Considerations for private equity investors in light of the coronavirus pandemic
The global financial crisis (GFC) was widely regarded as the biggest threat to the world economy since the Great Depression. COVID-19 arguably presents similar challenges. Here are the repercussions for private equity (PE) investors:
● Capital calls: economic crises increase liquidity risk, leading PE firms to draw down capital from investors (limited partners or LPs):
• For emergency financing, as fund deployment shifts away from new deals towards portfolio bailouts. In the wake of the GFC, capital calls often took the form of equity cures (to address covenant breaches);
• To tie up loose ends and avoid defaults on LP commitments if the crisis drags on. Fund managers have already sent drawdown notices to redeem subscription credit lines, one of the preferred tools adopted in recent years to massage returns;
• Fund managers are usually entitled to re-invest income and capital proceeds, either for bolt-ons or to recapitalise portfolio assets. Given today’s extreme scenario, they will recall monies previously distributed when allowed.
Capital calls will be painful for LPs, as distributions are expected to dry up. Unless an investee company is hopelessly distressed, a PE owner will not sell at discounted valuations. Fewer proceeds will be upstreamed to LPs this year.
● Strategic shifts: LPs must review commitments and avoid over-allocation to the asset class:
• Owing to the ‘denominator effect’ (a fall in public market valuations – the denominator – proportionally pushes up PE allocation – the numerator), LPs might want to reduce their exposure. In 2008, the decline in stock markets pushed Harvard’s PE allocation above its 13% target, forcing the university to sell off parts of its holdings;
• Secondary transactions are likely to happen at a marked discount, after taking place at par or at a premium in recent years;
• LPs will focus on efficiency and cost savings, considerations that led CalPERS in 2015 to shrink the number of manager relationships by almost two-thirds;
• Fund managers might set up annex funds, which will operate as lifelines for existing portfolios. During the GFC, for instance, KKR raised an annex fund to provide firepower to its European Fund II;
• New opportunities: LPs will get invited to commit to special-purpose investment vehicles or to participate as co-investors. The extent of the deal flow will depend on whether they can get comfortable with PE firms going hostile. Many LPs have political responsibilities and community-friendly missions;
In the wake of the GFC, some LPs (BlackRock, Singapore’s GIC and Canada Pension Plan) launched primary funds focusing on long-term plays. The COVID-19 crisis will see the practice spread across investment themes. For LPs with a broad capital base, it makes sense to run proprietary direct PE portfolios rather than commit to fee-sucking third-party managed funds.
● Performance of the 2016-17 vintages: the internal rates of return (IRRs) of these funds will be hit as:
• A big chunk of their commitments was invested at top valuations;
• Cash flows of portfolio companies have collapsed and will remain below the management base case adopted when structuring the original transaction. Companies with high financial risk (leverage) are not ideal candidates for reorganisations. Fund managers will perform aggressive portfolio triage, adding operational value where possible;
• Additional equity will be injected in portfolios. LBO fund managers are sitting on $800bn (€742bn) of dry powder. They will use it to bridge the financing gap during the (temporary) lull in credit markets. Blackstone, for instance, has allocated 20% of its dry powder to support its portfolios;
• During the GFC, leveraged loan volumes fell 85% from the 2007 peak – lenders focused on sorting out legacy loans rather than adding new ones;
• Leverage ratios might not decrease as much this time because $250bn of commitments to credit funds are available for deployment. Banks’ balance sheets are also a lot healthier. Finally, governments and central banks are behind giant loan programmes;
• Investees stuck with high leverage and active in afflicted sectors – such as travel, tourism, hospitality – are heading for bankruptcy or deep restructuring. April recorded the untimely demise of Carlyle’s amusement park operator Apex and of KKR’s energy producer Longview Power. Yet the log of bankruptcies will be shorter than the list of zombies;
• At the outset of the crisis, 70% of all PE-owned firms had debt rated below investment grade. This proportion is set to rise sharply. With over 80% of today’s leveraged loans issued with cov-lite terms and some structured with the help of earnings manipulation tricks called EBITDA addbacks, many PE-backed companies will tread water for several years;
• Holding periods will lengthen as exits are deferred indefinitely.
Preqin data shows that PE vintages of 2005 and 2006 – funds invested during the credit bubble – delivered median IRRs of about 8.5%. The sector is now more mature and competitive, so investors should expect the 2016-17 vintages to deliver mid-range, single-digit average returns. Because smaller enterprises tend to suffer more in recessions, lower mid-market funds will deliver even weaker performance.
● Performance of the 2020-22 vintages: their IRRs should benefit from:
• Lower business valuations, thanks to a sharp and, perhaps, enduring economic correction;
• Desperate funding needs from many targets, due to lower operating cash flows as well as ongoing uncertainty and business disruption;
• The ability to refinance these transactions at low interest rates once the economy stabilises.
The 2010, 2011 and 2012 vintages, invested at the trough of the GFC, delivered median IRRs of around 15%. PE investors could expect the 2020-22 vintages to deliver lower, double-digit average returns due to the greater availability of dry powder this time around.
“Because smaller enterprises tend to suffer more in recessions, lower mid-market funds will deliver even weaker performance”
● Impact on fundraising: capital commitments will be undermined by the following factors:
• During the global lockdown, travel restrictions stopped office visits and marketing meetings from happening. According to PitchBook, in the first quarter of 2020, PE only raised one-tenth of 2019’s total tally. Some restrictions are expected to remain in place for several months;
• LPs will pause initially, then make smaller and slower commitment decisions. Fund closings will take a year or longer where they took only a few months in 2018-19;
• LP-friendlier terms: investors should be able to negotiate better terms with fund managers who, in recent years, demanded lower hurdle rates and supercarry structures;
• First-time funds will find it difficult to raise;
• Zombie funds: according to Bain & Co, a quarter of PE firms did not raise a fund post-GFC. Some of them will not recover from this crisis. Likely explanations for failing to raise include:
• Poor performance from the fund manager’s recent vintage(s). This was the case for Fortsmann Little in the telecom crash in the US in the first decade of this century, and for European firm Candover during the GFC;
• Investors defaulting on capital calls and not committing to a new fund. In the UK, lower mid-market shop Lyceum Capital shut down in 2018 .
Expect zombie funds to be bottom-quartile performers and distressed candidates for the secondary market. CalPERS, for instance, sold its Candover holdings at a discount in 2011.
The pandemic will reinforce two current fundraising trends:
• Generalist and multinational strategies, to mitigate sector and country-specific risks, emphasising the benefits of diversification;
• Impact investing, in particular social responsibility and sustainable development.
● Sector concentration and consolidation: the industry’s dry powder, asset base and number of firms have more than doubled in the past decade. But fundamental underlying trends have appeared:
• Going for scale: according to McKinsey, half of the capital raised in 2019 went to megafunds ($5bn upwards). The market share of firms running less than $1bn was at a 15-year low. This crisis should accelerate allocations towards larger fund managers;
• Market oligopoly: private equity has seen the emergence of a ‘big four’ – Apollo, Blackstone, Carlyle and KKR hold more than one-fifth of the industry’s assets under management;
• US-centric concentration: together, America’s eight largest groups ran $1.8trn in late 2019, or close to one third of the global asset base. By contrast, the eight biggest European firms managed less than 5% of the $5.8trn run globally. The top US firms are expected to extend their lead in asset-gathering;
• Global consolidation reinforcing US dominance: US PE groups have a track record as predators. In 2011, Carlyle bought Alpinvest. Five years later, HarbourVest acquired British firm SVG, a cornerstone investor in Permira. The aim is to buy low. In April, Blackstone announced that it had $4bn of cash available for corporate acquisitions.
In a market with over 5,000 mostly undifferentiated fund managers, focus is a necessity. More than ever, investors must carefully select those firms that can consistently deliver top-quartile performance. That will require painstaking due diligence.
Sebastien Canderle is a private equity adviser and the author of The Debt Trap
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