Late Cycle Limited Partner Ruminations

The following comments are mine, and mine alone. They are not intended as investment advice. If you are investing in private equity or other private assets, please make sure to consult with a professional before taking any action. Investing involves the risk of loss and should not be undertaking without appropriate safeguards in place.

As we all are keenly aware, we are now in the later stages of the current market cycle. It has been 10 years since the global financial crisis and the economy and stock markets globally have shown solid growth, although varying greatly by geography. Recent pronouncements by the Fed signal that the US economy may be slowing with knock-on effects around the globe. As an LP, what does this scenario mean for you? Here are my thoughts, based upon experience from the dot-com bubble and the GFC.

Trees don't grow to the sky - Howard Marks and many others, including several of my mentors, have made the same comment for many years regarding market cycles. After 10 years of sustained growth, albeit at a reduced rate compared to history, we are inching closer to an eventual recession and market downturn. When it will come, I don't know, but I do know that it will come, eventually.

The best returns in private equity have historically been the vintage years directly after a downturn - This is due to two prevailing reasons in my opinion: 1) you get a huge tailwind as the economy and markets recover, and 2) prices are depressed from the recession as capital is scarce, so you can buy assets cheaply. Most PE investors will share with you that buying right is the key to making money in private markets and this is more easily done when everything is on sale.

Returns of late cycle buyout funds tend to disappoint - This is due to the fact that the likelihood of buying at the wrong time has increased (leading to future losses) as we are much closer to the recession. Many portfolio companies will be over-levered with debt levels predicated on peak earnings (which will likely disappear in the ensuing recession) leading to significant value compression on the way down. These peak cycle funds will likely need to spend considerable time triaging their wounded portfolio companies which may also make them take their eye off the ball at exactly the wrong time.

So, what does this all mean? When allocating capital to illiquid assets at the end of a cycle, LPs need to be extra selective in making new investments. Due to the recency bias, it seems as though everyone is printing money and losses become a thing of the past. Thus, increasing allocations to the asset class in general and to existing managers in particular seems the easy choice to keep printing money, but you may be led astray. The increasing size of investments at the peak of the cycle have historically been the undoing of many an LP, especially if they have a co-investment program that further concentrates risks in individual companies at exactly the wrong time. Understanding this dynamic and mitigating these risks is key to a successful investment approach. Anecdotally, I might suggest that the contrarian strategy of investing more heavily coming out of the recession and reducing allocations when everyone else is piling in at the end of the cycle may help you increase overall investment results. This may require nerves of steel and enduring some criticism as the fear of missing out kicks in. But, it may also prove to be the best approach to maximizing value in the long term.

Let me know your thoughts. I would love to hear from other LPs who have had similar or different experiences.