COVID-19 and Private Equity deal-making - a lesson learnt from GFC?
Updated: May 23, 2020
There’s no doubt the global pandemic will have a deep impact on the way Private Equity is going to think and how they will focus their time, effort and capital during this crisis.
Some implications may not be as obvious though, so let’s have a look at what happened during the GFC, which can be relevant to our present situation and overlay the unique elements of COVID-19 to draw some conclusions on what is likely to occur and to see whether history will repeat itself again.
The priority list of Private Equity firms
For PE firms, the priority list during the coronavirus downturn will firstly be their own team, then their portfolio companies (protecting their existing investments), followed by their investors and then only at the bottom of the list comes new opportunities.
We have already seen PE buyers withdraw from signed deals, executing their Material Adverse Change rights. In January and February 2020, we saw M&A deal volumes decline 27% just as the virus was starting to spread outside of China and that decline in activity will only have deepened in March and we don’t expect to see it recover until most of the developed world has crested the peak of COVID-19 cases.
Why do investors come ahead of new opportunities?
There is an interesting insight here, which Private Equity firms will definitely remember, although the rest of the market may not be aware of, about the reason why investors sit at number #3 on the PE’s priority list, coming before new opportunities.
During the GFC most of the investors were over committed to PE. The nature of how PE works is that an investor makes a commitment to invest for 10 years, with the capital to be called over 5 years. Then the investor forecasts how they think their capital will be called and returned over the life of the fund, and they layer it against their portfolio forecasts. As a result of this, investors to meet the right portfolio mix might be over committed - it could happen they might have committed somewhere between 120% and 140% of their current capital, based on their forecast for the next decade.
What happens in a downturn like this, when investors have a portfolio that is exposed to fluctuating assets that are marked-to-market on a daily or more regular basis (i.e. equities, bonds, commodities) is that the value of those assets decline (sometimes very rapidly) while their PE valuation remain stable as they are priced on a monthly basis using a methodology that provides more short-term stability. The result is that PE investors with a portfolio allocation target to Private Equity of say 10%, can very quickly find themselves with a portfolio concentration closer to 25%, as everything else has gotten cheaper while at the same time PE managers are calling money forward to support their existing investments.
The investors’ ultimate trump
So, what happened at the beginning of the GFC is that some investors imposed unofficial restrictions on PE managers calling “committed” capital from investors to help them manage this imbalance in their portfolios. Because PE managers are contractually allowed to call capital investment, investors can’t officially say no without consequences, but the handle that capital investors used during the GFC was to withdraw support for any future capital raising if the PE managers were to call capital within a defined period of time.
Now that was a pretty powerful card to play and it worked. It will be interesting to see if that happens again because listed markets have been hit so hard, and PE valuations are likely to have held up, thus the portfolio concentrations will look quite high again. So, we know it happened during the GFC, but will it happen again?
What comes next?
What we can be assured of is that the average ownership duration will be longer through this cycle as Private Equity Funds hold on to their investments rather than sell at a discount during a down market. We also expect that some PE owned companies, especially those with high leverage and that are heavily exposed to social activity may require some restructuring to get through this period.
Fundraising is also likely to slow down as Limited Partners (the investors into Private Equity Funds) keep their powder dry until there is greater certainty on the timing and nature of the recovery that will follow this downturn. This also gives the LP’s greater flexibility to support or deploy capital to PE strategies that are likely to benefit most during the recovery phase.
Finally, although we don’t expect to see many PE deals done over the coming 2 quarters, what we can guarantee is that as the pandemic's full effects become clearer, PE managers are likely to pursue new deals in even greater numbers as they seek to capitalise on depressed valuations once there is clear visibility of the recovery.