GPs, LPs downplay recession, but worries persist

A sustained market correction could lead to lower private equity allocations as LPs rebalance their portfolios to make up for falling public equities. But it’s still too early to say where the market is heading, according to LP and GP sources.

“I’ve felt since early last year that we’ve been in frothy territory because of the record number of deals I was being shown — we were overdue,” said Rosemary Sagar, chief investment officer of the Kingdon Foundation, which invests in private equity funds along with other alternatives.

“We feel safer in alternatives right now because of the low net exposure in our long/short hedge funds,” Sagar added. “On the positive side, the turmoil may delay future interest rate hikes by the Fed. Quantitative easing was one reason the market went up so much. Government policy giveth and government policy taketh away.”

With the S&P 500 selling off sharply over a China slowdown and depressed oil prices, combined with disruption in high-yield debt markets, 2016 started off with uncertainty.

The S&P 500 closed at 1,883 on January 27, down 7.8 percent for the year and the lowest it has been since early 2014. The benchmark index peaked at 2,135 in May of last year, up from its multi-year trough of 677 back in March 2009. Meanwhile, oil prices have fallen below $35 a barrel, causing disruption in commodity markets and volatility in equities.

Despite signals of a possible economic recession on the horizon, private equity GPs and LPs said it feels more like a correction than a harbinger of a serious economic slowdown. But the landscape is changing.

“Things are slowing down a little bit, but are still terrific for us,” said Stephen Schwarzman, CEO of Blackstone Group, on the firm’s fourth-quarter call with Wall Street investors. “I think that it’s a more nuanced world. It’s not a simple world.”

Schwarzman sees the recent stock market sell-off as normal. “People are overreacting to the stock market,” he said. “We had a seven-year run without a correction. We were way overdue.”

Blackstone said its portfolio companies expect EBITDA growth in the low single digits, but well into positive territory. U.S. GDP growth may slow down from earlier projections, but it is still expected to expand at about 2 percent this year.

China talk looms large

Turning to China, Schwarzman said parts of that country’s economy remain healthy and pointed out that its oil imports have increased 10 percent, something that may be overlooked in energy markets.

Meanwhile, BlackRock Chief Executive Larry Fink said uncertainty in China and elsewhere is “the fundamental reason” behind the sell-off.

“Chinese domestic consumption is up 15 percent, but unfortunately that’s not enough to overcome the vast slowdown in its manufacturing platform,” Fink said in a meeting with the New Jersey Investment Council. “I’m not saying the world is falling out of bed, or that China is falling out of bed, or that it’s a deep dark black hole. But it’s not as good as it was.”

Asked about sluggishness in the U.S. economy, Fink said nest eggs for future retirees may be weighing on domestic economic activity. “The main reason we are not seeing an increase in consumption is because there are so many men and women in the world, and especially in this country, who are waking up to the notion, ‘Oh my Gosh, I haven’t saved enough for retirement,’” Fink said. “If that is the case, we are going to see a slower economy for longer … We have such inadequacy of savings that these men and women are forced to either work longer, or become Uber drivers when they’re 65.”

Cost of debt rising

Steve Young, the former San Francisco 49ers quarterback and co-founder of HGGC, said he’s noticed the cost of debt in some pockets of the borrowing market getting more expensive, but it doesn’t affect HGGC directly.

“Everyone in finance gets nervous in rocky times,” Young said. “We don’t use a lot of leverage, though.”

Other private equity pros, who didn’t want their names used, said they are seeing more challenging market conditions overall, but they downplayed the possibility of an economic meltdown.

“Debt levels seem to have softened on buyouts,” said one credit specialist. “It’s been a tighter market. It takes longer to get a deal done.”

A good company will always sell at the high end of the multiple range, but ‘B’ companies may not command strong prices right now, he said.

A placement agent said allocations to private equity funds may come down as portfolios get re-balanced to match lower public equities prices. This hasn’t happened yet, but it could take place unless markets reverse course in the near future.

An investment banker said the economy may be moving closer to recession territory, but he wasn’t sure if it would happen. “I think this quarter will be poor,” the banker said. “Don’t know about the rest of the year.”

Action Item: See a chart of the S&P 500 here: http://bit.ly/1PWftYO

Luisa Beltran, Sam Sutton and Christopher Witkowsky contributed to this report.

Photo courtesy of Shutterstock