Man Institute

Analysis

Hidden From Sight:

The Real Liquidity Crisis
April 2020

Recent volatility saw huge volumes being traded on equity exchanges as

investors sought to de-risk their portfolios. We look at the two distinct
phases of liquidity in the market during this time: at first, the sell-off was
orderly and liquidity was strong; then, as panic gripped, dealers retrenched.
We then ask whether private equity ought to be attracting more focus given
the high leverage and refinancing risk inherent in many LBOs, and what PE
portfolios would look like if they were truly marked to market?

For institutional investor, qualified investor and investment professional use only. Not for retail public distribution.

Author

Pierre-Henri Flamand
CIO Emeritus and Senior
Investment Adviser, Man GLG

www.man.com/maninstitute
‘‘
Just as it was
beginning to seem as
Introduction
When, at the tail end of the last millennium, Francis Fukuyama wrote about the “end
of history”, it was as if history immediately decided to show him what it could do,
unleashing everything from 9/11 to Brexit to multiple euro crises. Now, just as it was
beginning to seem as if the bull run would go on forever, it’s as if the bear market is
if the bull run would trying to make up for lost time.
go on forever, it’s as It’s been a little over a month since the S&P500 Index hit its highest level in history
if the bear market is and the size and swiftness of the retrenchment since then has been extraordinary. In a
time of enormous volatility, we take a look at the dynamics of liquidity, thinking about
trying to make up for how the present moment has been influenced by regulatory responses to the Global
lost time.  ’’ Financial Crisis (‘GFC’). We also recognise that the liquidity dislocations observed
in the public markets are probably a reflection of much more serious problems for
the private markets. As such, we believe that private equity is likely to come under
increasing focus as the COVID-crisis plays out.

The End of History

Often over the last year, we wrote repeatedly that investors needed to prepare
themselves for the end of the bull market, and that the end – when it came – was likely
to be swift and brutal. However, we admit that we never foresaw something like this.
That’s the thing about black swan events, though: by their very nature they blindside
everyone. Indeed, while we are only weeks into the current bear market, the speed and
sharpness of the decline outpaces even 1929 (Figure 1). Indeed, USD27 trillion has
been wiped off global equity prices – equal more or less to the combined GDPs of the
euro area and China.

Historical days indeed!

What is different this time around, of course, is the size, speed and concerted global
nature of the governmental response to the crisis. Policymakers these days are well-
trained …

Figure 1. Bear Markets Over Time

100
S&P pri ce performa nce reba s ed to 100

90

80

70

60

50

40

30

20

10
0 75 150 225 300 375 450 525 600 675 750 825 900 975 1,050 1,125 1,200 1,275
Number of da ys pos t ma rket pea k
Great D epressio n (16/9/1929 - 1/6/1932) WW2 (10/3/193 7 - 28/4/1942 )
Po st war slump (29/5/1946 - 19/5/1947) Nifty Fifty (29/11/1968 - 26/5/1970)
Oil crisis (11/1 /1973 - 3/10/1974) Black M onday 25 /8/1987 - 4/12/1987)
GFC (9/10/20 07 - 9/3 /2009 ) Do tCom (24 /3/2000 - 9/10/2002)
Co ron a 19/2/2020 - ?)
Source: Bloomberg; as of 31 March 2020.

We might make a small digression here to point out that people tend to reach back –
first to Black Monday and 1987, then directly to the Great Depression – when looking
to establish precedents for the current volatility.

The 1970s appear forgotten altogether. Yet, UK equities fell more than 70% 1 over the

1. Source: BBC News, Reading the Stock Market, 6 May 2003.

Hidden From Sight: The Real Liquidity Crisis |  2

 course of two years at the start of the decade, following the end of the Bretton-Woods
system, a localised housing-driven recession and the global oil crisis. In many ways,
the early ’70s provide a better template for what we’re currently living through than
the more commonly-cited historical crashes – and we’d draw your attention to what

‘‘
happened to inflation subsequently.

How do traders A Look at Liquidity

separate their very One of the things we worried about as this most recent panic took hold was liquidity:
human concerns we know that dealers become more conservative at times of uncertainty, and that
nothing fuels uncertainty like the breaking of routines. The disruption and technological
for their own health challenges we’ve all endured over recent weeks have been magnified immeasurably
and that of their for those dealers for whom success or failure lies in the spread they can make on
securities whose prices are less certain with every passing day.
families from their
What’s more, this virus conflates personal and professional worries in a way that
broader sense of the is hugely problematic psychologically – how do traders separate their very human
likely impact of the concerns for their own health and that of their families from their broader sense of the
likely impact of the crisis on earnings and sentiment? The answer is that they can’t,
crisis on earnings and this is another factor that will weigh on dealers’ willingness to saddle risk.
and sentiment? The The rout has essentially seen two distinct phases so far: an initial, orderly unwind
answer is that they followed by a period of panic as the virus took hold in Europe and the oil price war
added fuel to the fire. During the initial deleveraging, the equity markets saw huge
can’t.  ’’ volumes as systematic strategies took off risk and a mixture of institutional and retail
money stepped in to plug the gap.

As we moved from retrenchment to capitulation, though, liquidity began to dry up,

with banks coming to recognise that their capital positions would come under threat
if they allowed their balance sheets to become bloated with inventory. It’s striking
that regulators in Europe have decided not to implement 2020 stress tests for their
banks, recognising that requiring adherence to strict post-GFC rules would both
dissuade dealers from continuing to support the orderly functioning of the markets and
potentially further spook an already panicked investor base. With equity markets still
whipsawing – in March we experienced both the steepest decline and most significant
rally since the Great Depression – we believe it is likely that liquidity will continue to be
a challenge as we move through this crisis.

Figure 2 provides an interesting breakdown of dealer activity during recent weeks,

showing the decline of dark venues and the rise of LIT trading 2 – effectively illustrating
a diminishing willingness for dealers to take on risk as the rout played out. LIT pools
show bid/offer pricing for the stocks they trade, while dark venues do not. Dealers tend
to step back from dark liquidity at times of market stress.

Figure 2. Daily Venue Distribution of the EuroStoxx 600 (2020)

100 %
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
W eek 1 W eek 2 W eek 3 W eek 4 W eek 5 W eek 1 W eek 2 W eek 3 W eek 4 W eek 1 W eek 2
J an-20 F eb-20 M ar-20
D ark LI S D ark M T F Per iodic A uct ion SI Lit M T F Lit p rim ary Prim ary auc tio n
Source: Reuters; as of 17 March 2020. Note: Displayed includes primary and LIT MTF volumes, including only the LIT MTFs
(BATS Europe, Aquis Chi-X and Turquoise). The data set only includes LIS venues (BATS, Liquidnet and Turquoise) that Goldman
Sachs connects to. SI data captures flow reported on the BATS/Chi-X OTC Reporting tape excluding technical trades.

2. A LIT or light pool market will allow traders to see the amount of liquidity that is posted on the bid and offer of the order book for a security.

Hidden From Sight: The Real Liquidity Crisis |  3

 Dealers have been caught between the Scylla of massive investor deleveraging and
the Charybdis of capital constraints that are enforced by risk committees far stricter
than prior to the GFC. The response has been to widen spreads (often by double-digit
multiples) or to back off from the market altogether, at least when it comes to securities
where there is any kind of question about the possibility of ongoing liquidity. As an
example, Figure 3 shows the gapping out of the bid-offer spread in the EuroStoxx 600.

Figure 3. Widening of Bid-Offer Spread

12.0

Basis points
10.0

8.0

6.0

4.0

2.0

0.0
2 Jan 9 Jan 16 Jan 23 Jan 30 Jan 6 Feb 13 Feb 20 Feb 27 Feb 5 Mar 12 Mar
Source: Reuters; as of 17 March 2020.

‘‘
A Reckoning of Private Equity?
Still, we believe that the stress in visible markets is likely to be only a fraction of that
being suffered by historically more opaque, illiquid instruments. The ‘hot potato’ nature
The ‘hot potato’ nature of private equity (‘PE’) make us nervous and it may be that this latest crisis finally
precipitates a reckoning in a market that has for too long been running on fumes. The
of private equity
private equity industry appears in robust health, having raised a near-record USD919
make us nervous billion in 2019 and with more than USD2 trillion in undeployed capital. 3 Private equity
does not suffer mark-to-market pressure, and asset valuations are largely down to
and it may be that
the discretion of the asset owners. As an example, when Southland Energy went
this latest crisis into bankruptcy earlier this year, its owner Encap noted in a filing that it had written
down the value of its investment by 25% in early 2019. This left the company valued
finally precipitates a
at almost precisely what Encap had paid for the firm: more than USD750 million. The
reckoning in a market investment was then written down to zero. 4
that has for too long It’s an example of the fact that private equity is more often mark-to-myth than mark-
to-market, a situation that is sustainable as long as funds are able to flip companies
been running on
between them, applying ever more leverage – in 2019, average leverage in leverage
fumes.  ’’ buyouts (‘LBOs’) exceeded pre-GFC levels for the first time. 5 The passing of problem
companies from one PE firm to another has become endemic in the industry, with 40%
of all deals in 2017 being secondary transactions (against a 12-year average of 29%). 6

It may be that, notwithstanding the dry powder available, the coronavirus-related

seizing up of the markets means that the appetite for debt diminishes dramatically.
With the likelihood of a raft of downgrades and a spike in defaults, and with traditional
buyers of LBO debt – collateralised loan obligations (‘CLOs’) and bond ETFs – absent
or substantially constrained, it’s unclear how private equity houses will be able to
refinance the deals whose debt comes due in the coming months, and the spate of
secondary deals may grind to a halt.

We tried to get an idea of where private equity valuations would price if they traded
in a public market by looking at the performance of listed private loan companies.
These firms, sponsored by some of the biggest names in private equity, make loans

3. Source: PrivateEquityWire; Private markets have seen an impressive decade of growth, says McKinsey report; 24 February 2020. 4. Source: FT; Private equity and the
mark-to-market myth; 28 January 2020. 5. Source: S&P Global Market Intelligence; LBO purchase price multiples hit record high as PE shops dig deeper for equity;
15 November 2019. 6. Source: Goldman Sachs.

Hidden From Sight: The Real Liquidity Crisis |  4

 to middle-market enterprises. It’s no surprise that their shares have traded off
dramatically, given the illiquidity and potential credit concerns of their underlying assets
(Figure 4). It may be that they give an early warning indication of the problems that the
entire private equity industry will face in the coming months.

Certainly, for deals to get done, they will need to be structured with greater equity
contribution from sponsors and more protection for debtors in loan covenants. Where
this leaves companies that have been limping along with excessive leverage and cov-

‘‘
lite documents is unclear.

Figure 4. The Public Face of Private Loans

Keep an eye on 16,000

publicly-listed loan
14,000
funds – the only visible
signs of the chaos to 12,000

come.  ’’ 10,000

8,000

6,000
Jun-15

Sep -1 5

Dec-15

Mar-16

Jun-16

Sep -1 6

Dec-16

Mar-17

Jun-17

Sep -1 7

Dec-17

Mar-18

Jun-18

Sep -1 8

Dec-18

Mar-19

Jun-19

Sep -1 9

Dec-19

Mar-20
Source: Bloomberg; as of 24 March 2020. Note: The index is comprised of Ares Capital, Apollo Investments, FS KKR and TPS
Speciality Lending in equal proportion.

Conclusion
We believe liquidity will continue to be an issue for all markets as we move through the
coronacrisis. However, it may well be that the most significant problems are brewing
out of sight. Eventually, private equity firms will need to let the light in on their assets,
many of which we believe to be marked well above anything approaching fair value. For
the moment, keep an eye on publicly-listed loan funds – the only visible signs of the
chaos to come.

Hidden From Sight: The Real Liquidity Crisis |  5

Authors

Pierre-Henri Flamand
CIO Emeritus and Senior Investment Adviser, Man GLG
Pierre-Henri Flamand is CIO Emeritus and senior investment
adviser at Man GLG. His role includes supporting Man GLG’s
portfolio managers and their teams. Before joining Man GLG
in June 2014, Pierre-Henri ran Edoma Capital Partners – a
European-focused, event-driven hedge fund. He also spent 15
years with Goldman Sachs, where he ran the Principal Strategies Group. Pierre-Henri
graduated from the Ecole Polytechnique, the Ecole Nationale de la Statistique et de
l’Administration Economique and the Institut d’Etudes Politiques de Paris.

Hidden From Sight: The Real Liquidity Crisis |  6

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Hidden From Sight: The Real Liquidity Crisis |  7