Asset Markdowns, Deal Defaults, and the Questions on Private Market Investors’ Minds

It’s no secret that the private markets face growing challenges, including liquidity and fundraising challenges, public market slumps and bank failures, an increasing hold period with decreasing exit velocity, a rise in deal defaults, and more. 

As Q1 2023 numbers come in, many of these difficult questions will start to have answers, and things will come into focus, and there will be additional questions too. Chronograph has four questions on its mind as these numbers come in. 

How aggressive fund managers are with asset valuations

During the Global Financial Crisis (GFC) and the early days of the COVID-19 pandemic, Chronograph observed that fund managers aggressively marked down — and then back up — asset values. In processing thousands of data points from more than 150,000 PE-backed assets from the largest and most influential institutional investors, Chronograph observed a similar pattern during the current volatility cycle. 

The marketplace has prepared, discussed, and predicted the “impending markdowns” since the beginning of 2022. Pensions & Investments noted that it expects a 10-15% drop. Several fund managers, including Partners Group and EQT, remarked in July 2022 that they marked down assets at the start of the current volatility cycle. Following notable bank collapses and precipitous declines and increases in several public market sectors, will the private markets react positively or negatively? If so, how aggressively will asset owners and fund managers change asset valuations?

Will there be an increase in deal default rates?

For years, venture capital firms and growth equity firms invested with a mindset of growth at all costs. This playbook generated meaningful alpha and returns during the era of cheap money and significant and rapid valuation increases. Multiple expansion continued to drive overall valuation increases, enabling aggressive valuations and cheap leverage.

However, as borrowing costs and incremental costs increase, the shift from growth at all costs to sustainable and profitable growth has left numerous questions unanswered. These questions center around the viability of investments, if asset owners continue to fund these investments, when investors consider the portfolio company a sunk cost and no longer strategically viable, among others. Principally, the questions center around deal default rates and overall losses, which weigh on the mind of many investors. 

Will hold periods extend?

With fundraising harder to come by and a dramatic deceleration of M&A, will general partners look at their holdings and funds differently? How many will decelerate exit velocity, roll portfolio companies into continuation funds, and explore the secondary market to generate additional liquidity?

The 2023 Bain & Company Global Private Equity Report notes:

“Lower valuations have put growth and venture funds in a holding pattern. Not only have the companies they acquired in recent years come down in value, making buyers and sellers reluctant to transact, but the IPO markets are virtually shut down, dramatically slowing the growth of the market’s favorite exit channel. Deal activity is unlikely to recover until valuations return to previous levels or enough time passes that assets are able to grow into their earlier valuations by generating higher earnings at lower multiples.” 

CFO, citing Pitchbook, noted that private equity exits were Down 57% in 2022

The inability to exit an investment is particularly troublesome. According to PitchBook’s 2023 U.S. Private Equity Outlook, the exit-to-investment ratio for PE firms stood at 0.38x at the end of the third quarter, the lowest since the global financial crisis in 2008. The number of exits was down 57%, as of September 30. The macro headwinds are likely to persist into 2023, said PitchBook.

Can fund managers secure the capital necessary to exit at the desired rate, or will GPs need to look to alternative paths? What does this mean for LP commitment cycles? 

Will the gap continue to widen between market leaders and laggards?

The gap between private market leader and laggard grew significantly in 2022. As an example of this trend, Chronograph partner eVestment found that pension funds deployed the most capital to Blackstone and Thoma Bravo in the 2022 / 2023 Private Fund Trends Report. Each firm received more than $6 billion in commitments over the period — more than $1 billion more than the next closest capital recipient.

Reports indicate that limited partners expect(ed) their GPs to markdown assets as early as late 2022. Will a slow — or no — markdown cycle make LPs think through which GPs will get their capital moving forward? How will this affect future commitments? Will this impact manager selection and kickstart a vicious cycle?

Moreover, for LPs with a less stringent allocation model, could markdowns allow them competitive advantage by deploying capital when others can’t?

Conclusion

The ongoing periods of volatility and rising interest rates have affected public and private market valuations. As Q1 2023 numbers come in, numerous questions within the private markets abound. Are markdowns inevitable? Will the rise of interest rates cause an increase in deal defaults? These questions exist at Chronograph as the data operations team prepares to process Q1 2023 performance numbers from a majority of the largest GPs and LPs.