Last week we highlighted three lessons for the private equity industry from an unprecedented first half of the year: operational resilience, new opportunities, reputation. Here are three themes to keep your eyes on in the second half:

Valuations: Beware H2

An ominous cloud hangs over the prospects for many private equity valuations in the second half. On the one hand, the stock market gives us a rosy picture, should we interpret its incredible recovery to investors’ reasoned projections for the future. The S&P 500 is some 5 percent away from its all-time high at the time of writing; the Dow Jones Industrial Average some 11 percent. That’s likely been a boon to many of the private equity fund valuations that rely on public market comparables, which were hit hard in the first quarter.

On the other hand, covid-19 cases have surged in the US, leading its top coronavirus expert, Dr Anthony Fauci, to say the country is “knee-deep” in what is still the first wave of the pandemic. Senate majority leader Mitch McConnell says another stimulus package is likely, but will be the last one. Should the economy re-open and children go back to school after summer, cases are all but certain to surge further.

Even if the economy re-opens, many are likely to continue living their lives according to the reality of the virus, not the wishes of politicians or the apparent vagaries of stock markets. For companies operating in many hard-hit industries, cashflows will likely remain at least muted for some time, a fact firms using discounted cashflow valuation methods will have to face.

And the existing stress is all too real, and severe. Look to the market for collateralised loan obligations – which largely hold LBO debt – where some are seeing senior tranches triggering overcollateralisation tests; a sign of incredible stress in leveraged loans.

The crisis appears to be far from over. Valuations are likely to reflect that for the foreseeable future.

Will the real denominator effect hit?

One hallmark for private markets investors of the previous downturn was the so-called “denominator effect” in which a drop in public market values leads to an imbalance in investors’ portfolios, causing some to have to sell off private fund stakes on the secondaries market in order to keep their portfolios on an even keel. This did not occur in the first half of this year, likely due to the rebound in public equities, but should this happen in H2, investors will be spoilt for choice.

Dry powder in the secondaries market hovers around $170 billion, according to investment bank Greenhill, and fundraising for dedicated secondaries vehicles in the first half of the year appear to have broken records: more was raised between January and June than any other full year in history, preliminary PEI data show. A well-capitalised secondaries market and buyers hungry for deals (the market’s two largest players, Ardian and Lexington Partners, raised $33 billion this year between them), means pricing will likely edge higher – a good thing for LPs wanting to get positions off their books.

Increased risk for sub line lenders

There are “real credit concerns” for some lenders, Wells Fargo head of asset management Jeff Johnston told sister title Private Funds CFO in its series, The shifting landscape for subscription credit.

The problem hasn’t been LPs funding obligations, so far. There had been just one default by an institutional LP – one in a “completely disrupted industry” – by mid-May, according to trade body the Fund Finance Association. Still, some banks are becoming concerned about LPs’ willingness to fund capital calls from struggling funds as the crisis stretches on, and in some cases there are worries about the funds themselves. One lender told Private Funds CFO he and his peers are “absolutely looking at [fund] assets” as potential secondary sources of repayment.

“I’m not sure every bank really understands the risk they have on their books,” said one banker. “There’s really no uniform underwriting methodology across all the banks.”

Write to the authors: graham.b@peimedia.com and adam.l@peimedia.com