During the financial crisis of 2007 – 09, hedge funds and private equity received their fair share of bad press. Not all of it was justified and neither sector triggered the event, but both arguably played minor roles.
Alternative investing has the potential to make a more positive contribution in the current crisis. While not all hedge funds have performed well, many have provided a ballast in storm-tossed portfolios. And while many small privately owned companies have a very tough time ahead of them, private equity and private debt General Partners (GPs) appear to stand ready to throw them invaluable lifelines of skill, experience and capital.
March 2020 taught us once again that diversification is critical.
Certain hedge fund strategies that looked uncorrelated with market risk before the crisis became highly correlated when it struck. Many long-short equity strategies had become crowded in a handful of momentum-driven and value names, some of which sold off by 50 – 60% when the market dropped by 30%. Funds depending on leveraged exposure to carry instruments, as well as those positioned to profit from credit-spread contraction, seem to have taken the biggest hits. The pain was most pronounced within structured credit-focused strategies where implicit leverage and illiquidity combined to exacerbate losses.
However, a number of strategies preserved capital and even produced impressive results during March. Many equity market-neutral strategies appear to have come through the month broadly flat, as one would have hoped. Global macro and managed futures, whether trading on short-, medium- or long-term trends, capitalized on the downturn and the surge in volatility. Long-rates, long-dollar and short-energy positions were particularly profitable. Volatility relative-value strategies were able to capitalize on the spike in both realized and implied volatility.
As Erik Knutzen cautioned last week, a lot more bad news is likely before the COVID-19 crisis is over. With that in mind, we think it may be prudent to maintain strategies that have already helped to mitigate market volatility. As volatility begins to subside, and forced selling due to leverage or liquidity issues dissipates, we believe there will be ample opportunity for well-capitalized investment firms to benefit from the price declines in the structured credit and distressed debt markets.
In one sense, the private equity industry got lucky. It came into 2020 with record amounts of uninvested dry powder, which could now be used to recapitalize cash-starved portfolio companies. After many years in a borrowers’ market, those companies carry a fair amount of leverage, but their debt has few or no covenants, giving them precious time and flexibility.
But private equity also appears to be much better prepared than it was during the last crisis, and that’s not down to luck at all. Fifteen years ago, a lot of GPs simply bought good companies and added debt. After 2008, that approach was defunct. Instead, many have invested heavily in accumulating often sector-specific operational and capital-markets expertise. This can add value to companies’ businesses and balance sheets and potentially be the difference between survival and failure in a crisis.
In our view, the number one priority is to maintain ample liquidity to get through the crisis. That means cutting costs and limiting capital investment, but also drawing on unused credit lines and in some cases injecting equity.
Where necessary, negotiations with creditors for relief on interest and amortization payments are underway. Given the nature of the crisis, we think lenders will be receptive, but a business generally stands to benefit greatly if its private equity owner has a close relationship with it. With an overwhelming number of loans to work through, many creditors are likely to bucket groups together based on quick, formulaic assessments of their immediate prospects.
Small and midsized companies are the foundation of most economies and the most vulnerable in the current crisis. In the firefighting stage, this is where private equity can use its broad resources to help ensure that we still have an economy when this is all over.
A Lot of Work to Do
Once we are through fighting fires, alternative investors can start solving problems.
In private equity, turnaround and special situations funds could help restructure businesses and balance sheets that have run into trouble.
In the overlap between hedge funds and private markets, distressed credit strategies are providing liquidity to banks and institutional investors that are ready to offload tranches of structured credit, or first-lien loans, at substantial discounts. These funds typically have the stable capital, the long-term investment horizons and the risk tolerance to hold what is likely to be fundamentally resilient paper through the coming months.
Private equity secondary markets are not yet clearing, but when they do, we believe they will provide another source of new capital for GPs to plough into their portfolio companies, as well as giving Limited Partners the chance to rebalance portfolios and increase liquidity. For the buyers, there may be opportunities to pick up attractive nearly new and mature funds at a discount.
And finally, the alternative investment world will likely provide longer-term support to companies, both public and private, as they struggle to raise debt or equity. Many private debt strategies will be there to lend when the banks and public debt markets are reluctant, and private investment in public equity (PIPEs) could be an important source of capital when debt issuance or secondary share offering markets are closed.
When a crisis comes, alternative investors have two really important jobs: One is to try to bring some stability to clients’ portfolios. The other is to identify attractive investments in good companies, providing them with the much-needed capital that could help prevent them from failing.
We have a lot of work to do.
In Case You Missed It
- NFIB Small Business Index: -8.1% to 96.4 in March
- U.S. Initial Jobless Claims: +6,600,000 in the week ending April 4
- U.S. Producer Price Index: -0.2% in March month-over-month and +0.7% year-over-year
What to Watch For
- Wednesday, April 15
- U.S. Retail Sales
- NAHB Housing Market Index
- Thursday, April 16:
- U.S. Housing Starts and Building Permits
- China 1Q 2020 GDP
Statistics on the Current State of the Market – as of April 10, 2020
|S&P 500 Index||12.1%||8.0%||-13.2%|
|Russell 1000 Index||12.6%||8.1%||-13.8%|
|Russell 1000 Growth Index||11.4%||6.8%||-8.2%|
|Russell 1000 Value Index||14.2%||9.7%||-19.6%|
|Russell 2000 Index||18.5%||8.2%||-25.0%|
|MSCI World Index||11.0%||6.5%||-15.8%|
|MSCI EAFE Index||8.3%||3.3%||-20.2%|
|MSCI Emerging Markets Index||6.8%||4.7%||-19.9%|
|STOXX Europe 600||8.7%||3.3%||-21.8%|
|FTSE 100 Index||7.9%||2.7%||-21.8%|
|CSI 300 Index||1.5%||2.3%||-8.0%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||2.8%|
|Citigroup 10-Year Treasury Index||-1.2%||-0.2%||11.5%|
|Bloomberg Barclays Municipal Bond Index||1.7%||0.0%||-0.7%|
|Bloomberg Barclays US Aggregate Bond Index||0.6%||0.8%||4.0%|
|Bloomberg Barclays Global Aggregate Index||0.9%||0.5%||0.2%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||4.3%||3.5%||-6.8%|
|ICE BofAML U.S. High Yield Index||5.3%||2.7%||-10.8%|
|ICE BofAML Global High Yield Index||4.6%||2.7%||-11.8%|
|JP Morgan EMBI Global Diversified Index||2.2%||1.6%||-12.0%|
|JP Morgan GBI-EM Global Diversified Index||4.5%||1.9%||-13.6%|
|U.S. Dollar per British Pounds||1.7%||0.6%||-5.9%|
|U.S. Dollar per Euro||1.3%||-0.3%||-2.6%|
|U.S. Dollar per Japanese Yen||0.0%||-0.5%||0.2%|
|Real & Alternative Assets|
|Alerian MLP Index||9.6%||11.6%||-52.2%|
|FTSE EPRA/NAREIT North America Index||24.8%||12.3%||-20.6%|
|FTSE EPRA/NAREIT Global Index||17.0%||8.1%||-22.5%|
|Bloomberg Commodity Index||2.1%||2.6%||-21.3%|
|Gold (NYM $/ozt) Continuous Future||6.5%||9.8%||15.1%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||-19.7%||11.1%||-62.7%|
Source: FactSet, Neuberger Berman.