Post-GFC (Global Financial Crisis) analyses suggest that the Private Equity (PE) sector missed the best buying opportunity due to overly cautious decisions of GPs and LPs. For the PE model, the GFC was a first real test of their reactive strategies and the questions that arose were whether the firms will succeed at refinancing their existing portfolio and most importantly do new deals. What might have seemed surprising for a number of creditors, the financial crisis left the PE sector with unused opportunities caused by not aggressive enough strategies in deploying new capital when firms hit the bottom.This mistake shall not be made twice, as today’s senior leadership involves players who were in the junior stages of their career paths during the GFC, and for whom the lessons learned are still fresh.
Firstly, the PE sector is highly vulnerable to the cyclicality of the credit. The median IRRs for the global buyout funds showed relatively low returns in the years prior to recessions caused by the dot.com bubble and subprime crisis and much stronger in both revivals caused by expanding capital in lower valuation environments. Having recognized the importance of credit cycle patterns, PE firms are relatively disciplined in regular investment activities and are ready to react accordingly and build on the upcoming opportunity coming from the crisis.
According to Harvard Business School research, during the 2008 crisis, PE-backed companies not only increased investment relative to their competitors but experienced greater debt and equity inflows leading to greater market share capture. During times of distress, many companies’ access to capital is limited. Here, the PE model proves to provide additional flexibility and access to capital both from its own funds and from long-lasting relationships with banks and other creditors.
Today, researchers suggest that private equity firms should quickly make investments in troubled companies and swallow up assets if hedge funds, mutual funds, and other managers are pushed to sell them. After all, the 2008 crisis showed that PE-backed companies suffered fewer defaults as private equity firms became hyper-focused on the survival of their portfolio companies.
Struggles in the portfolio
The private equity industry has been booming for several years now, with growing transaction volumes, valuations, and fundraising. Furthermore, PE firms have also become increasingly aggressive, with deal leverage and deal multiples paid reaching multi-year highs. The severe economic slowdown caused by the Covid-19 pandemic could prove to be particularly dangerous for private equity portfolio companies that were acquired at high valuations with significant leverage.
In their report on the new reality of coronavirus, McKinsey recommended that financial sponsors set up a “cash war room” team to support portfolio companies that face particularly severe liquidity constraints or drops in consumer demand in order to manage financial and liquidity risks. This team needs to rapidly assess current risks and potential cash savings, identify cash levers (analyze working capital, restructure debt, etc.) and communicate with outside experts to find possible solutions. This solution would allow for keeping the focus on the strategically important levers.
Furthermore, private equity firms need to support their portfolio companies in quickly stabilizing operations. The ways to achieve it vary by sector. For instance, manufacturing companies may focus on analyzing inventory and identifying alternative suppliers for critical parts. Other companies for example in the e-commerce sector may experience the challenge of rapidly rising consumer demand and how to fulfill this while keeping quality high and operations smooth. Depending on the business model and sector, it might be useful to specifically tailor product and service offerings to the current crisis and enhance customer loyalty.
Finally, according to the Bain&Company study, the real question that should be posed is what to do next. Having recognized the time and resources constraints, it is essential to identify key priorities and pressing threats by assessment of the unique risks to each portfolio company, prioritization of companies with the greatest impact on the portfolio, and development of customized contingency plans for each priority firm.
In December 2019, the global head of research at Carlyle, Jason Thomas, claimed that we were “entering the year with people feeling much better about the economic and geopolitical outlook than was the case a year ago.” Kewsong Lee, the co-chief executive at the same firm, explained the opportunities that PE firms will be able to capture with the excess cash held at hand while entering 2020 i.e. expanded investment options due to opening of the new asset classes (e.g. private credit) and regions (e.g. Japan). Additionally, Bloomberg was predicting that M&A activities this year will be present at a scale not seen since the financial crisis.
As the epidemic went global during March, European countries went into lockdown. Pitchbook analysis, expects PE firms to feel the economic pain in the coming months as countries entered the rapid recession. Firstly, the fundraising activities fell substantially in the first quarter of 2020 and are on track for decade low fundraising totals. Secondly, exit activities are expected to plummet in 2020 and holding periods will most probably extend as future sellers are waiting for the markets to recover in order to proceed with transactions. However, Bain & Company report estimates that the exits might rebound faster than after the GFC. Finally, the same report predicts that the returns will fall in the short term as funds will be marking down their portfolio as a measure taken regarding the plummet in public valuations. Long term impact on the returns is not simple to estimate as it will heavily depend on the length of lockdown and the shape of the recovery. However, it is to be further recognized that returns from investments made during the crisis can offset the pre-crisis returns.
In political terms, the global pandemics might force the imposition of new laws and rules regarding financial institutions. For instance, in the USA, Elizabeth Warren and Alexandra Ocasio-Cortez want to halt the mergers through the duration of Coronavirus pandemic in order to prevent “predatory behavior from private equity firms and corporations”. This act would limit the takeovers involving firms with less than $100m revenue and financial institutions with a market cap smaller than $100m.
Light at the end of the tunnel
Large private equity firms are already making adjustments to deal with the social and economic effects of the coronavirus pandemic. It is of critical importance for private equity firms to quickly put the infrastructure in place that allows the daily operations of their portfolio companies to run as smoothly as possible. This, for example, includes virtual training sessions or frequent videoconferences to keep employees connected with each other and to the organization itself.
Furthermore, private equity firms need to quickly understand the individual needs of their portfolio companies and prioritize them. While some portfolio companies in e-commerce may experience high growth, other portfolio companies in travel or hospitality could face a significant drop in consumer demand that possibly results in financial issues. Understanding and addressing these very different situations will be a key future success factor for private equity companies.
Finally, financial sponsors need to establish strong communication channels to their limited partners as well as other relevant stakeholders to guide them through the current market environment and communicate the steps that are being taken.
If they manage to react to the crisis in a quick and agile way, it could even prove to be an opportunity for them. Valuations have undoubtedly dropped as a consequence of the coronavirus pandemic. After years of increasing multiples, firms with sufficient dry powder resources can now potentially find cheap investment opportunities with high future upside potential.
Authors: Joanna Przadka, Julius Petersen