Private equity looks to capitalise on post-COVID economic recovery

September 2020  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2020 Issue

Private equity (PE) funds are on the hunt for new investment opportunities. With the emergency work ensuring portfolio companies can weather the COVID-19 storm largely done, pressure to make acquisitions is building. It is partly the weight of available capital – we recorded dry powder of almost $1.5 trillion at the end of 2019 – and partly the knowledge that, in the past, the best returns have come during and after market corrections. Corporate finance advisers say they are inundated with calls from their PE clients trying to source new investments.

Our ‘Quarterly Update: Private Equity & Venture Capital Q2 2020’ paints a bleak picture, with COVID-19 having an immediate and dramatic impact on almost every aspect of the business. Deal volumes and values are way down and fundraising is down, while the number of funds in the market has increased as the fundraising process takes longer. And if that was not bad enough, investors are planning to reduce commitments to the asset class.

PE-backed buyout deals tumbled to their lowest quarterly level in several years in Q2, after keeping relatively steady in Q1 2020. North America was hardest hit with just 444 deals completed in the region, compared with 850 in Q2 2019 and 766 in Q1 2020. Aggregate deal value fell to $61bn during Q2 2020, barely half of the $115bn recorded in Q2 2019. The $116bn in aggregate capital raised was the lowest amount since Q1 2018 ($110bn) and of the funds that closed in H1 2020, just 39 percent took less than 12 months, compared to 52 percent of 2019 vintage funds.

Buying opportunity

However, the quarterly update is a snapshot of what is a relatively long-term business. Our survey of institutional investors in April 2020 found 63 percent did not expect COVID-19 to affect their alternative assets strategy beyond 2020, with a further 29 percent saying they expect to increase investment in alternatives and just 8 percent planning to reduce their exposure. Funds targeting distressed situations are attracting capital while limited partners (LPs) also see opportunities in non-cyclical sectors such as healthcare and the emerging healthtech sector.

Falling valuations will present a buying opportunity for PE funds and historically there has been a strong correlation between lower pricing on acquisitions and higher returns. Looking at funds raised through the global financial crisis (GFC), after dipping below 10 percent in 2003, median net internal rates of return (IRRs) stayed in single digits until 2008 when they hit 12 percent before climbing to 14.7 percent, 15 percent and 15.3 percent in 2010, 2011 and 2012 respectively.

The PE industry has managed its phenomenal growth well. Outperformance over public equities has continued even as the available firepower has increased. Assets under management (AUM) have increased from $646bn in 2000 to $5.18 trillion at the end of 2019, according to our data. As far back as any practitioner can remember there have been concerns there is “too much money chasing too few deals”, but the ratio of dry powder to annual investment rates has remained surprisingly consistent. In 2000, buyouts with a combined value of $87.2bn were completed, while the amount of dry powder raised for buyouts stood at $146.9bn, giving a ratio of dry powder to investment of 1.68x. In 2019, the total value of completed buyouts was $423.2bn while dry powder was $796.3bn, a ratio of 1.88x.

Safety first

We expect PE buyers to focus their firepower at both ends of the spectrum in terms of asset quality. In the past, the public perception of PE may be of asset strippers buying up companies on the cheap, but firms generally invest in high-quality companies with strong market positions, businesses that command high valuation multiples on all metrics. When markets are difficult, businesses with strong and stable positions are even more sought after.

Companies in sectors such as retail, leisure and hospitality will have a difficult job attracting the interest of PE buyers, though it should be noted that these sectors were unattractive even before COVID-19 shut them down. GPs making investment choices will have one eye on their customers, the LPs, who are wary of these sectors. More than a quarter (26 percent) of LPs in our survey plan to avoid retail-focused PE this year.

Investment in non-cyclical sectors is set to grow. More than a third (36 percent) of investors surveyed said they planned to target healthcare-focused PE in 2020 because of COVID-19, while the emerging healthtech sector is expected to build on the 1000-plus deals recorded in 2019 as demand for digital and distanced services grows. In the broader technology space, rising demand for digital technologies, such as cloud computing services and cyber security, will drive investment.

At the other end of the quality spectrum, GPs are ready to tackle turnarounds and distressed situations. The amount of dry powder available for PE-backed turnarounds stood at a record $8.2bn at the end of 2019. This is in addition to $68bn of dry powder in debt funds at the end of June 2020 that has been built up since 2014, when the amount available was $41bn. There are currently 60 distressed debt funds in the market seeking a total of $72bn.

However, every crisis is different, and headwinds are coming from several directions. First, there is no shortage of available equity and debt capital to invest, where the GFC led to debt finance becoming extremely difficult to find and even equity finance being in relatively short supply. Second, valuations on public markets have bounced back very quickly, which will feed through into higher valuations for private companies. Third, the private equity industry has a much higher profile than it did a decade ago, so executives in boardrooms and across the advisory spectrum know that if they are selling a quality asset there will be no shortage of PE funds interested. Where private equity firms are bidding, the balance of power is unlikely to swing as far toward buyers as it has done after the last two major corrections.

However, the importance of multiple arbitrage as a driver of returns has declined over time, and GPs’ focus on improving the operations and finances of portfolio companies will be the key to any future outperformance.

Using a pandemic scenario we developed jointly with US-based risk management firm FRG, and comparing it with a baseline scenario in which there was no pandemic, we found 2018 and 2019 vintage funds – previously considered the vintages that were more likely to underperform because of the high-valuation environment in 2019 – are now more likely to outperform. This suggests that fund managers with significant amounts of financial firepower are well positioned to generate strong returns.

Grant Murgatroyd is senior writer, EMEA at Preqin. He can be contacted on +44 (0)20 3207 0232 or by email: grant.murgatroyd@preqin.com.

© Financier Worldwide

BY

Grant Murgatroyd

Preqin

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