North America in 2020: LP portfolios unprepared for downturn

High valuations, high multiples and GP discipline are expected to continue into the new year.

LP demand for private equity has been insatiable in the last few years. Investors have increased allocations and added secondaries and co-investments to their private equity portfolios.

But most LP private equity portfolios are not downturn-ready yet.

Almost 80 percent of North American LPs, 70 percent of those in Asia-Pacific and 45 percent of those in Europe responding to Coller Capital’s latest Barometer said modifications are required to prepare their PE portfolios for the next downturn.

Not surprising then that in 2020, LPs are expected to start or continue the process of modifying their portfolios in anticipation of a downturn.

“It’s interesting to see such a large percentage of LPs stating that further portfolio modifications are required,” Coller Capital partner Eric Foran told Private Equity International. “LPs widely acknowledge the macro environment as a risk to PE returns, and many have been active in using the secondary market for portfolio management purposes.”

Modifications could include rebalancing the portfolio by geography or strategy.

The continued appetite for private equity has led to difficulty for some private equity managers in putting capital to work and resulted in high levels of dry powder, according to DuPont Capital’s Antonis Mistras, managing director of alternative investments.

While most LPs appreciate GP discipline in investing in an environment of high valuations and multiples, this will further increase competition for high-quality GPs and co-investment opportunities, Mistras said.

For the first time, the market is seeing entry multiples of 20x or 25x, Mistras noted. However, he considers leverage to be under control, and the average private equity deal is smaller than it was pre-GFC.

“If you are a disciplined manager, it takes you longer to get comfortable with a deal, the funnel of your deals becomes narrower at the bottom, you reject more deals, and eventually that results in fewer closed deals.”

That might also lead to fewer co-investment opportunities, he added.

LPs in this cycle are trying to make investment decisions with an eye toward an expected economic recession and market correction. They are wavering between investing in growth-oriented quality private equity strategies, in distressed deep value managers, or a barbell including both, according to Alicia Cooney, managing director at placement firm Monument Group.

“People are considering managers investing in healthcare companies with unique advantages or in software companies growing at an amazing rate; even if growth slows, I still may be in a better place,” Cooney said.

There is increased LP appetite for sector-focused and specialist funds that may be particularly appealing in the late cycle. “The more knowledge you have about the sector, the better you are able to find true quality companies. However, I would not diminish the role that distressed investing can play once the markets do decline,” Cooney said.

“There is no one-size-fits-all strategy, and the high-quality managers, sector-focused or generalists, will continue to see more LP interest.”

Indeed, almost 93 percent of the 113 respondents in Coller’s barometer said the differences in the quality of GP strategies and teams will lead to divergence in results in the next economic downturn.

The more extended and risky managers are going to suffer in the downturn, and valuation multiples will return to healthier levels – something that could hurt firms on the exit. “Unfortunately, we are all going to pay for that with lower returns or losses, but the market is going to get cleaned up,” Mistras said.

The quality difference also has a potential advantage: it will lead to divergence in fund terms offered to LPs, according to 65 percent of respondents in Coller’s barometer.

“The quality difference between GPs is likely to be a factor – especially in relation to less active managers who may not be able to navigate their portfolios through a market downturn,” Foran said. This will lead to management fees coming under pressure.