Private equity activity in the COVID-19 environment
June 2020 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2020 Issue
Despite recent volatility in the capital markets caused by the outbreak of the novel coronavirus (COVID-19), financial sponsors and other private equity (PE) investors, including large family offices and sovereign wealth and pension funds, remain in active pursuit of investment opportunities across the capital structure and in a variety of industries.
Such investors are particularly well‑positioned for investment at a time when others face liquidity crises – US PE funds in particular raised a record amount of capital during 2019, and global PE and venture capital (VC) funds ended the year with a record $1.45 trillion in ‘dry powder’ to deploy. With cash readily available, the primary challenge facing investment managers in the COVID‑19 environment is identifying investments that will provide the rates of return their investors expect, while remaining somewhat resilient during a potentially prolonged market dislocation.
Finding investment opportunities
In the years prior to March 2020, which marked the end of the longest bull market in history, the market for acquisitions of whole companies became increasingly, and sometimes prohibitively, expensive for PE investors, and many of the targets that were available were not necessarily as attractive to these types of investors as compared to the companies that were sold off in prior periods. The ‘low hanging fruit’, for some time, had been picked through and exhausted in the market for the types of businesses with steady cash flows that traditionally have been the most attractive to PE investors.
Moreover, companies that came up for sale in this period increasingly were being sold by other PE firms looking to cash out and lock in returns, or were being sold in highly competitive auction processes at valuations that would make it very difficult to achieve the return on investment that PE investors had come to expect. The market dislocation and liquidity crisis created by the COVID-19 pandemic has made finding the right investments more difficult and riskier, but, as in any crisis, we expect these circumstances to provide investors of private capital tremendous opportunities, particularly if they are flexible as to where they are willing (or able) to invest in the capital structure.
PIPEs. Private investments in public equity (PIPEs) present an attractive option in the current market to PE investors because these investors can deploy capital without the exposure of owning the whole company, almost always can make the investment without obtaining external financing, can typically acquire the stake at a very favourable price and should have a clear path to exit. While PIPEs often have been used as a way to help fund acquisitions without triggering debt incurrence restrictions in the indentures or credit agreements of the acquirer, they also are being used now to fund liquidity shortfalls. Because the need for liquidity is immediate for many companies in the current environment, PIPEs are usually negotiated between the issuer and, at most, a small group of potential investors that are willing and able to move quickly, instead of a drawn-out competitive auction with scores of bidders.
PIPEs tend to be highly tailored and must take into account, in addition to restrictive debt covenants, ratings agency concerns, potential stockholder and regulatory approval requirements, and other factors. The securities issued may take a variety of forms, including preferred stock, common stock with warrants or convertible notes, and the investor may obtain board representation, as well as other governance rights. The rates on dividends or interest, which often will pay-in-kind (either by default or at the issuer’s option), tend to be high, which reflects the risk to the investor both due to the location of the security in the capital structure and the circumstances for the financing. Moreover, while a PIPE is not meant to be a long-term source of capital – it is too expensive – it usually will not be redeemable by the issuer for some period of time. On the other hand, the investor’s path to liquidity will be a key source of negotiation.
Chapter 11 restructurings. The opportunity to invest in distressed companies that seek bankruptcy protection, particularly in the retail and hospitality industries, can be expected to become more prevalent as social distancing and other effects of COVID-19 persist. Debtor-in-possession (DIP) financing, which debtors incur to maintain operations during Chapter 11 bankruptcy, can strategically position a PE investor to own equity in a debtor following its emergence from bankruptcy. Debtors and existing lenders may view such equitising financing favourably because it minimises the risk that a debtor will become administratively insolvent before confirming a plan of reorganisation and may leave more cash available for existing lenders, which may not have an interest in holding an equity position in a company. PE investors may also provide DIP financing in order to protect an existing equity investment in the debtor, both in terms of providing the debtor liquidity for its operations and having greater control over the reorganisation process.
PE investors may also serve as ‘stalking horse’ bidders in sales of assets pursuant to Section 363 of the Bankruptcy Code, pursuant to which a debtor in Chapter 11 bankruptcy discloses the offer from a stalking horse bidder and seeks competing proposals in an effort to obtain the highest price for its assets. The stalking horse bidder has the ability to negotiate specific terms of a transaction, including specific assets to acquire and liabilities to assume, negotiate the procedures for the subsequent auction and, to a certain extent, receive incentives in the form of expense reimbursement and termination fees in the event of a superior bid. However, each of the foregoing is subject to the approval of the bankruptcy court, and stalking horse bidders assume the risk that the business of the debtor may deteriorate during the subsequent auction process (unless such decline rises to the level of a material adverse effect and the stalking horse bidder can refuse to close, which is a typical closing condition for third-party bidders).
Transactions with distressed sellers. The current environment already has forced some financially distressed sellers to sell assets or businesses to shore up their balance sheets, and we expect the pace of this activity to accelerate the longer the pandemic continues. These situations can present a good opportunity for purchasers willing to move quickly. Speed of execution at a defensible value may be more important to a distressed seller than its ability to obtain the highest possible sale price for an asset. Purchasers that can execute on a transaction without a debt financing contingency have a tremendous advantage in these scenarios. Many large family offices, pension funds and sovereign investors have longer time horizons and different return requirements than traditional PE funds, and therefore may be willing to underwrite the full purchase price for an asset with only equity; this may give them an edge over PE funds as counterparties to distressed sellers.
Leveraged loans. As rising valuations and competition eroded expected returns on investment for equity acquisitions, many PE investors expanded over the past five years into the leveraged lending market, which was underserved as banks withdrew from middle-market lending, by raising credit funds. Those funds are now well‑positioned to lend to companies facing cash flow difficulties at a time when credit is in high demand and banks are lending cautiously. Private lenders have been lending both to replace maturing debt and to address immediate liquidity needs of companies.
Traditional acquisitions. Notwithstanding the types of investment opportunities described above, PE investors are continuing to pursue more traditional investments. Since the market downturn, assets of particular interest have been in countercyclical industries and in industries likely to be less affected by the effects of COVID‑19, including financial services, renewable energy, infrastructure, technology and healthcare.
Additionally, even outside of these industries, acquisitions that made sense prior to the COVID‑19 pandemic may make sense during it, especially smaller, bolt‑on transactions by existing portfolio companies that have not been severely affected by the change in economic and operational environment. PE investors also may be driven to pursue bolt‑on transactions to protect their existing investments. Many sponsors are addressing liquidity crises at their portfolio companies and are seeking ways to strengthen the balance sheets of those companies, particularly if they had been purchased at the peak of the value cycle. A strategic acquisition could be necessary to protect an existing investment.
Final thoughts
The expansion of PE investment across the capital stack that was driven by fierce competition in a bull market, coupled with unprecedented levels of cash commitments, now leaves PE investors ideally positioned to take advantage of the alternative investment opportunities available in the current downturn. We are seeing many of these opportunities arise for investments in companies that sponsors know already – for example at companies they have invested in and exited already, or with management teams they otherwise already know and trust.
While many sponsors focused their initial attention on shoring up their portfolio companies in the pandemic, we expect that PE investment, especially in minority equity stakes and lending, will accelerate once there is greater certainty regarding the duration and magnitude of the effects of COVID‑19. We expect there will be a further increase in activity once seller price expectations for quality assets stabilise and financing becomes more available, albeit subject to lower leverage ratios than were required prior to the market downturn.
Brian Hamilton and Rita O’Neill are partners and Kelly Meric is an associate at Sullivan & Cromwell LLP. Mr Hamilton can be contacted on +1 (212) 558 4000 or by email: hamiltonb@sullcrom.com. Ms O’Neill can be contacted on +1 (310) 712 6600 or by email: oneillr@sullcrom.com. Ms Meric can be contacted on +1 (310) 712 6600 or by email: merick@sullcrom.com.
© Financier Worldwide
BY
Brian Hamilton, Rita O’Neill and Kelly Meric
Sullivan & Cromwell LLP