‘Most GPs are simply in fire control mode’

Joncarlo Mark, a former senior portfolio manager at CalPERS, gives his take on the current market: how LP co-investments will fare, what the opportunity set looks like and whether LPs will have to ‘walk away’ from some capital commitments.

As a senior portfolio manager with the California Public Employees’ Retirement System, Joncarlo Mark was in the private equity trenches during the global financial crisis.

He left CalPERS to set up investment advisor Upwelling Capital Group in 2011. He’s also a faculty member for the Institutional Limited Partners Association Institute, which provides executive education for its members, and a trustee for the University of California Davis Foundation.

See all Private Equity International’s coverage of covid-19 and its impact.

We caught up with him via phone to find out how he thinks the industry will weather its latest storm.

Joncarlo Mark Upwelling Capital
Joncarlo Mark

What’s the main focus of discussion with your clients right now?

A lot of the discussions we have had are with groups that are trying to understand what they have in their underlying portfolios and where they need to play defence. On the other hand, what’s quite interesting is you have a number of people that have been reaching out to us who provide capital, particularly capital for fund-level preferred equity or lending, knowing that is an area of need and opportunity right now.

Near term, there are companies that have lost substantially all their revenue overnight or are having major issues because their employees can’t come into work, which is obviously detrimental to a portfolio. On the other hand, you also have some situations where GPs are saying “We have an opportunity to acquire a tuck-in business right now as a particular company or set of companies are less impacted by the shutdown.” In these instances, this is a great opportunity to take advantage of market dislocation.

All that said, most GPs are simply in fire control mode and devising plans to minimise loss and triage. New deals will generally be hard to get done because GPs can’t look at the Q3 numbers and Q4 financials of a company to determine the health of a company or price a company. LPs are focused on their liquidity needs and trying to gather as much information as they can about what is happening on the front lines.

Are you seeing any M&A activity?

The only deals that are getting done are deals that were mostly agreed to by the time the market fell apart. I don’t think you’re going to have, in the near term, companies being bought and sold from private equity portfolios. What you will have, again, is situations where there can be add-on deals to existing portfolio companies. Think of a non-private equity, family-owned business that needs growth equity, or is in a tough spot: they may be open to selling their business at a depressed price as the founder or entrepreneur may not have it in him or her to battle through this tough period.

What are LPs expecting from their GPs?

Investors should expect private equity managers to be intimately involved in their companies right now, looking at everything and tracking weekly how covid-19 is impacting their businesses. How do they stay afloat for the near term? What happens when restrictions are lifted? Where do they invest in those companies in the future? Is this a business that has come out looking a third of what it was before? And if it was a highly levered business, is there a way out for the equity? They’re going to have to triage. They’re going to have to make hard decisions on some of these companies.

Communication is key – this is when LPs need their GPs to be most active with updates. Everyone realises these are unprecedented times but LPs will be keeping count of those GPs that aren’t transparent with what is really going on. The focus should also be on the fund subscription lines and how those are being managed.

Are LPs thinking about rebalancing their portfolios?

I believe there is a bifurcation in the LP community. The first set are the seasoned LPs, who learned a lot from the last cycle. In the financial crisis, they were caught with being overallocated and not having enough flexibility in their investment policy targets. Many didn’t have a target range for private equity. When the denominator dropped, they were overallocated and stuck without being able to commit capital. In some cases, LPs were forced to sell at the exact time they should have been putting money to work, albeit at a more measured rate since the fundraising market was much smaller coming out of the crisis. So now, many of them have gotten range flexibility, and they have the ability to commit capital above their PE targets.

These LPs will not be committing the same amount as they were committing in 2019 and 2018 and I think they’re going to be highly selective in what they do. They will home in on special situation opportunities and likely find comfort with their most seasoned and trusted relationships. For instance, at CalPERS, in 2009 we committed heavily to credit opportunity funds, which was a really important move. We took advantage of the market dislocation at that point and made huge returns.

In summary, what I have heard and discussed directly with LPs is that they are following through with some of their commitments that were in the works. They haven’t just put everything on hold. Interestingly, I have done multiple reference calls in the last two weeks related to LPs considering a large fund in the market.

Where I think the biggest challenge is going to come from are new entrants to the asset class – and there’s been a lot of those of the last many years – who are not used to this kind of volatility in their private asset classes. They may not have PE investment policy ranges and their boards or other governing bodies may not have the stomach to deal with the extended erosion in value in their PE portfolios, especially when they learn about the ill effects of leverage. I suspect there will be some bad press about PE-backed companies that will not sit well with certain institutions’ leadership.

Ultimately, there are multiple factors that will lead to rebalancing initiatives and we are observing some of this activity already. I think you will see some LPs try to walk away from recent commitments that are less than 25 percent funded where they are most concerned about relieving their 75 percent future funding obligation. And some may simply want to cut exposure across the board. Last, you may see LPs want to separate from certain managers they deem less desirable players or with whom they have lost trust.

How will this new market environment affect LP appetite for co-investment?

In a good market, everything looks great, but when things go sideways, it will certainly have an impact, because what do the suffering companies need in a down market? More capital. A lot of institutions aren’t set up to deal with these situations, such as feeding working capital to a company on multiple occasions or if the manager is asking them to put up capital to buy down company debt. All of this is already in the works or will start shortly.

The reality is that most LPs go through a mechanical process with co-investments. Once they make the decision to co-invest, it’s usually thought of as a one-time deal. Three to five years later, they expect to get their money back plus a return without paying fees or carried interest. But what happens when the company needs money right now to address a credit situation – not $50 million, but $4 million pro rata from everyone? Does the LP have even the ability to ramp up to go through their mechanical process to execute this transaction? Do they need to hire an advisor? Do they need to go to their board with the deal? This is especially tough if the money needs to be made available in the next two or three weeks. So your question is really interesting. Co-investing can be very successful, and theoretically now would be a great time. But this requires the right governance and processes to do it effectively.

Also, one should not be fooled that co-investing with your best managers always generates returns that are better than fund returns. The conventional wisdom with co-investments is “I save fees, I save carry, and I’m co-investing next to my best partners”. That’s assuming you’re getting the best deals. But when something like this happens and there is new money coming into portfolio companies to help them survive, such as a bridge loan or new preferred equity, it is going to be pretty taxing to the existing equity. It’s certainly going to have liquidity preferences and other terms that are advantageous to the new money. If you don’t participate, you run the risk of being diluted, at least in the near term or until that new capital is taken out.

The other issue is how an LP handles the headline risk of having co-investments go sideways. When a deal fails within a fund, it’s a part of a portfolio and is one step removed from the LPs. When an LP is invested directly in a company – even if the deal is relatively small compared to the overall PE program – it can absorb an unbelievable amount of time and energy to manage. This is especially true if company stakeholders such as workers or customers feel they were disadvantaged in the process of a restructuring and are vocal with their objections.

Back to my point – an institution needs to have the right governance and protocols to endure and work through such issues. And if they do, their capital will be very valuable as a co-investor.

Do you see now as a good time to lean into private equity investing?

I think there’s going to be tremendous value that’s going to come out of this. It may not happen overnight. And it’s not likely going to be levered opportunities. I’ll point to an example: Silver Lake acquired Skype back in the last cycle, and people said, “Crazy – an all-equity deal?” It worked out to be a really great deal.

Right now, everyone’s just waiting for the dust to settle a little bit more, but then I think there are going to be tremendous opportunities. This is right when you don’t want to be completely out of the market. There will be a reckoning of companies and managers, and those who survive will do remarkably well.

In the interim, we’re counting on the managers to do what they tell the LPs they do well, which is that they’re both financial experts and they’re operating experts or have critical operating resources that they can call on. Not across the board, but every firm has companies that are really challenged right now. I think you’ll see a pretty big separation of those who can manage through the tough times well and those who really struggle when they’ve got an impaired portfolio.