September will see the 10th anniversary of the collapse of Lehman Brothers, an event that caused unprecedented uncertainty and left markets wondering which institution would fall next. For Finnish pension fund Ilmarinen, like other limited partners, it meant seeing their managers mark down the value of their assets in line with the plummeting public markets.
“The larger funds were marking their holdings very much to market, so this was where the pain was most acute and visible,” says Katja Salovaara, a veteran private equity investor and senior portfolio manager at Ilmarinen. Some GPs demonstrated “a lot of honesty” in their marks, which in turn led to a perception that their performance had suffered.
“What really happened afterwards was that very few companies were lost in the end; they made a lot of changes, worked with the companies, and these turned out to be really good funds,” says Salovaara.
“I think the financial crisis was a great acid test for creating value and being hands-on”
Academic research supports the notion that companies owned by private equity funds received more investment during the financial crisis – through debt and equity – than companies under other forms of ownership. In a similar vein, those crisis-era funds – raised between 2006 and 2008 – ultimately returned a pooled median net money multiple of 1.5x, exactly in line with the 15-year trailing historical average, according to CEPRES. They did take longer to do so, however, which meant the pooled IRR for that three-year group was circa 300 basis points lower than the 15-year average.
“I think the financial crisis was a great acid test for creating value and being hands-on,” says Salovaara. “The firms which have gone through it have come out better and have thought about what to do differently. There have been a lot of learnings.”
KEEP IT LITE
In January 2006, just 0.95 percent of outstanding leveraged loans in the US were covenant-lite. In July 2016, that number was 72.71 percent, according to S&P Global Market Intelligence. Many people would look at this trend – facilities that give the lender little ability to take control of an asset in times of distress – as an indicator that discipline, at least among banks and other lenders, has eroded.
For investors in private equity, however, this should be a source of comfort. Reflecting on how the global financial crisis of 2008-09 has informed the institution’s current approach to investing in private equity, Salovaara says that managers have adjusted their investment strategies to include more buy-and-build activity and more thoughtful approaches to sector trends. Alongside this, however, the right type of financing will be essential to performing through the next downturn.
“Most of the portfolio loans will be cov-lite or cov-loose,” she says. “If you have financing that will enable you to work through a downturn, then that is how you can position yourself for the correction.”
“Managers understand that cov-lite was very valuable in the last crisis and are prepared to pay up front for it”
“Managers understand that cov-lite was very valuable in the last crisis and are prepared to pay up front for it,” she explains. That cov-lite loans – formerly the preserve of larger buyouts – are now increasingly being issued in the mid-market is, says Salovaara, “a good thing from an investor perspective”.
For Ilmarinen, the crisis pushed the private equity team to increase its focus on co-investments. The private equity programme was in its growth phase and in 2010 the team started co-investing with its managers.
“We viewed it as a way to get closer to our managers, learn more about our investments and lower our fees at the same time: to become better investors,” she says.
While the crisis-era funds ultimately performed well, they tested the limits of the 10-year fund structure; GPs and management teams needed more time to bring to bear operational and capital structure changes. The consequences can be seen in the emergence of more GP-led secondaries transactions, where investors in funds that have reached the end of their life are offered some sort of liquidity option.
IT AIN’T BROKE
For Salovaara, these processes – which are fraught with conflicts that need to be managed – are not evidence that the 10-year fund model, with its fixed investment and harvest periods, needs rethinking. “I think it is a great model that puts a lot of focus on getting the job done within the time frame,” she says. “It instils discipline and I think that is one of the drivers of performance: there is a real intensity to value creation.”
The emergence of longer-dated vehicles will not threaten the more widespread 10-year fund model, says Salovaara. “For humans – because we are not machines – it is the time period for which we are engaged. A four or five-year plan is more realistic than a 10-year plan.”
Today’s fundraising market is characterised by its lightning speed. Asian heavyweight GP Affinity Equity Partners is putting the finishing touches on a $6 billion fund that was vastly oversubscribed and had spent less than four months in market. It is not alone in raising quickly; funds that closed on more than $1 billion in 2017 did so after an average time of 10 months in the market. In 2010 that figure was 17 months.
Did a slower raise make it easier for LPs to access top funds and take their time on due diligence? It’s not that simple, says Salovaara. “In a way that it made things harder if you wanted to invest, because fundraising took so much longer. As a good LP you can get into the funds you want to. The downside is that if you want to invest, it is very drawn out as to when the fund actually closes and starts investing.”
Nowadays, with more than two in every five funds holding only one final close, “if you are not there, it is gone”, says Salovaara, who is sanguine about this speed of process. “When it is well planned, then there is time for due diligence… you treat investors well, but it is not stretched out – you have a focused and real timeline.”
During the global financial crisis, investors who were close to their target private equity allocation suddenly found themselves over-allocated, as the liquid portions of their portfolio quickly devalued; the so-called “denominator effect”.
Ilmarinen was trying to build up its allocation at the time, so the denominator was not an issue. However, looking across the wider market today, Salovaara notes that any recurrence of the denominator effect could be exacerbated by the increased use of credit facilities.
“With credit facilities it is not so easy to track how much more you are invested than what you pick up in your portfolio values. Is it 10 percent, 15 or 0 that you are effectively more invested than you think?”
Listen to Katja Salovaara tell Toby Mitchenall about the effects of the facilities on investors
“With the added dimension of the credit lines, most investors are not picking up their real investment level,” says Salovaara. “If I think my portfolio is €2.5 billion – because that is what has been called down – then on top of that you are trying to track how much is outstanding on the subscription lines and it is not an easy task.”
Salovaara estimates LPs are likely to be between 10 or 15 percent more invested than has been called down. It is possible to piece together the data from quarterly reports, she says, but “not an easy task” to gather the information in real time.
Beyond these technical concerns, the crisis and the way in which some managers stewarded their portfolios have left Salovaara optimistic, even as GPs invest in a richly priced environment.
“Even in a high valuation environment there are always great investment opportunities. For example, if you have deep sector insights, investing behind secular trends, or are experienced in executing buy and build strategies successfully, there are great opportunities at every point in the cycle.”