The impact on private equity markets will level economic hardship. The coronavirus (COVID-19) outbreak is causing widespread concern and economic hardship for consumers, businesses, and communities across the globe. The situation is changing quickly, with widespread impacts. Most companies already have business continuity plans, but those may not fully address the fast-moving and unknown variables of an outbreak like COVID-19. Typical contingency plans ensure operational effectiveness following events like natural disasters, cyber incidents, and power outages, among other crises.
They don’t generally take into account the widespread quarantines, business and community disruptions, extended school closures, and added travel restrictions that may occur in the case of a health emergency. The S&P Listed Private Equity Index is crashing faster than the S&P 500 Index. The Index is designed to provide tradable exposure to the leading publicly listed companies that are active in the private equity markets and space.
Private Equity (PE) firms may be facing a situation in which they have multiple underlying companies with hundreds or thousands of employees looking for guidance and direction during this crisis. While cybersecurity is always a top priority for PE firms and their portfolio companies, they may face additional threats and vulnerabilities now. This is because they will have significantly higher levels of remote access to core systems, along with employees and management who could be more susceptible to social engineering efforts in the midst of a crisis.
Portfolio companies often don’t have the HR expertise and infrastructure required to manage during a crisis, so they may seek guidance from their PE sponsors to help them effectively address workforce issues. PE firms should leverage their resources to provide necessary guidance to their portfolio at scale. Without the right monitoring and planning, PE firms could be overloaded with issue after issue, causing a fire drill every time. Additionally, HR policies and directives may be inconsistent within and across the underlying entities.
The crisis may not hit every geography equally. In areas that have been particularly hard hit, PE firms could be trying to adapt quickly to new rules and deadlines. In other areas, they may still need to comply with traditional filing and compliance deadlines. PE firms should also evaluate how an impact on operations of the portfolio company (from a reduction in normal operations, business interruption or non-recurring expenses) may be treated from an indenture perspective in their lending agreements. Depending on the potential add-back, they may need to track and monitor those costs and losses.
Generally speaking, private equity firms do not allow redemptions, thereby avoiding investor issues that affect other fund classes. However, investors can demand full transparency when it comes to a PE firm’s actions in this crisis. In dealing with COVID-19 issues, PE firms could lose sight of basic investment company issues, such as commitment call deadlines, financial statement filings, and shareholder updates.
Some portfolio companies in healthcare or retail are part of the frontline response or provide critical products and services; ensuring that their supply chains are operating at peak performance is essential. Others (such as travel and hospitality companies) are experiencing immediate and unthinkable drops in consumer demand. Since most sponsors have limited resources to share with their own companies (such as liquidity, operating executives to provide leadership and execution support, and critical relationships with other organizations), they will need to decide where best to allocate time and resources.
Private Equity Markets in 2019
As of the end of 2019, more than 75% of PE deals included debt multiples greater than six times EBITDA, a stark difference from that same figure following the GFC, which came in at around 25%, according to a recent report from Bain & Company. With tighter lending, PE firms will be forced to enter transactions with more conservative capital structures that include a larger equity proportion. That said, funds are indeed better positioned to do that than ever before. In 2019, capital committed to PE alone grew 20% YoY to $1.3 trillion. Private debt funds were also sitting on record capital bases ($275.0 billion) by year-end, which should be paramount for middle-market transactions and companies.
A combination of tighter and more scrutinized lending markets, in addition to depressed earnings and cash-flow profiles, will pressure companies. As economic activity subsides, we still expect to see an enhanced risk premium in the types of leverage and debt solutions used by PE, which will drive yields in those pockets higher despite the central bank’s actions to depress overall rates. Thus, as we see earnings fall and the cost of capital rises, asset prices will decline across the board, hurting exit multiples. PE vehicles will be forced to inject more liquidity into portfolio companies, reducing the leverage that provides the enhanced returns in the LBO market. Holding periods increase as firms will be forced to hold struggling assets and may find exit markets to be completely subdued for most assets, particularly across the strategic M&A and IPO avenues.
While there may be a pullback in fundraising (as some PE analysts predicted entering the year), we do not anticipate a dramatic downturn. We also do not foresee panic-selling in the secondaries market. Smaller firms are naturally more susceptible to a downturn, particularly generalists without a differentiated strategy. Consolidation within PE has led to large asset managers with multiple platforms that can still capitalize on a range of opportunities in a variety of economic environments.
The IPO market underpinned record VC exits in 2019, but that seems unlikely to repeat in 2020, with several high-profile listings rumored to be delayed. In PE, GPs are less willing to part with choice assets in a bear market. We expect to see more special-purpose continuation vehicles and GP-led secondaries funds. Today, a higher proportion of LBO financing comes from dedicated direct lending funds (as opposed to banks). While banks are likely to pull back in a recessionary environment, private debt funds are likely to continue investing through a downturn.
After taking initial actions to recover and stabilize, portfolio companies can prepare for growth in private equity markets. In the last downturn, many portfolio companies had success by investing at greater rates than their competitors. Portfolio companies should also prepare for M&A. Public companies that outperformed coming out of the last recession divested underperforming businesses faster than others did and made acquisitions earlier in the recovery phase. Portfolio companies can utilize a similar strategy by planning and executing a through-cycle strategy for M&A and divestitures and by building a pipeline of potential strategic targets.
We also covered a more broad approach to global economies and impact o private equity markets.