Q&A: Preparing for private equity exits: impact of COVID-19
September 2020 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2020 Issue
FW discusses the impact of COVID-19 on private equity exit preparations with Michael J. Ulmer at Cleary Gottlieb Steen & Hamilton LLP and Jennifer Bellah Maguire at Gibson Dunn & Crutcher LLP.
FW: How would you characterise the current private equity (PE) exit environment? How has the COVID-19 crisis affected available exit routes?
Bellah Maguire: In many, if not most cases, financial buyers had been ‘sitting out’, and while the initial public offering (IPO) window remains open, it is at a discount to pre-pandemic expectations and not a panacea. The earlier movers on the buy-side in the US were special purpose acquisition company (SPAC) buyers and we have seen a recent explosion in the number and size of these vehicles that portends favourably for exits in the sectors they are attracted to. Further, as of the recent quarter end, private equity (PE) buyers have become more receptive to traditional auction sale processes, at least those involving targets that appear to be weathering or flourishing in the coronavirus (COVID-19) environment. Finally, PE fundraising has skewed toward distressed fundraising in various sectors, with the result that portfolio companies in software and other sectors that are perceived as attractive in the long term but written down by their owners, may fetch more than anticipated as a result of competition among turnaround buyers.
Ulmer: Under the given circumstances, nobody sells who is not forced to sell. Without a reliable basis for valuation, appropriate pricing is hardly possible. Even businesses benefitting from the COVID-19 situation are difficult to handle. The very moment an effective vaccine is found their value might decline significantly. While capital markets are drawn on heavily for financing purposes, they have not yet been robust enough for IPO exits. Finally, the risk sharing structures used for acquisitions, such as earn outs, are usually impracticable for PE exits, which call for the distribution of funds.
FW: Has it become more difficult to properly assess the health and future performance prospects of a portfolio company, and in turn its viability for exit? How are financial forecasts and the economic outlook impacting this assessment?
Ulmer: There is hardly a business plan that has not been affected by the COVID-19 pandemic. The fundamentals forming the basis for valuations remain in flux. Even businesses benefitting from the current crisis do not offer a sufficient basis for reliable valuations. Once a vaccine is developed, their comparative advantage might dissolve. Some sectors, such as remote working technology, could show improved long-term prospects, but even they are challenging targets as no one wants to overpay. With forecasts and outlooks changing by the week, exits are even more of an art than before.
Bellah Maguire: Clearly, economic uncertainty makes assessing a portfolio company more challenging. However, a number of sectors, such as life science, biotech, certain sectors of healthcare, engineering, construction and certain consumer markets – along with online instruction, exercise, home improvement, nutrition and alcoholic beverages – while infrastructure, broadly speaking, and renewable energy, among others, appear to be transacting on the basis of their fundamentals. After a full quarter of weathering the pandemic, companies in these industries with durable or enhanced demand are beginning to emerge and to report second quarter earnings which will give more credence to their perceived performance. Paradoxically, it may be less challenging to sell a performing business in the context of a market that can fairly value it than to arrive at a well-reasoned valuation that takes into account a relatively sparse array of comparable transactions.
“Sticking to their knitting is the primary GP tactic. They are continuing to grow their healthy portfolio companies both organically and by way of ‘tuck in’ acquisitions when available. ”
FW: In broad terms, how would you describe current deal valuations? What can PE firms do to help bridge a price expectation gap and achieve exit?
Bellah Maguire: It is truly a question of whether a buyer and seller are transacting without pressure, which is the very definition of the term ‘fair market value’. The best evidence that there is a discount on many, if not most, portfolio companies, is the fact that deal volume has fallen substantially. Specific valuation gap closing devices include rollovers and earn outs, but those have hazards of their own. The cool-headed general partner does not necessarily want to close the gap, but rather ensure that its portfolio has sufficient capital to fight another day. It will be important but, in many cases, insufficient to report a full quarter’s performance in the new normal environment, yet one full quarter is sparse data and many buyers will prefer to wait and see what is sustainable. For that reason, probably the single most important thing PE firms can do is what most of them have been working on diligently from the very outset, and that is using all means at their disposal to ensure sufficient liquidity to their existing portfolio. For smaller firms, that has included the opportunity to seek federal funding which in some cases is entirely forgivable, while for medium and large firms, that has meant working closely with their lending relationships and exploring methods for infusing capital from their own undrawn commitments.
Ulmer: Current deal valuations are indirect bets on the future of vaccine research, unless a business case is completely COVID-19 independent. Bridging the gap for PE firms aiming at an exit involves participating in risk-sharing structures. Remaining invested in the target or earn outs usually do not match full exit requirements. These could probably be accommodated by PE firm-internal roll-overs, but this would be an exception. The ‘buy and build’ approach currently being applied by many PE firms might alleviate the situation, however. Adding value by ‘buy and build’ requires longer holding periods that would probably allow sitting out the period of valuation uncertainty while the portfolio company is developed further.
FW: To what extent has the deal process become more challenging? What kinds of obstacles and practical problems can dealmakers expect to encounter?
Ulmer: The COVID-19 situation shows that dealmaking remains a people’s business. Identifying opportunities is much easier when people meet in person, when they can talk about the market in a natural rather than a Zoom environment. Without physical meetings it is very difficult to build trust in the management of a target company. Often the dinner following the management presentation is far more important than many Excel sheets, and building even a virtual data room requires people to meet – something that is not encouraged these days.
Bellah Maguire: The melt rate is higher, and, in many cases, financing has been much more challenging. Further, in-person due diligence is far more challenging, and while such activities as financial presentations and key negotiations can move to a Zoom format, physical diligence cannot – although there are some reports of the potential use of drones, and in fact we do see plant and other physical visits being arranged when feasible. That said, most of the obstacles have to do with the uncertainties around projections and the concern that a material adverse effect (MAE) is simply too narrow a concept to protect a buyer against even a very substantial decline in outlook, if it is not fundamental or clearly long term in nature. While a great many transactions that were under signature before the crisis are in litigation in the courts today, probably an equal number have reached a compromise with the result that the jurisprudence in this arena is certainly not broadening in a manner commensurate with the number of potentially controversial transactions.
FW: To what extent are PE firms using new technology to facilitate and enhance exit processes?
Bellah Maguire: New technologies are primarily being used in the virtual meeting and visit spaces, which have of necessity replaced the previously peripatetic lifestyle of a typical PE investment professional. This has also become notable particularly in public offering, portfolio company management presentations and IPO roadshows, where the use of online meetings has gained enormous hegemony and the results are compelling. The challenges of physical inspection and site visits are ongoing and depending on the industry and geography, firms remain cautious about onsite diligence of businesses, particularly where they have limited knowledge of the protocols followed by their current owners.
“Flipping a portfolio company following a refinancing and the distribution of a super dividend no longer presents a viable option. Rather, a ‘buy and build’ strategy is applied to create value.”
FW: What strategies are general partners (GPs) adopting to prepare a portfolio company for exit and generate expected returns? How have these strategies shifted in response to the COVID-19 crisis?
Ulmer: For some time already, many PE firms have been reacting to a changing market environment. Flipping a portfolio company following a refinancing and the distribution of a super dividend no longer presents a viable option. Rather, a ‘buy and build’ strategy is applied to create value. Implementing such an approach takes time and therefore requires longer holding periods. This now allows general partners to sit out the immediate COVID-19 situation until the basis for valuations becomes more reliable again.
Bellah Maguire: Sticking to their knitting is the primary GP tactic. They are continuing to grow their healthy portfolio companies both organically and by way of ‘tuck in’ acquisitions when available. In some cases, such as the recent sale of an emergency contact device company by a PE firm exiting it by way of a trade sale to a major electronics retailer, there are themes that resonate strongly with consumers’ current preoccupations. Clearly, if it is perceived as time for an exit, all confidential information memoranda now include a fulsome discussion of how the business has fared and expects to fare in the pandemic and post-pandemic environment. Some more narrowly focused strategies – particularly in regard to businesses that have a wide physical footprint, such as multi-location stores and medical or dental providers – include hiring expert sanitation engineering firms that can perform a safety, sanitation and facility flow overhaul of a business that has been closed or underutilised for pandemic reasons and has been or is expected to resume operations in the near term.
FW: What are your expectations for PE exit activity over the coming months? How is the PE value-creation playbook likely to evolve in both the short and long term?
Ulmer: I would expect PE firms to be seen on the buy-side, pursuing COVID-19 related opportunities. The increased percentage of transactions with PE involvement will decline again once strategic investors re-enter the scene. ‘Buy and build’ strategies as well as minority participations will appear more often, resulting in longer holding periods. IPO exits might come back more quickly than trade sales and the number of secondaries is likely to drop off.
Bellah Maguire: For the right businesses and with preliminary second quarter data in hand, we see sponsors starting to regain focus on an exit. That is a positive change from several months ago, when everything seemed to freeze overnight. Paradoxically, prudent PE firms may carry successful investments at a flat or modestly enhanced valuation out of regulatory prudence, such that their collective net asset values paint a conservative portrait to such constituents as the secondary market. Yet when transacting a well-established and successful company, a ‘fully valued’ price can be commanded, particularly in light of the substantial dry powder in place before the pandemic, as supplemented by the phenomenon of nimble SPAC and special situation fundraising gaining traction in the short window of the ongoing crisis. Paradoxically, in some cases an exit is potentially a matter of degree. For example, there is a growing trend to explore fund-based ‘GP recapitalisations’ involving one or more operating portfolio companies that are perceived to require more capital, more runway or both. In this scenario, liquidity is provided to limited partners who prefer to exit at a current valuation, while maintaining control and the opportunity to participate in further appreciation for a new constituency comprised of the sponsor and a mix of old and fresh capital.
Michael J. Ulmer’s practice focuses on domestic and international private and public M&A transactions, joint ventures, general corporate advice and private equity transactions. His work extends to a broad range of industries and clients, including leading German corporates, Mittelstand companies, and domestic and international financial and strategic investors. He has vast experience in assisting clients from the Middle East with outbound investments. Mr Ulmer joined Cleary as a partner in 2016. He can be contacted on +49 69 97103 180 or by email: mulmer@cgsh.com.
Jennifer Bellah Maguire is a partner in Gibson, Dunn & Crutcher’s Los Angeles office and is co-chair of the firm’s investment fund group. Ms Bellah Maguire’s practice focuses on private equity fund formation and mergers and acquisitions, including public company transactions and divestitures. ‘Chambers Global: The World’s Leading Lawyers for Business’ has recognised her as a leading lawyer from 2012-2019 in the area of private equity. She can be contacted on +1 (213) 229 7986 or by email: jbellah@gibsondunn.com.
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Cleary Gottlieb Steen & Hamilton LLP
Gibson Dunn & Crutcher LLP
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