Every industry is under pressure from the current circumstances and their consequences. However, private equity remains a robust investment choice, explain Gareth Davies and Norman Armstrong.
The private equity (PE) industry is feeling the pressure of the coronavirus outbreak, both in terms of deal-making and managing existing portfolios. However, when measured against recent downturns, namely the dot com bubble at the turn of the century and the credit crunch and banking crisis of the late noughties, the industry has generally proven robust and capable of adapting rapidly to a changed world.
This is, in part, due to a propensity to invest in inherently robust assets, operating in relatively insulated sectors, and enabling portfolios to weather-market fluctuations and economic downturns over the long run.
How will buy-out activity be impacted?
Many transaction processes have been put on hold or are moving at a much slower pace since lockdown commenced in mid-March. The ability to undertake a successful transaction isn't easy at the best of times, and is now a little trickier. However, investors and buyers are quickly adapting.
A new coronavirus lens has to be laid over all aspects of the deal process. These include deal terms themselves, new due diligence questions and the manner in which due diligence is conducted (remotely), the availability and pricing of debt terms, and the increased timescales taken to complete a transaction.
Unlike previous recessions that have had a bearing on private equity buy-out activity, current events have called for a sea change in the very manner in which those transactions are developed and negotiated. With all principal players required to work remotely, the effective use of new and creative collaborative tools, technologies and techniques have become more crucial as investors and all of their respective legal and financial advisors adjust to the new environment.
Maintaining private equity portfolios
Although private equity’s primary focus will be on managing and maintaining existing portfolios, a handful of new investments will still progress. Typically these are likely to be assets operating in sectors that are proving resilient and are likely to emerge stronger after lockdown.
Those with insulated, long-term revenue models are likely to do well, such as, tech or tech-enabled assets, including software as a service (SaaS) or managed-services models with high recurring revenue; or assets operating in areas such as pharma, bio and health tech, which have seen increased demand, and mission-critical service offerings in the public sector that are not likely to see any significant interruption in delivery.
Equally, transaction structuring and valuations will have to be addressed on a fluid basis. The ability to invest alongside senior debt providers and financially engineer optimal returns has somewhat diminished at present, with leveraged finance providers, banks and specialist lenders all relatively inward-looking and prioritizing existing customers’ liquidity needs as well as responding to Coronavirus Business Interruption Loan Scheme (CBILS) applications.
The liquidity positions of potential targets will now be under increased scrutiny with post-deal cash requirements likely to include additional headroom for a short- to medium-term buffer against any future shocks. Less free cash for shareholders, combined with suppressed headline price deductions, may stop some deals from getting over the line or even kicking off.
However, Bridgepoint’s recent buy-out of healthcare communications agency and consultancy, Fishawack, proves that transactions can still get there.
Portfolio focus and key issues
From a portfolio perspective, private equity firms are facing multiple considerations. They may be confronted by a situation in which they have many companies under their stewardship, with a significant number of employees looking for guidance and direction during this crisis.
To overcome this, private equity firms are currently prioritising:
Continuing support, financial and operational advice
The level of support required will be dependent on how diversified portfolios are, the sector balance, liquidity levels and the reliance upon third-party debt. In some cases, investors may need to double-down on their existing investments and inject additional capital for any struggling assets in order to help keep them above water and ensure cash headroom is in place to meet immediate needs and avoid covenant breaches.
Private equity will also be able to employ considerable financial skills to help assets access key government schemes. Clearly many PE-backed assets in the middle of the immediate crisis have taken actions to protect their ongoing business interests, including furloughing staff where necessary, drawing down available credit facilities, utilising government support, such as CBILS or deferment of PAYE or VAT obligations.
It is worth noting that all these measures will be subject to scrutiny in years to come, with businesses experiencing close diligence, so ensuring accurate data and information supports the decision-making process will be essential.
We've also seen many of our clients seek to negotiate payment holidays on debt obligations (as well as resetting periodic covenant tests), rents and leases, and business rates, while lenders themselves have been receptive to exploring how coronavirus interplays with ‘exceptional items’ under lending agreements.
The pandemic hit at a time when many firms were deeply engrossed in the process of finalising accounts for December and March year-ends. Moreover, uncertainties with regards to the impact of coronavirus on trading and cashflows, combined with increased scrutiny of directors and auditors assessments is likely to lead to an increase in modified audit reports, including an ‘emphasis of matter’ focused on going concern. Qualifications may also be required for those businesses operating in significantly exposed sectors where medium-term forecasting is now even more challenging and unpredictable.
Ensuring the wellbeing of personnel
Portfolio companies, particularly those in the mid-market, often do not possess the HR expertise and infrastructure required to manage during a crisis, so they may seek guidance from their private equity sponsors to help effectively address workforce issues.
Private equity firms should leverage their resources to provide necessary guidance to their portfolio at scale. Many firms are already investing heavily in expanding remote technology and back-office infrastructure (for example, by adding secure VPN access and increasing help-desk hours). We are witnessing a paradigm shift in the way we work and are now more likely to be comfortable working from home and joining a video call.
Others are planning to enhance virtual training across their portfolio, to come back from the crisis with a better-skilled team and adding benefits, such as telehealth services.
David Rolfe, Investment Partner, NVM
“One thing is for sure, that our management teams will never have experienced such a disruption to the working environment. We, therefore, quickly put support networks in place throughout the portfolio to share best practice and learnings as they all navigate the unchartered territory. We also deployed resources to assist with preparing for the various government schemes to ensure each company was best placed to weather the storm and remain cash positive. The second priority was then to plan what shape each business needs to be in to maximize the opportunity arising out of the current situation.”
Other strategic board considerations
The pandemic presents complex issues for private equity-backed businesses and their boards of directors to navigate. With many companies facing unprecedented uncertainty about their immediate prospects in an environment that may challenge or disrupt their usual strategic decision making and governance processes.
We highlight below some key areas of focus:
Short- and long-term strategic initiatives are being re-assessed, while boards look to understand how operating models can become more resilient and agile in the future, as well as the application of technologies to drive efficiencies and streamline processes
With the shift to remote and home working, many appear to be examining the ongoing need for multiple or large office locations, which were previously the norm. We expect to see businesses move to flexible-working practices and over the medium term are likely to offload premises or not seek to renew current lease arrangements when they expire
Digital and cloud transformation
A heightened need to ensure that data and information is securely backed up in the cloud and all business continuity scenarios are catered for. A robust cloud solution will facilitate the adoption of the latest business intelligence and ERP systems, allowing CFOs access to low-latency data and information, supporting crucial real-time decision making
Supporting employees in their return to work
Managing the end of lockdown and thereafter a protracted period of social distancing within the business will need management. Employees will require additional support and boards should plan to rally around them with a clear cultural purpose and business focus, while maintaining high levels of engagement and clear two-way lines of communication
Targeted portfolio acquisitions
Over the short to medium term there will be opportunities for consolidation and focused bolt-on acquisitions for portfolio companies. Some will require strategic investment and access to additional funds
Maintaining long-term value creation for shareholders
Exits will inevitably decrease in number in the short term and holding periods for some assets will extend, as sellers sit tight and wait for the markets and valuations to recover. Expect returns to take a hit initially as funds mark-down portfolios in step with the drop in public valuations. Valuations of certain assets may well be nigh-on impossible in the current climate, for example, property and real estate.
The full impact will not be known until the transaction environment recovers and we start to see successful exits at visible multiples, and whether pricing arbitrage is still a key weapon in driving returns and allowing private equity to benefit from lofty valuations with multiples on exit exceeding those on entry.
The industry is coming off a number of consecutive years of strong returns, and many private equity houses are sitting on assets that they would expect to sell soon in a normal market. However, they will not exit if the price is not right, unless they have to. However, there is reason to believe that, if market conditions improve rapidly, with pent up demand escalating, exits could rebound faster than we saw coming out of the global financial crisis 12 years ago.
And as for the future…
Given the present uncertainty, it is incredibly tricky to assess the likely long-term impact on private equity industry performance. Much will be dictated by the duration of the lockdown and how quickly economies and financial markets rebound thereafter.
Portfolio investments priced at lofty multiples undertaken before the downturn may ultimately suffer as company performance and highly leveraged balance sheets come under pressure. However, it is unlikely that this will be as severe as the aftermath of the credit crunch when leverage on deals prior to the drop off was frequently well in excess of 50% of the overall consideration.
It is also worth noting that the macro forces this time around could be very different. The initial impact of COVID-19 may well be deflationary, as companies seek to drive demand, however, once the immediate crisis abates, government actions and supply-chain restrictions could trigger inflation, consequently forcing interest rates to eventually rise.
Higher borrowing costs could impact private equity
Higher borrowing costs could, in-turn, impact debt levels, which could then limit private equity’s ability to leverage higher returns and consequently the ability to pay higher multiples. Valuations may be suppressed and take some time to adjust.
A likely consequence is that sector expertise will become more crucial than ever. Understanding the sector trends, at a granular level, will likely differentiate the winners from the losers and this will be essential. The post-coronavirus world will see new sub-sectors emerge and funds will require additional sector expertise to place smart bets on how the future will play out.
Due diligence will change. Extensive scenario analysis, factoring in unpredictable and significant disruption will become a standard part of due diligence in the future.
Increased analysis on target resilience
Earlier this year, in the initial days of the coronavirus, we saw private equity undertaking increased analysis on a target’s resilience to potential supply-chain weakening. Being able to model a temporary or long-term unraveling of global markets will be an important part of determining a company’s sustainability and future success prospects.
After a period of strong performance, the private equity industry is now readying itself for a more volatile period. However, PE’s advantage, versus previous dips, is that it can closely manage portfolio companies to diagnose and mitigate problems in real time, thanks to technological advancement and digital reporting.
Navigating stormy waters
In the wake of the last crisis, firms have built new capabilities and learned important lessons about how to navigate stormy weathers. Successfully managing the new world will likely involve increased reliance on a broad spectrum of resources and advisers to help prepare for the next wave of prosperity and blue skies.
Henry Sallitt, Managing Partner, FPE Capital
“We have seen a number of broader technology trends accelerated and concentrated into a quarter. As a software and services growth investor, these have been unsurprising to us and welcomed. We and the portfolio have transitioned seamlessly to working from home, delivering professional services and SaaS remotely. The portfolio is performing well and we have completed our first post-COVID bolt on. We are beginning to see some interesting new opportunities emerge”