After a decade of strong and improving performance, the onset of the coronavirus pandemic hit LBO returns sharply in the first half of 2020. Performance of active funds globally, measured by total value to paid-in (TVPI) slumped from a near-record of 1.45x in late 2019 to 1.36x in Q1 – returning to levels last seen in 2014. Risk, meanwhile, jumped sharply, reflecting the turbulent market conditions.
Private Equity returns have now fallen back to 2014 levels, and at the same time, selection risk increased and appears to have stabilized. The first quarter witnessed a sharp drop, and the decrease then continued in Q2 2020, albeit less sharply downward, as the impact of the Covid-19 pandemic on portfolio companies’ value and activity started to materialize. To some extent, managers have included the evolution of listed stock prices in the fair value of investments. However, listed stock prices have subsequently recovered some lost ground, while net asset values have continued to deteriorate, signaling adjustments due to the impact of the virus on portfolio companies’ operations. So far, this is a significant drop, but not a “crash”.
Not surprisingly, fund selection risk also increased in Q1 2020. Again, though, the increase is commensurate to the drop in multiples: it is significant, but not exceptional. Interestingly, the dispersion of fund performance decreased in Q2, signalling that fund managers have converged in their NAV corrections. Some fund managers might have also dialled back adjustments made in Q1. The consequence is that, so far, 2020 has reverted to the ten-year average. Here again, the contrast comes from the prolonged period of low dispersion of fund managers’ performance. As the economic consequences of the current health crisis unfold and hit specific sectors, while sparing others, selection risk could further increase in the second half of 2020.
Looking at vintage years, each year has recorded a decrease in multiple of invested capital during the first semester, including relatively mature ones such as 2011 and 2012, which are now aligned with the historical average. 2014 is still performing well above historical levels, despite adjustments, while 2013, 2015 and 2016 are now performing significantly below the average.
Further examination shows that most of the downward adjustments were made in Q1 2020. Managers rapidly reflected the changes affecting financial markets and the macroeconomic environment, and adjusted quickly and sharply the value of their funds in Q1. The second quarter shows a stabilization of the performance of active funds, illustrating the stance of managers, who have prudently remained conservative in Q2.
US LBO funds are usually reasonably representative of the global evolution. This is the case again, although the evolution of their active vintage years is slightly more contrasted. 2011 remains above the historical average, while 2012 is now installed below, along with 2013. Other vintage years perform in line with the global average. 2014, in particular, distinguishes itself and provides an explanation of the outlier in the global analysis.
Western European LBO funds also suffered from a correction of their multiples in Q1 2020. However, the vintage years 2011 and 2012, which had the wind in their back, are still expected to outperform the historical average. Surprisingly, the vintage years 2013 and 2014 did not suffer much and remain close to the historical average. 2015 and 2016 were probably the most affected and are now significantly lagging their historical peers at the same maturity level. Although 2017 and 2018 are very recent vintage years, they have also reverted to the historical average.
Predicting the LBO market return evolution in the second half of the year is a challenging task. The good news is that valuation multiples commensurate with public market indices and these are back to their pre-COVID19 levels. When it comes to the other part of equation, the earnings of a typical LBO-backed portfolio company have been severely affected by the worldwide lockdown in H1.
If H2 brings less restrictive public health management measures, we anticipate operating performance to improve as compared to the first half of the year. Furthermore, GPs and management teams have been taking every measure possible to prepare their companies for an extended challenging period. These measures include cutting costs and shoring up balance sheets. As such, we anticipate performance to be positively impacted by these proactive steps.
There are still many unknowns around further Covid shutdowns, the impact of the US elections, and general geopolitical factors that could add further volatility to returns. Other factors, such as the shift in industry profitability caused by changing lifestyle habits or the fact that LBO funds are sitting on billions of dry powder to invest in future investment opportunities, will materialize in years to come.
