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- Narrowing the Bid-Ask Spread
TLDR:
🔮 The paradigm is changing. The days are numbered for GPs counting on "levered beta" (abundant capital, cheap debt and multiple expansion)... while the true alpha generating value creating GPs will weather this storm and come out stronger.
Interesting anecdote from Bain & Company's #PrivateEquity 2024 Midyear report on the narrowing of the bid-ask spread hindering PE deal activity.
“The market is clearly still getting used to the notion that interest rates may stay higher for longer and that valuations derived amid much friendlier monetary policy will ultimately have to be adjusted
Anecdotal evidence suggests that buyers and sellers are feeling each other out, albeit slowly, and trying to find creative ways to break the stalemate over price expectations
Existing data suffers from a small sample size, but deal multiples appear to be easing somewhat as investors focus on company performance and business fundamentals
Any lingering hope that simple multiple expansion will carry a deal to a strong return has receded sharply”
❓ How did we get here?
💡 Remember - the value of an asset today is the present value of its future cash flows. When interest rates increase, the discount rate used to calculate this present value rises, resulting in a lower current valuation of the asset.
🔍 So when the #Fed started hiking rates in early 2022, private equity funds holding assets acquired before 2022 (especially assets at lofty valuations at the apex in 2021) faced immediate headwinds to their unrealized portfolio.
🚱 A key feature of private equity is the #illiquidity of assets. Unlike public markets that have a real-time stock price that is determined by a liquid market of buyers and sellers agreeing on a prices and transacting...
...a private equity funds don't have to sell as an asset as long as their fund is still open (which can be 10+ years).
🐇 There is an entire rabbit hole we can (and will, in future posts) go down on the pros and cons of liquidity and the implications for investors into private equity assets. Stay tuned... 📻
🥊 The punchline is that many GPs have been unwilling to "realize" a lower valuation than they previously hoped for... and have marked on their books... than the market clearing price they can get in the new heightened rate environment.
⌛ However... time is not on their side for these PE GPs holding out hope for rates to come back down and kick save these deals... especially for assets that otherwise do not have much upside to capture.
🏔 If you take a look at the three charts below from Bain, the weighted average life of private equity portfolios and total value of unrealized / unexited companies has hit record highs.
🧠 Perhaps most interesting, some of the oldest companies in portfolios are also some of the most obvious underperformers... meaning GPs are holding companies that aren't clear winners hoping for a change in fortune before locking in a sub-par exit.
🎯 As i) LPs continue to pressure GPs to drive realizations... ii) GPs accept reality rates may stay higher longer... iii) and portfolios become older / funds approach maturity dates...
💵 ... we should hopefully see more deals getting done as the bid-ask spread closes and the market normalizes. But this won't be without some painful realizations for GPs who are holding out hope for market forces to save their portfolios.
🔮 The paradigm is changing. The days are numbered for GPs counting on "levered beta" (abundant capital, cheap debt and multiple expansion)... while the true alpha generating value creating GPs will weather this storm and come out stronger.
Exhibits
Source: Bain & Company
