Just a couple of weeks ago, we wrote how investors are concerned that the more than $1.2 trillion* of uninvested capital in private equity (PE) funds will force them to become irrational and undisciplined. And before March began, that fear may have been reasonable. After all, purchase price multiples have doubled since the financial crisis. And the value of target companies has risen exponentially. Ten years ago, a company was considered small-cap if it had a market cap of $1.2 billion; today, that same cutoff is $3.6 billion.

It’s Good to Be Flush with Cash…

While these critiques may have been of concern just a few short weeks ago, in our opinion, they are moot today. The COVID-19 driven market sell-off has made the cash on hand at PE firms that much more valuable. What seemed like a problem just weeks ago, is a blessing today.

Additionally, PE funds do not have to compete against “strategic” buyers—publicly traded companies that use their appreciated stock as currency to buy companies. Most of those public companies are shuttering in as their stocks fall and are not in the M&A market at this point.

…And to Own Companies for the Long Term

These volatile public equity markets are also a reminder that private equity funds don’t experience the same level of volatility. PE funds hold companies for many years because they need time to make the necessary changes to improve the company’s value, so investors need to have an investment horizon of at least seven, and more often 10 years to realize returns.

The long-term nature affords managers the time to conduct continuous, in-depth due diligence throughout the entire investment holding period—to understand disruptions that may occur on the back of specific market and economic developments, and how to address them. For instance, in today’s environment, they can have proactive discussions regarding the COVID-19 crisis, including supply chain disruptions and liquidity concerns, so they can monitor individual situations, better anticipate company performance issues, and formulate responses across a variety of potential outcomes. So the locked-up capital not only gives managers the option to deploy money for opportunistic new investments, but also to support existing portfolio companies as they navigate through performance or liquidity disruptions.

The long-term nature of private equity shields investors from the daily swings that occur in public markets. They experience less volatility for two main reasons: First, they are valued or marked-to-market only at specific points in time—usually quarterly—but their exact return is only known after disposal of the investment. Second, investors cannot readily buy or sell private placements, making them less prone to overall market sell-offs. It’s entirely possible that private market investments are experiencing similar stresses as public ones, but private investors are typically only concerned with their exit price, not the intermittent price that burdens the public investor. So, the daily whipsaw movements of the markets may be less influential on the investor’s mindset while the fund holds the investment.

Hordes of Cash Spell Opportunity

The market will take time to resolve the issues that have emerged in light of the sell-off and the expected associated recession. But being in a position to be an opportune buyer instead of a forced seller is where PE funds and their investors find themselves. Exploiting market dislocations is key to making profitable investments, especially when PE can take advantage of interest rates at near-zero levels. Nearly half of private equity firms have raised capital to have cash on hand for a tougher time ahead. That time is now, and these funds have the capital to go bargain hunting!

*As of end of December 2018
Based on Russell index methodology
https://www.bdo.com/news/2019-december/bracing-for-a-bear-market,-private-capital-readies

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

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