September 2020 Issue
Ordinarily, the private equity (PE) industry is less susceptible to the ebb and flow of the global economic cycle due to its long-term investment horizon. For example, it was largely successful in weathering the 2007-08 global financial crisis; however, PE will not emerge from the COVID-19 crisis unscathed. Fundraising, buyouts and exits will all be affected as portfolio companies suffer.
The COVID-19 pandemic has had a catastrophic effect. Employees have been laid off or furloughed, businesses have closed (in many cases permanently), and all but essential economic activity ceased as travel restrictions and social distancing measures were introduced to curb the spread of the virus. Companies across the spectrum face challenges that will last for months to come.
According to Edward Johnston, a partner and national leader of the private funds practice group at Gowling WLG, the COVID-19 crisis has placed tremendous pressure on managers and sponsors. “They have been scrambling to ensure that portfolio companies and assets remain adequately capitalised, to communicate with and manage investor enquiries and expectations during an uncertain time, and to take advantage of potential buying opportunities presented by the pandemic,” he says. “COVID-19 is different from other historic crises based on the truly global impact of the pandemic and the sheer scope and scale of adjustments that it has forced the business community to make in order to maintain business continuity and remain profitable.”
PE poised
Despite the gloom, there will be a silver lining for some. The crisis will create opportunities for savvy, agile investors to capitalise on a ‘new normal’. As their financial prospects fade, a plethora of distressed and insolvent businesses will come onto the market – and the PE industry is poised to pick up assets at reduced valuations.
Moreover, shrewd PE investors have an opportunity to help lead the global recovery. Through prudent portfolio company management, firms can steadily rebuild and reinvigorate sectors, generating value.
Following the global financial crisis, as banks withdrew from the financing markets, private lenders moved in to fill the void. That role may fall to them again in the COVID-19 era. Indeed, private debt funds have evolved into a major force, with more than three times the assets under management they had in 2008 – a substantial amount of capital waiting to be put to work, according to Bain.
The level of dry powder in the PE space is significant. According to Preqin, dry powder has kept rising in recent months, increasing from $1.41 trillion at the end of 2019 to $1.48 trillion at the end of Q2 2020. And PE firms will be under pressure to deploy it.
In the coming weeks and months, with public markets flagging and potential corporate buyers holding onto their cash, overall competition for assets is likely to wane, leaving PE to reap the rewards. Certain industries, such as personal protective equipment (PPE), healthcare goods, and logistics and delivery services, for example, could be fertile areas for investment.
Mixed conditions for dealmaking
Unsurprisingly, there has been a sharp drop-off in global PE transactions in the first half of the year. According to Preqin, buyout-backed deals slumped in Q2 2020, with 888 announced deals worth a total of $61bn – about half the activity recorded in Q2 2019, when 1567 deals reached an aggregate $115bn.
Despite this, PE groups have remained active dealmakers, accounting for 16 percent of worldwide activity in the first half of 2020 – the highest level since 2007, according to Bain. Several notable buyouts took place in Europe, including a €5bn agreement by KKR, Providence Equity Partners and Cinven to buy Spanish telecoms operator Masmovil in June, and KKR’s £4.2bn acquisition of UK recycling group Viridor in March. This kind of activity helped to cushion the fall in total dealmaking volume, holding it to just a 15 percent year-on-year decline for the region.
According to Mazar’s ‘Covid-19 and the world of private equity’ report, most global PE investors are continuing to pursue transactions despite COVID-19. The study found that investors are still on the hunt for deals that make sense, with two-thirds of respondents saying they would be interested in distressed opportunities. Investors may be willing to look outside their normal criteria in the current environment, adopting a more opportunistic acquisition strategy. Valuations have already declined enough to make some companies affected by the pandemic attractive buyout targets.
Though there will be opportunities for PE, it is logical to conclude that some players within the industry will back away from making new acquisitions during the worst of the COVID-19 crisis. Many general partners (GPs) have already begun to shift their focus toward stabilising and triaging their portfolio companies in the midst of unprecedented upheaval.
Ultimately, the pandemic may demand a rethink of returns expectations within the industry. Before the effects of COVID-19 were felt, 90 percent of respondents to Investec’s GP Trends survey, released in May 2020, expected their firms’ returns over the next two years to perform at least as well as 2019. Now, 58 percent expect returns to be worse over the same period.
“Through prudent portfolio company management, firms can steadily rebuild and reinvigorate sectors, generating value.”
While many PE firms will be eager to take advantage of investment opportunities, a range of factors could be working against them. “There are a number of challenges presented by current global conditions that will challenge the PE industry,” says Mr Johnston. “First, political and trade-related volatility will continue to create uncertainty and potentially drive more nationalistic business strategies. Second, traditional sources of debt and financing may be significantly restricted as banks tighten credit requirements. Third, many industry sectors, such as real estate and infrastructure, continue to experience valuation and appraisal challenges and uncertainties that are creating impediments to transactions. Fourth, sellers remain resolute and patient for the time being, hoping for a speedy recovery, which is effectively pausing deal activity.
“Until there is more certainty as to the duration and depth of the impacts of COVID-19, we are likely to see reduced volumes of transactions, potentially leading to the floodgates opening once market confidence returns,” he adds.
The COVID-19 crisis has lowered transaction volumes, slowed the pace of realisations and distributions, and applied significant downward pressure on pricing. Arguably, it presents a test unlike any the PE industry has faced, and many firms will need to get creative.
For buyers, this may mean exploring forms of price protection in purchase agreements. Buyers may consider utilising variations on traditional contractual provisions, such as material adverse change (MAC) closing conditions or force majeure clauses to protect their interests. They may consider incorporating pre-closing price review and adjustment mechanisms, or altering their processes such as by executing more transactions on a simultaneous ‘sign-and-close’ basis. Sellers may face difficult decisions around accepting price reductions, deal uncertainty and transaction risks.
Some PE firms are gearing up for a potential wave of distressed sellers in the short term, followed soon thereafter by a prolonged, attractive period of motivated portfolio management-driven sellers. According to Adams Street Partners, this wave of sellers could be caused by a combination of operating distress and disruption at corporations and institutions, a slowdown in distributions from decreased M&A, public market valuations decreasing at a faster pace than PE, and PE portfolio companies facing liquidity issues.
Secondary solutions
The slowdown in buyout and PE investment activity is expected to encourage GPs to seek out secondary solutions, according to Schroders. It points out that secondary transactions have proven to be a flexible provider of capital across market cycles and, in the present COVID-19 environment, they can be used to take advantage of market dislocations and liquidity requirements. In addition, dropping valuations will result in more attractive entry points for investors.
In 2019, secondary transaction volume reached a record $86bn, up 15 percent on 2018, marking the third consecutive year of increasing volume, according to UBS. Prospects were bright for continued activity at the beginning of 2020, not least as dedicated secondary buyers held around $91bn in dry powder.
However, the COVID-19 crisis put on the brakes. As Mercer notes, virtually all deals in the market have been pulled or repriced, as potential sellers focus on portfolio and investment issues, and actively rethink their timing and evaluate the impact of the pandemic on their portfolios. Both GPs and limited partners (LPs) are hesitant to move forward with transactions in the absence of market clarity due to COVID-19.
That said, once second-quarter valuations are available, there should be more interest and more activity in the secondaries market. Secondaries can be used to distribute cash and return capital to help balance an LP portfolio. As Shroders notes: “While secondary activity has slowed during H1 2020, due to the widening of bid-ask spread between buyers and sellers amid speculation on further portfolio write-downs and market volatility, the consensus is that volumes will rebound in the latter half of the year when those dynamics stabilize. Secondary investors then will be acquiring private equity portfolios at lower valuations, even if optical discounts end up back in-line with pre-crisis levels.”
Looking ahead, and based on prior downturns, once market volatility subsides and some stability is restored, the secondary market may recover quickly and offer attractive opportunities for investors with available capital.
PE exits constrained
Not surprisingly, traditional PE exits have slowed significantly, dropping almost 70 percent globally in May 2020 versus May 2019, according to McKinsey. In the view of Mr Johnston, there are a number of reasons for this fall. “First, the uncertainty as to the duration of the crisis is causing GP sellers to take a ‘wait and see’ approach in order to avoid selling at a ‘COVID discount’. Second, government support and bank forbearance in certain instances have allowed many businesses to avoid insolvency and stabilise operations, pushing out forced exits at least for the time being. Third, we suspect that GPs will consider restructuring to allow certain assets to be held beyond fund sunset dates, thereby allowing further flexibility to ‘ride out the storm’ with the hope of better days ahead,” he says.
But those days may be some way off. According to Investec’s survey, 83 percent of respondents did not expect to make a portfolio exit within the next 12 months. PE firms will not be prepared to exit at any price, and will hold on for value in the hope of releasing expected returns to investors when possible. This would delay or reduce carry substantially, with a knock-on effect for fundraising.
Fundraising challenges
In the first quarter of 2020, before COVID-19 really took hold, fundraising was relatively robust. During the first three months of the year, 282 PE funds with a collective $134bn held final closings, according to Preqin. That was 87 fewer closings than in the same quarter of 2019, but $14bn more in total capital commitments. In Q2, however, only 225 funds closed, raising a combined $116bn – compared to 425 funds that secured $150bn in the equivalent quarter of last year.
In its analysis of investor appetite for the private equity asset class, Preqin notes that this has diminished on a sliding scale, with the greatest decline among larger investors: “The proportion of investors looking to commit more than $300m in the next 12 months has halved from 22 percent in Q2 2019 to 11 percent in Q2 2020. But the proportion looking to commit less than $50m has remained stable, suggesting compression at the top end rather than a general fall in investor appetite.”
The second half of the year is likely to be more difficult for fundraising. Indeed, 33 percent of GPs recently surveyed by Investec said they had suspended, or expected to suspend or postpone, fundraising for their next fund.
Larger, more established GPs with pre-existing investor bases may continue to achieve fundraising success, while smaller and start-up players are likely to encounter challenges in both their fundraising and capital deployment efforts.
“We see this trend continuing for the foreseeable future with respect to funds with a more general investment strategy, although certain niche ‘special situation’ or distressed opportunity funds will likely find success the longer that businesses remain impacted by the pandemic,” says Mr Johnston. “With relatively few investment targets relative to the amount of capital seeking transactions, we suspect that certain funds with significant dry powder and lengthy investor queues may slow their fundraising efforts in the near term.”
In addition, due to COVID-19 many of the usual processes associated with fundraising, like investor roadshows, cannot take place in the traditional fashion. Though video conferencing has helped to pick up the slack, there are limitations to what can be done through technology alone. While virtual meetings may be less of a problem for established sponsors, newer PE funds may find it harder to build relationships with LPs this way.
Finding prosperity
The initial period of ensuring the health and safety of employees and meeting the immediate needs of portfolio companies to ensure their survival during the crisis will give way to additional, longer-term challenges. PE firms will need to examine their portfolios and find ways to create more value.
Rather than adjusting existing strategies, some may entirely reimagine their operations. The PE industry has performed exceptionally well for the last decade, and though there are challenges ahead, it will be able to draw on its experience of weathering the last global financial storm. Though there will be casualties in the short to medium term, the industry as a whole has demonstrated its ability to prosper.
© Financier Worldwide
BY
Richard Summerfield