Insights from Private Equity – Post Covid-19 Crisis

To be honest, it is hard to predict: we are in an unprecedented crisis and no one knows how long it will last or what more lingering consequences it will have on business activities and consumer behaviour. As economies slowly reopen, all eyes are focused on possible re-infection risk and whether the unprecedented levels of fiscal and monetary stimulus (trillions and counting globally) will be enough for economies to fully recover. Most expect a slow U-shaped recovery as social distancing measures, high rates of unemployment, lower levels of productivity and permanent damage to hard-hit sectors continue to take a toll on economic activity.

However, interest rates should remain low as Central Banks universally have committed to stave off debt deflation and help provide liquidity to support the economic recovery. We expect an initial burst of activity as consumers and businesses get back to some form of normalcy, followed by a slower pace of growth than would have been the case had the pandemic not occurred. It may be well into 2021 before the levels of GDP of 2019 are fully restored.

Lessons from prior shocks, along with the preliminary observances of the Covid-19 effects, could help us analyse possible consequences to the Private Equity (“PE”) industry.

Some of our key conclusions:

We expect a period of better valuations due to the combination of a downturn in business performance and a more cautious approach to risk, which should translate into a better pricing environment, lower multiples paid and/or higher discount factors applied to the PE transaction.

Clever deal structuring can help to align buyers’ and sellers’ goals, meaning the PE firm and company management teams are incentivised to create and monetise value working together through the use of earn-outs, preferred shares or convertible loans.

The best managers will return to basics, focusing on value and value creation and long-term return of capital. But in the context of opportunity, we think there is fertile ground for strong returns ahead:

1. PE firms are sitting on an impressive amount of dry powder and, in addition, some of the most sought-after PE firms offer exceptional financial, operational and managerial skills that are required in complex times. PE could be a solution for distressed or hard-hit companies.
2. The private lending market is larger (more than three times) and more mature than compared to 2008 and thus could fill some of the gaps left by banks, especially in the case of distressed and special situation deals.

An allocation to the equity of private companies, with active managerial and operational oversight, purchased with greater price and leverage discipline, could well show some of the best vintage returns experienced in some years.

Lights and shadows at the end of 2019

2019 saw near-peak levels of PE activity in terms of investments (as measured by deal count), exits (using global buyouts by way of example) and fundraising (close to $300bn).

See article download for additional graphs.

But it was also a lofty period for the industry in terms of:

1. Asset pricing: Average LBO EBITDA multiples were 11.5x in the US (55% of deals above 11.0x) and 10.9x in Europe.
2. Leverage: Leverage multiples on average were above 6.0x EBITDA in more than 75% of LBO deals in 2019.
3. Holding period: Holding periods of the exited investments declining from the maximum of 6.0 years in 2014 to a post-Global Financial Crisis (“GFC”) low of 4.3 years in 2019 (before the GFC, the median reached a minimum of 3.3 years in 2008).
4. Expected returns: Value creation was increasingly dependent on multiple expansion, which represented the main value driver of performance since 2010. US funds achieved a pooled net 10-year internal rates of return (“IRR”) in line with listed equities returns over the same timeframe, making it the first time in the past 10 years that PE has not outperformed listed public markets. Additionally, the share price performance of PE-led IPOs has been particularly weak recently.

See article download for additional graphs.

Covid-19, the Black Swan

According to industry surveys, General Partners (“GPs”) of leading PE funds were already preparing for a downturn mainly due to the length of the economic cycle (one of the most prolonged in history) and fears that valuations were showing very typical patterns of late-cycle exuberance. GPs had already begun to reduce the pace of commitments and build dry powder in anticipation of some form of economic weakness in the years ahead. PE is conservative in that respect, with the industry having a keen focus on value and wanting to ensure that it has ample liquidity to invest when tougher times emerge.

Covid-19 was merely the Black Swan event, triggering a downturn that was far more devastating in its impact and severe in the velocity of economic decline. However, it is fair to say the industry had been preparing for some form of economic weakness. As the virus hit, PE activity, like other industries, saw an immediate impact.

According to industry data provider Prequin:

1. Q1 2020 showed early signs of a fund-raising contraction, with a 30% reduction globally (lowest quarterly fund-raising since Q1 2018, but the fewest number of closed funds since Q1 2013), more evident in Europe (-48%) and Asia (-66%, the worst quarter since 2013).
2. The Q1 data showed Asia buyout deal flow (in value) fell by 80%.

According to an early April Prequin survey:

1. 60% of Limited Partners (“LPs”) expect to reduce the value of their commitment plans for 2020, while 70% of managers expect a reduction in fund-raising, 59% a contraction in deal origination and 62% a downturn of portfolio company’s operations.

2020 capital calls and distributions are expected to contract.

Return expectations also changed: Funds that were already largely invested (vintages 2014 to 2017) are now likely reflecting lower IRR’s than planned (and dispersion among best and worst performers is expected to widen, with the latter potentially generating negative returns). This performance will largely depend on where the PE fund invested. Hardest-hit sectors such as leisure, hospitality and travel will be slower to recover, with parts of the industry perhaps never resurfacing in any viable commercial form. Other sectors associated with digital, data centres, telecommunications and health care, for example, may actually benefit.

Returns will also be a function of entry price, strength of business model, sector and company focus and the amount of leverage applied, to name a few factors affecting value in a downturn. Those PE managers with strong operational skills may be better able to mitigate the downturn, taking the necessary steps to turn around a flailing investment through draconian cost-cutting and industry consolidation. Hence, it is hard to make sweeping statements as to which funds may fare better or worse, but we expect the dispersion of returns to be high.

In contrast, 2018 and 2019 vintages will likely yield higher IRR’s (even if with higher volatility) as these managers are more likely to have only invested a portion of their capital, leaving them with ample dry powder and liquidity to take advantage of price disparities that may now arise as a result of the economic dislocation.

See article download for additional graphs.

Most Investors believe that 2020 will be a challenging year for fund-raising, deals and exits.

Some could say that there are many similarities with the GFC, but there are also remarkable differences:

1. The PE industry is bigger than in 2008 and 2009, both in terms of:
2. Assets under Management (“AuM”): About $4.1tn AuM for PE managers in June 2019 (compared with about $1.8tn in 2008).
3. Dry powder: About $1.5tn dry powder (compared with less than $0.7tn in 2008), of which more than 60% is in funds closed in 2018 and 2019 (thus able to invest over the next few years).
4. The market is more mature, both on the LP side (risk awareness and liquidity management) and GP side (lower leverage than coming out of the GFC and many with deep operational expertise to bring to their portfolio companies).

Therefore we have a higher degree of confidence in PEs ability to deliver returns commensurate with longer-term averages and well ahead of public markets, with a forward-looking view.

There are also many positive features of PE investing today:

1. The PE value creation model has changed over the past decade, moving from value arising from leverage and multiple expansion to value enhancement through operational improvement and active involvement in invested companies’ management processes.
2. Downturns are fertile ground for operationally skilled PE managers to make a significant difference in addressing cost and cash flow and encouraging consolidation in their investee companies.
3. Funds with dry powder now have the opportunity to take advantage of the economic and price dislocations being caused by the crisis.
4. As public markets race to recover, leadership has been narrow, favouring technology companies and all things digital; this has meant that many parts of the real economy – both public and private – are trading at significantly depressed valuations by way of comparison.
5. While leverage levels will be lower than in the past, given the current state of interest rates, financing costs should remain attractive.

In the short term, we should expect something that we already observed after the GFC:

1. A lowering of deal activity: On the buy-side, investors will postpone some investment decisions to understand the full impact of the economic downturn on underlying businesses and asset prices; on the sell-side, corporates are likely to postpone carve-outs and dispositions, if not under liquidity concerns, and families will reconsider business disposal if not obliged by non-economic factors.
2. A reversal of the easy money environment of the past several years: Banks will put lending on new deals on hold as they focus on working with existing borrowers who may be seeking to avoid default, while private debt lenders will move to more selective terms and conditions (covenants). Leverage will be harder to obtain and its cost will rise. The result will likely be more equity in the capital structures.

But eventually, the recovery should be faster than in the past.

We should likely expect an extension of the average investment holding period, but exit activity may not fall off as steeply as it did in 2008 and 2009. At that time, the majority of deals in PE portfolios were about two years old; now, after many years of strong deal-making, investments are more mature. So as soon as market conditions improve, exits could rebound faster.

While the scale of economic devastation is greater than after the GFC, the policy response has also been greater by a factor of 4.4 times. The GFC was also followed by years of austerity. This pandemic is not only a period of exceptional largesse in fiscal terms but monetary accommodation as well. We think this will ultimately have a positive impact not just on the real economy, but potentially inflation levels as well.

See article download for additional graphs.

On the fund-raising side, the current shock is unlikely to shake the underlying confidence in PE, especially considering that LPs have learned the importance of vintage-year diversification. It suggests that the decline in fund-raising this time might be less severe than in 2008 and 2009, despite the challenges arising from the so-called “denominator effect” (allocation to PE exceeds its limit on total assets because the total asset value declines) and from the potential issue coming from the cash-flow management (in the coming quarters, capital calls should likely exceed distributions).

Looking at the PE firm’s behaviour and approach to allocating its time during the crisis, we foresee three different phases:

1. Defence: At the beginning, effort is focused on understanding the impact on the portfolio companies and working with them to ensure they can weather the storm. Safety of workforce, implementation of remote working to continue operations, liquidity preservation and cost-cutting are the short-term goals.
2. Fast break: Dislocated markets offer new opportunities, many of which not for the faint of heart. Rescue capital, portfolio debt repurchase and defeasance, opportunistic debt purchases and private investments in private equity (“PIPEs”) etc have brief windows of opportunities that could be seized only by firms that already have funding structures in place and available capital.
3. The long game: It is clear that the pandemic will change the world, even if it is unclear how deep the change will be; the impact on people’s behaviour and companies’ procedures, the role of public intervention in the economy and the acceleration of some secular trends will be truly understandable only in the future. It also depends on how long it will take to find a cure or a vaccine against Covid-19.

However, PE firms are well positioned to find winners in this new environment: GPs with deep domain expertise and experienced operational teams will likely be better placed to assess these opportunities early, price them correctly and act on them quickly to create long-term value.

There are many sectors benefitting from the crisis (for example e-commerce), others that are more resilient (such as telecoms, technology, business services and software), and some that will be strongly hit (such as transportation, tourism and leisure).

Some private market teams, moreover, are well positioned to take advantage of the situation in the short term, including specialists on distressed debt and special situation, restructuring and public-to-private (especially if public markets fall following poor quarterly results and profit warnings). Also, secondaries could benefit from forced selling and the subsequent decline of underlying asset values (please see following section).

We also believe that investors will pay more attention to the long-term resilience of a company’s business as a result of the pandemic. There will likely be a premium for stability and resilience over growth, cash-flow generation over cash-flow drain. PE has the luxury of a medium to long-term view, and that means it can implement strategies to create value in ways not available to public companies forced to live to the beat of short-term earnings results.

Some comments on Secondary Markets

Historically, crises and volatility have generated some of the most attractive buying opportunities for secondary managers with underwriting, negotiating and structuring capabilities.

Secondary markets have more than tripled in the past decade, reaching $88bn deal volume in 2019. As growth slowed in H2 2019, market dynamics were already beginning to change before the pandemic, as showed by widening bid-ask spreads: buyers were increasing their selectivity and caution around valuations and capital deployment.

Because of the crisis, secondary firms expect to see:

1. A reduction of planned sales by institutional investors: They used to arrange auctions to maximize their return and, in absence of liquidity concerns, will postpone it to more favourable times.
2. An increase in forced sellers’ deals, driven by liquidity constraints and/or by the so-called “denominator effect”.
3. A repricing of assets following the decline in underlying NAV and higher discounts.

Secondary firms will focus on asset quality (resilience, prospect of recovery and room for further value creation) and quality of NAV (review of the valuation metrics) instead of pure discounts.

Deal structuring and deferred payments will help in matching prices, and there will likely be less leverage.

GP-led transactions will focus on providing liquidity and time to recover to underlying companies.

A few words about Venture Capital

This crisis is accelerating some long-term trends, such as e-commerce or digitalisation (for example, in education services, non-urgent healthcare provision and remote working). Even if there is no certainty that today’s reality (forced by the pandemic) will become the “new normal”, it is clear that some temporary changes will be structural (or, at least, the speed of the transition to the new paradigm will accelerate).

If the future has been altered by Covid-19, it is also impacting the present Venture Capital (“VC”) industry because early-stage businesses are, by their very nature, more vulnerable to negative external forces than their more established counterparts. Three key questions are likely to determine the prospects of VC-backed startups around the world:

1. How badly has current and future cash flow been affected?
2. What business metrics should the management pay attention to?
3. Are the products/services provided by the company likely to be deemed “essential” by its customers at a time when they could have financial troubles?

A direct consequence is that venture capitalists should become more “activist”, helping their companies shift the emphasis from growth to cost-savings, cash-burn control to liquidity management.

If there is a lesson from prior crises, it is that real leaders are going to emerge from the current chaos: the founders that successfully organise, manage and inspire their teams throughout the current crisis will be tomorrow’s industry leaders. As per the evolutionary theory, new champions are not necessarily the strongest or the most intelligent, but the most adaptable to the new environment.

The pandemic will probably determine a rise in the cost of capital, both for investors and entrepreneurs. Investors will become more selective, getting back to fundamentals, placing more emphasis on profitability over and above growth: this trend was already emerging before Covid-19, and now it is accelerating.

Fundraising will likely slow down and, in investing, venture capitalists will focus their attention on economics and financial metrics: liquidity management and fund-raising planning will become key factors.

In the end, we should consider that returns in VC largely come from companies that look like the anti-pattern because they disrupt commonly accepted ways to manage a business. Venture capitalists who can identify the disruptors and help them focus on fundamentals will deliver outstanding returns to their investors.

In short: Some of the best returns in PE and VC emerge just after a period of crisis and dislocation.

See article download for additional graphs.

An allocation to the equity of private companies, with active managerial and operational oversight, purchased with greater price and leverage discipline, could well show some of the best vintage returns experienced in some years.

We expect both forms of private investment to deliver strong returns in the years ahead, not only greater than in the past but at a premium to public markets. However, manager selection remains a key driver of alpha generation and our disciplined manager evaluation process remains laser-focused on finding the top-quartile managers of tomorrow.

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