confront a global healthcare crisis. The duration of this economic disruption is not driven by economic forces. The ultimate arc of recovery – whether a V, U, W, L, or any other shape – will be driven by science and public healthcare policy.
Finally, not all managers meet this crisis on equal footing. There’s always unevenness in each manager’s capabilities, but it’s during a crisis where this unevenness especially reveals itself. And these differences magnify across time, making the duration of the crisis incredibly relevant to the outcome. GPs and their portfolio companies might all be confronting the same pandemic-driven shock today, but they weren’t all at the same starting point on 1st January.
Many GPs will find that value preservation is a very different exercise than value creation. The operational base-case of many existing portfolio companies already reflected impressive assumptions – multiple add-on acquisitions, supply chain digitisation, data-driven demand curve optimisations – growth initiatives which were no small feats in the best of times. GPs must now pivot their operational playbook from offence to defence. How your managers play defence for you today should inform whether you want them to play offence for you tomorrow.
What’s the significance of this emergency being a healthcare crisis versus a financial crisis?
Some shock events are sequential – the event impacts the portfolio, and then we later ask how the manager is handling the consequences. In contrast, the coronavirus outbreak is more explosive in its reach, impacting the manager’s portfolio, its people and its processes, all at the same time. This simultaneous collision makes this crisis very different than one driven by fundamental business weakness and economic uncertainty. LPs can’t fully dissect the impact of the pandemic on the portfolio without first understanding the impact on the people involved. An investment team’s superior investment skill does not matter much if the investment team is unable or unwilling to come to work.
These are the moments when we’re reminded that investment organisations are not impenetrable permanent institutions, but instead fragile human eco-systems. In good times, it can be tempting to see topics like business continuity, succession, leadership and culture as “soft factors”, less relevant than the “hard math” of track record analysis or portfolio valuation. But the humans responsible for investing, capital raising, risk management, and the broader “business-of-the-business” are all vulnerable to human stresses and fatigue. The longer this emergency continues, the harder these soft factors will become.
Perhaps the most powerful binding force during stressful times is the manager’s culture. This is the collection of unwritten understandings, rituals and expectations that guide the team’s conduct. During a pandemic crisis, culture serves as an important compass for a scattered and unsettled team, remotely managing personal stress and confronting daily uncertainty. These are the defining moments for a firm’s culture, the things that will leave a lasting impression in the hearts and minds of the firm’s human talent, long after the pandemic fades.
Just as they experienced in 2008, LPs investing are once again at an inflection point. There is a serious amount of new information – about people, portfolios, processes – that LP investors are about to receive on their managers. A shock like the one we’re experiencing will reveal unexpected surprises, both positive and negative.
Beyond the manager re-assessment, how should LPs consider their portfolio construction?
Most LPs access private equity, at least in part, through external managers. This “GP delivery mechanism” and the wide dispersion of performance around the average add a layer of complexity in analysing the underlying pieces. These managers are also solving the risk-return objectives of their own portfolios, not the overall portfolio of any particular LP. No matter how clever each GP may be at risk management, it is highly unlikely that the sum of individual GP decisions will perfectly coincide with what an LP requires at its own portfolio level.
This means that it’s harder for private market investors to know what has happened to their portfolios. Understanding each underlying manager is only a starting point. Like the architect and engineer surveying a building after a severe earthquake, LPs need to consider not just the disruption to the underlying building blocks, they must also consider the stability of the building itself. And in a global crisis with uncertain duration, the risk of aftershock is high. LPs now need to repair the building blocks, fortify the building and correct imbalances so the structure fits the original blueprint, or evolves to a new blueprint. A portfolio-wide solution requires a portfolio-wide perspective.
Looking out, how might investors imagine the other side of this pandemic?
On the other side of the immediate recovery, both LPs and GPs will need to ask how things have changed, and how enduring the changes will be. No matter what their assumptions are about the disruption and recovery, investors might reasonably sense that some enduring changes are in store, and that the world is unlikely to simply spring back to its former self. It’s possible we’ll later frame this as yet another in a series of big shockwaves we endured. But in 2020, the entire world simultaneously quieted itself, in a co-ordinated effort to combat something that threatened everyone. It seems more likely that the human dimensions of the threat, and the gravity of the response, will leave a deep psychological impression that echoes into the future.
The heavy work being done today on business operations and capital structures is appropriately focused on the next several months. But long-term investors are considering time frames beyond these near-term stabilisation efforts, beyond the flattening of epidemiological curves, and even beyond a vaccine. These LPs and GPs recognise that today’s investment vehicles can extend into the 2030s, and that those future time frames are very much relevant for the eventual buyers of the portfolios built in this decade.
One over-arching theme that seems reasonable revolves around a new appreciation for our vulnerabilities – a desire to make products, experiences, processes and systems more resilient and less fragile. Most of us in 2019 would have found it inconceivable that the entire economic production of the world could be suddenly arrested for months in 2020. Disruptions to the food, water or energy supply will now seem less inconceivable. Scenarios that were once dystopian fiction will need to be re-considered as realistic risks falling squarely within our investment horizons.
How relevant is 2030 to the decisions we make today?
We’re looking less for some answer from a time machine, and more for evidence that managers are asking the questions. Futurism isn’t an easy exercise when we’re in the middle of an emergency. It is clearly for tomorrow to ask how strongly businesses, employees, consumers, governments, citizens and investors feel about the vulnerabilities they experienced in 2020. But if investment managers are asking LPs to make new commitments today – for investment programmes extending to 2030 and beyond – it is reasonable for LPs to evaluate their managers’ vision for this future, and the ways this vision has changed as a result of this pandemic.
What are you hearing from other CIOs as they react to this pandemic?
Each CIO is unique, and so the pandemic challenges each of them in different ways. But many CIOs in 2020 are now asking themselves the same question: how many times in a single lifetime can a once-in-a-lifetime event happen? These LPs are already considering how they can better prepare for the next black-swan event, whether it is a failure of the power grid, a climate-driven natural disaster, the collapse of a systemically important financial institution or next pandemic. They’re looking to build the Ark before the rain.
Following the 2008 financial crisis, some LPs launched some new initiatives, many of which proved useful over the past decade. Some CIOs embraced a “one fund” model, encouraging investment teams to work across traditional asset-class silos, enabling holistic risk management, a common language across public and private markets, and more agile engagement on opportunistic strategies. Some CIOs viewed their underlying managers as a source of market intelligence as well as a source of alpha. And other LPs launched ambitious data science projects, collecting and synthesising massive volumes of big and small data, arming themselves with important context and maybe even some basic AI to look around corners.
These sorts of innovations helped some CIOs maximise opportunities across the 2010s, and perhaps made their portfolios more resilient for 2020. Experienced LPs will see the current crisis as an opportunity to evolve their private markets programme once again.