Private equity deals have been halted by poor visibility on the economic outlook, but this will be temporary, and if history repeats, bold investors might be rewarded.
More than ever, cash is king…
Money is the sinews of war, as crises tend to reaffirm. Today, liquidity is the most important asset for a business to have, which makes private-equity-backed companies better positioned to fare the current crisis than those without support from financial sponsors. Private-equity firms have ready capital at their disposal that can be tapped into to recapitalise struggling businesses if necessary.
and knowledge is power
Another valuable asset private equity firms offer to portfolio companies is specialised knowledge. Indeed, the contribution of private equity firms goes beyond their deep pockets, with operational expertise playing a crucial role in a company’s survival today. In the near term, investors are focused on working with their portfolio companies to ensure that they have the liquidity and runway required to withstand any negative impact on revenue and earnings. The ultimate goal is to avoid a liquidity squeeze. Indeed, it is running out of cash, not poor earnings, that leads a company to bankruptcy.
“Putting money to work during market downturns produces higher returns on average.”
Working around the clock to prevent cash from leaving the company
To avoid this cash scarcity, private equity firms are actively at work behind the scenes, working with lenders to defer interest payments, negotiating with landlords to amend leases to abate or defer rent payments, drawing on credit lines and surgically cutting expenses in almost every line item. They are also vigilant in identifying any accounts receivable opportunities, proactively encouraging customers to pay, using creative marketing and sales initiatives in the attempt to convert any expensive inventories into cash and applying for government support programs. General partners (GPs) who went through similarly difficult times in 2008 are naturally better equipped to deal with such issues. Their operational toolkits are broader, their playbooks more comprehensive.
Recessionary vintages tend to shine
Yet as funds take action to ensure the long-term health of their portfolio companies, deal making will inevitably resume. And as the private equity industry learned during the global financial crisis, putting money to work during market downturns produces higher returns on average. In fact, for private equity firms, a downturn represents opportunity. Capital can be deployed on more attractive terms and bold, calculated moves are possible. It is therefore no surprise that funds launched in the middle of the last economic slump – namely in 2009 or right after – have outperformed. 2009, 2010, 2011 vintage funds achieved median net multiples on invested capital and net internal rates of return (MOIC/IRR) of 1.91x/14.2%, 1.71x/12.6% and 1.80x/16.0%, respectively.
A window of opportunity for private equity investors
Firms that were previously on watchlists but inaccessible could become easier targets in the wake of the coronavirus crisis. These are scary times for any business owner who lacks the capital or management capabilities requisite to navigate through the crisis. Some of them, having never considered selling or taking on a financial partner before, may be open to the discussion now, especially if there is a potential injection of capital into the company on the table.
The current environment is also ideal for GPs and their respective portfolio companies to be bold, putting emphasis on strategic add-on acquisitions to capture market share, complement product and service offerings and penetrate new geographies. Many unprecedented buying opportunities were missed during the global financial crisis due to GPs being too cautious. Chances are that this time, GPs will be nimbler and PE-backed firms will integrate competitors and emerge from the crisis even stronger. With Covid-19 pushing the world’s major economies into recession, we are likely to witness the re-emergence of more opportunistic strategies, such as turnaround or distressed investing.
“Venture and growth capital firms may see this 'home economy' trend as an opportunity and start looking for winning deals.”
These strategies experienced muted activity over the past decade, especially in the US and Europe, whose economies have been supported by low unemployment and interest rates. Finally, investors could be keen to leverage new consumer habits adopted during lockdown. Since the Covid-19 outbreak, healthcare and technology proved the most resilient sectors in both private and public markets, demonstrating the largest growth potential. Some sub-segments of activity have even benefitted from improved demand. This is obviously the case for telecommunication firms, work-from-home software providers and food-delivery platforms, but also for tele-medicine start-ups, to a large extent. The pandemic has forced the adoption of new technologies, including video-consultation, and chances are that this will leave a durable print on consumer habits. Venture and growth capital firms may see this "home economy" trend as an opportunity and start looking for winning deals.
Being selective and diversifying
If it is true that GPs taking advantage of more affordable prices (beta) and offering liquidity in stressed markets today should be rewarded for the risk taken, human capital, skills and sound experience (alpha) remain a major part of the equation when it comes to cash-on-cash returns. Distinguishing the bargains from the "cheap for a reason" would be the initial major stake over the coming months and years. Private equity firms that rely solely on financial engineering, quick cost-cutting measures and market momentum to drive performance after a company is acquired are destined for hard times. Having a superficial and limited hands-on approach in recessionary times can be extremely dangerous as companies will certainly be facing unprecedented challenges.
For limited partners (LPs), having access to and partnering exclusively with sophisticated and experienced GPs, preferably those that have proven their investment skills and operational capabilities in difficult markets, becomes paramount. LPs with sharp fund-selection skills who are able to build a diversified and balanced exposure in private assets should continue to benefit from promising returns.