Market Tenor
Bob Farrell was Merrill Lynch’s Chief Market Strategist from approximately 1977 to 1992. His “Ten Market Rules” remain widely quoted on Wall Street today. Rule number one is: markets tend to revert to the mean over time.
As of the penning of this article in early December, leverage loans, high yield bonds, and publicly traded equities are under varying degrees of pressure. The Russell 2000 has fallen about 15% from its early September high; the S&P 500 is down about 10%; and the option adjusted spread (“OAS”) on BAML’s high yield bond index has widened over 125 bps.
Unless the sell-off reverses, the set-up will create pressure on the year-end valuation of many private equity and private credit positions. The pressure could become intense if the correction turns into a bear market (defined as a fall of at least 20% versus 10% for a correction).
However, the risk greater than marksto-models for private equity and credit is capital flows. Liquidity is the lifeblood of markets. Many PE investments, especially those that tend toward venture, generate negative cash flow and are dependent upon new capital to roll-over maturing debt, cover deficit operating cash flows, and fund growth capex. Should the torrent of capital that has flowed into funds directly or indirectly providing the means for investors to cash-out through an IPO or sale turn to a trickle, then there could be significant pain in 2019 and maybe 2020.
The magnitude of any markdowns to private equity and credit positions in coming quarters is unknowable after years of a fabulous run, but Farrell’s rule number two is: Excesses in one direction will lead to an opposite excess in the other direction.
FEATURE ARTICLE
Adjusted Earnings and Earning Power as the Base of the Valuation Pyramid
Also in This Issue
Updated Metrics for
Private Credit and Equity
Publicly Traded Private Credit
Venture Capital