For private assets, the pandemic repricing is just getting started
Tom Bradley gives a sneak preview of what to watch as the process unfolds.
Things move quickly in our digital world. An email sent from Vancouver is received in Mumbai in seconds. Rumours spread on Twitter in a heartbeat. And stocks and bonds react instantly to new information. In March, price declines were head-spinning as investors reacted to a deteriorating outlook.
There’s a category of investments, however, that was slower to react. Prices for private investments such as commercial real estate and mortgages, private equity, infrastructure and private debt take time to adjust. The POST-COVID reality will filter into their valuations over the course of the year.
This sorting-out process will be fascinating to watch. Some private assets will skate through without a wobble while others will surprise us with bad news and writedowns. Here’s a sneak preview.
GETTING REAL
Real Estate Investment Trusts (REITS) trade on the stock exchange. So far this year, buyers and sellers have taken the sector down over 20 per cent. Private real estate funds work differently. They rely on independent valuations to set a price, a process done over the course of the year outside the emotion and volatility of the stock market.
I feel for the people doing the current round of assessments. COVID-19 makes it extremely difficult to forecast operating income, particularly for office buildings and retail malls. Valuation multiples (cap rates) will be even harder to peg due to a lack of comparable transactions (one real estate manager described the deal market as “frozen”).
The range of possibilities is wider today. I’ve seen predictions of commercial properties dropping as much as 10 to 20 per cent. If this were to occur, it would take several quarters to be fully reflected in fund prices.
It’s not uncommon for property and mortgage funds to be gated (temporarily closed) due to economic distress and liquidity issues. There may be some dislocation this time, but right now fund transactions are being delayed because of a lack of confidence in valuations.
PRIVATE = LEVERAGE
Private equity funds also rely on estimates. In the first quarter, managers reduced the value of their holdings, although generally the markdowns were less than the stock market decline. This makes some sense given that markets rallied significantly after quarter-end. On the other hand, private equity uses copious amounts of debt, which amplifies outcomes — i.e. the highs are higher, and the lows are lower.
In Canada, the poster child for “lower lows” is one of our creative and corporate gems. Cirque du Soleil is on the ropes because of debt put on the balance sheet when it was acquired by private equity.
PLANES, TRAINS AND AUTOMOBILES
Infrastructure funds are in great demand. Healthy yields and low volatility have caused this relatively new asset class to grow significantly since the last financial crisis. Now that they’re in the spotlight, it will be interesting to see how the managers navigate the economic cross-currents.
Each fund’s results will largely depend on their mix of industries. Prices for regulated assets (i.e., energy distribution) will be affected modestly by the slowdown. They may even go up. In contrast, holdings that are more cyclical or involve the movement of people and goods (airports, toll roads, ports) may see their valuations reduced.
TIME-LAG DIVERSIFICATION
For Canadians, the best lens to watch private assets through is our public service pension plans and high-profile asset managers (Brookfield and Onex). I’ve watched with envy as large plans like CPPIB and Ontario Teachers use their scale to make savvy, sometimes unconventional, private investments.
Part of my envy, however, comes from the smoothing effect these investments have on overall returns. This is also something to watch for. The protracted nature of private valuations means that their quarterly and even annual returns can be out of sync with the public markets. This timing difference is of little consequence most of the time but in years when stocks are down sharply, it’s meaningful. In 2008, the commercial real estate index was up eight per cent while Canadian stocks were down 33 per cent. It had a negative three-per-cent return the next year when portfolios didn’t need the help (stocks were up 35 per cent).
This perverse form of diversification is playing out right now. In the first quarter, the hit to public markets was buffered by minimal changes to private assets. So far in second quarter, stocks have rebounded sharply, and the repricing of the alternative asset classes has begun.