- Private equity’s slow-moving valuations may make it look like a safe haven, but leverage may amplify its sensitivity to the recent downturn, according to our model.
- We use MSCI’s private equity model to “nowcast” private-equity values and look through the stale, smooth valuations into the current market.
- Our model estimates that values of U.S. large buyouts may currently be down about 35% from their recent highpoint in the first quarter of 2020.
Private equity’s valuations might give it the appearance of a safe haven during the COVID-19 crisis, but portfolio companies may now be struggling under high levels of leverage. While the world has watched the crisis ripple through public markets day after day, private assets are out of view. What may be happening to the value of a private-equity portfolio in the COVID-19 crisis?
Valuations for private equity have been slow-moving. They usually arrive many months after the fact, and even once they arrive, they often smooth out price changes over many quarters. The valuations’ low volatility and low correlations with public assets have led some observers to think of private assets as a mildly correlated asset class.
But reported valuations may be a poor indicator of the actual value of private assets or their sensitivity to the broader economy. Some have pointed to the levels of leverage in buyouts and predicted disaster.1 A prominent hedge-fund manager recently said of leading private-equity firms: “They do a tremendous job. But every one of their companies has a lot of leverage. Every one of their companies goes bankrupt if this thing rolls out over 18 months.”2 (He later apologized.) Could investors expect private equity to be spared during this crisis, or is this apparent safety just an artifact of the slow valuations?
Seeing through the smooth valuations
We explore these questions using MSCI's private-equity model to “nowcast” the underlying value of private equity — using factors observable in the public markets to estimate the current value in private markets. The model brings together Burgiss’ private-equity data set3 and MSCI’s multi-asset-class factors, using statistical techniques that look through the smooth valuations to model the underlying value. It interprets the dynamics of private equity as driven by both “private” and “equity” with exposures to many of the systematic factors driving the public markets, as well as to diversifying private-market factors.4
The figures below show the model’s estimates for the current value of U.S. large-buyout funds during the COVID-19 crisis — and through the 2008 global financial crisis, for comparison. In 2008, it took many months for the valuations to be updated, by which time the public markets had already rebounded substantially. Today, most limited partners (LPs) have not yet received valuations for the end of 2019, let alone any reflection of the new state of the world.
Performance of US large buyouts
The model indicates private equity is somewhat less sensitive to a downturn than a portfolio with the same amount of leverage applied to public equity. This could reflect an initial overreaction in the public markets driving up risk premia that eventually subside. It could also reflect the ability of the general partner to make opportunistic deals when valuations are low, or to help manage portfolio companies through a crisis.
But private equity may still have large exposure to an economic downturn or financial meltdown, and our model indicates that it has likely taken large losses already. In the absence of a recovery, U.S. large buyouts may be down about 35% from their recent highpoint earlier in the first quarter. Private companies are exposed to the same economic fundamentals as public companies and may have an even harder time riding out a recession if they’re more heavily leveraged. Either the public markets have wildly overreacted, or private equity has likely taken a similar beating.
A more immediate risk?
As unwelcome as this scenario may be, many investors in private equity may face a more immediate risk: liquidity. A recent article by Burgiss explores how an unexpected wave of capital calls might affect LPs. Limited partners may need to come up with cash quickly if general partners call capital to take advantage of buying opportunities from depressed valuations or seek to stabilize struggling portfolios by injecting more capital.
We’ve seen how private equity has performed over the long term. But valuations are slow-moving, and there may be a reckoning ahead.
1U.S. buyouts are estimated to average about 1 1/2 times the leverage ratio of public counterparts.
2Bill Ackman, founder and CEO of Pershing Square, in remarks to CNBC, on March 18, 2020.
3MSCI entered a entered into a strategic relationship with The Burgiss Group, LLC in January of this year.
4The model is calibrated using approximately 40 years of private-equity data history and Bayesian desmoothing methodology to estimate sensitivities to public-market factors. In the case of U.S. large buyouts, the public factors are from the MSCI U.S. equity model. For full details on the model, see Shepard, P. and Liu, Y. 2014. “The Barra Private Equity Model (PEQ2).” MSCI Model Insight.
How might capital calls respond to the COVID-19 crisis?
Multi-asset class factor models
The Barra Private Equity Model (PEQ2) Research Notes