Private Equity and ESG investing

Private Equity and ESG investing

Private equity (PE) asset managers have actively developed products to meet increasing demand in the ESG space.  Private equity companies have been waking up to the importance of purpose, responsibility and transparency for the last several years. The pandemic has put these ESG concepts to the top of the agenda.

There was an increased interest in transparency and accountability and in developing ESG policies by private equity firms, according to research. Increasing demand has been noted in terms of transparency and accountability, particularly around ESG policies.

Investment companies are adopting ESG policies for practical reasons as well. Decreasing utility bills and focusing on energy efficiency are the cornerstones of ESG, and in the light of the pandemic, these policies can be effectual methods of saving.

Moreover, some sources state that ESG investing has become mainstream. With the global pool of exchange-traded fund (ETF) assets under management considered ‘ESG-focused’ now reportedly exceeding $100bn (£76.2bn). Companies are raising their ESG credentials in AGMs and annual reports and on occasion, companies perceived to have strong ESG credentials appear to enjoy enhanced valuation compared to their peers. 

Private Equity ESG Intentions and Actions

In 2020, private equity firms have raised in excess of $370bn (about £282bn) of commitments to funds that integrate ESG principles into their investment decisions, according to data provider Preqin. But a recent survey by Institutional Investor found that fewer than 10 per cent of 8,810 global private equity firms, with a total of $3.4 trillion under management, are signatories to the UNPRI.

Source: Preqin and PRI, chart from Institutional Investor

Analysis by Institutional Investor shows that the majority of the private equity firms reporting to PRI have a responsible ESG investing or ESG policy. However, ESG policies focus on process, not outcomes. To assess ESG progress at PE firms is to examine their reporting. Overall, the opacity of ESG reporting by PE firms contrasts with the increased transparency provided by many public companies.

Private equity still has considerable room to deliver improved public – social and environmental outcomes. The growing prevalence and severity of environmental and social challenges have elevated the issue set to the highest ranks of PE firms.

According to a report by Private Equity International, “The current state of affairs allows flexibility for GPs to choose how much to report and how often to do it, which leaves the door open for managers to cherry-pick examples of favorable outcomes while burying unfavorable ones.” In addition, GPs can determine if they want to share ESG information at the GP or the portfolio company level.

Lastly, to address climate change and challenges, institutions, including those in finance and private equity, will have to play a more active role in social and environmental problem-solving. The current support for ESG investing appears to be a combination of several factors. The holy grail of investments that not only generate acceptable rates of return to owners and advance the better interests of stakeholders and society is obviously appealing.

Standardisation of ESG

For those working and investing in private equity, the inclusion of ESG criteria in the investment screening and decision-making process is often a recent adaptation and a learned process.

Approaches should become more standardised and more authentic, with skills more broadly disseminated. For now, there is still an experience gap that makes implementation challenging. One of the early challenges identified in the space is the plethora of metrics, standards and styles of reporting on ESG. Recently, several industry leaders agreed to make more collaborative efforts to harmonise measurement standards.

Positive change is possible and happening. Increasing the transparency and rigour of assessment and reporting will benefit performance.

Impact of Covid-19 on Valuations and Debt

Impact of Covid-19 on Valuations and Debt

The extensive economic changes provoked by the COVID-19-crisis have led to some urgent questions regarding the business valuation.  In the process of business valuation, one should consider “all significant information that could have been obtained with due care up to the valuation date”. Therefore, business plans within the detailed planning phase would need to be adapted accordingly, if the consequences of the COVID-19-crisis were already foreseeable on the valuation date.

Many factors lead to a massive increase in planning uncertainty at the present. First, long-term health implications cannot be evaluated orderly at the moment. Second, governments around the world found themselves forced to arrange significant economic restrictions in light of these health-related insecurities. Especially the shutdown of entire industries has affected the economy in a negative manner. Third, nobody can anticipate how long those restrictions will last.

The effects of the COVID-19-crisis are not limited to the short view, long-term aspects have to be considered additionally. Even though the global development of the current situation cannot be anticipated accurately, it can be assumed that long-term negative effects on cash flows strongly depend on a company’s business model and thereby its robustness and resilience.

Due to the current market situation, cash flows need to be adjusted in the detailed planning phase. Nonetheless, whether the crisis has to be considered in the terminal value strongly depends on the underlying business model and is therefore not that clear. This also applies to the growth rate within the terminal value. At the present, there are no hints indicating the requirement of adjusting the long-term valuation parameters when the underlying business model can be seen as robust.

Negative Interest Rate

Since the base interest rate is usually seen as a proxy for the risk-free rate, it plays a crucial role in business valuation. In the context of the Capital Asset Pricing Model (CAPM) the base interest rate plays an important role in determining the cost of capital as well as the market risk premium. To begin with, the low-interest environment has existed even before the COVID-19-crisis. By the mid of 2019, negative risk-free rates were already observable. However, after the interest situation has somewhat improved and interest rates turned positive again (at least temporarily), the COVID-19-crisis has triggered a renewed downward-trend. The spot rate of the 10-year Croatian Government Bonds fell to an historical low of about 0,99%.

Source: Tradingeconomics

The COVID-19 Beta Effect

For some companies, we observe that Beta as a measure of the volatility of the company’s equity value relative to the market has decreased. This reflects an increase in correlation between the company’s equity return and that of the overall market. To the extent an analyst believes the cost of equity should have increased to reflect a higher risk in the projected financial information, an offsetting adjustment can be made to the company-specific risk premium that compensates for the change in the risk-free rate and a possible beta decline. The order of magnitude of any adjustments to the company-specific premium will depend on the company’s specific risk profile in terms of factors such as profitability relative to its peers, financial and operating leverage, liquidity, operational efficiencies to name a few.

In finance, the relationship between an equity’s returns and that of the overall market is measured by beta. Stocks with betas over 1.0 have greater systematic risk than the market as a whole. So if the market rises 1%, high beta, riskier stocks like tech, pharma, and luxury goods companies will increase by more than 1%. Conversely, if the S&P 500 drops 1%, they will fall by a greater percentage.

Source: Damodaran

Company specific risk premium

If Covid-19 happened to affect the subject company more dramatically than its competitors due to specific circumstances (e.g. severe outbreaks and/or lockdowns in locations of manufacturing plants, contingency plans, and procedures not put in place, key personnel being in quarantine or caught in a lockdown abroad, etc.), an increase in company-specific risk premium may make sense. Still, because this premium is very subjective, it should be considered only if the valuer is not able to assess the duration and intensity of adverse circumstances on cash flows.

Conclusion

It is sensible to put more effort in developing reasonable forecasts of cash flows or scenarios, instead of risking overestimating a discount rate. This is especially the case if V-shaped or U-shaped recovery can reasonably be expected for a subject company, implying quicker recovery. Valuers also need to keep in mind the long-term aspect and avoid undue wariness. Arguably, residual value calculation and assumptions do not need to be changed. This is not the first nor the last crisis, it shall also pass, and recovery will follow. On the other hand, not all industries have been affected dramatically, or even adversely, global demand for certain products has increased, many have switched to e-commerce, shifted to remote working, etc. In terms of methods to be employed, depressed multiples due to sell-off will definitely be a conundrum for some time. Possible distressed M&A activity may also distort transaction multiples. Therefore, results obtained from an income approach may be more meaningful than those from the market approach.

Healthcare M&A Deals in 2020

Healthcare M&A Deals in 2020

The health care industry is on an edge and caught up in the middle of a hurricane. With the hospitalizations for COVID-19, revenue that is crucial to the economic growth and stabilization for most hospitals has declined. In addition to directly or indirectly supporting COVID-19 care, health services companies face economic disruptions of uncertain location, timing, and scale.

Reports by Pricewaterhouse Coopers and Kaufman Hall showed a decline in mergers and acquisitions, but still reported sustained interest from buyers. Although there was a minor decrease in mergers and acquisitions in the first half of 2020, some major deals and acquisitions were closed.

Laborie Medical Technologies’ $525 Million Acquisition of Clinical Innovations

 

LABORIE Medical Technologies executed the definitive agreement to acquire Clinical Innovations for an enterprise value of $525 million. The transaction is subject to customary approvals and is expected to close in early 2020. Clinical Innovations is expanding its global presence while directly researching and developing state-of-the-art technologies and innovative medical devices that fulfill its mission of improving the lives of mothers and their babies throughout the world.

Align Technology’s acquisition of Exocad — $420 million

Align Technology announced it has agreed to acquire dental software company Exocad for approximately $420 million in cash. The move will add Exocad’s experience in restorative dentistry, implantology, guided surgery, and design to Align’s technology portfolio, which includes Invisalign clear-aligner orthodontic and iTero digital solutions. Exocad will also bring nearly 200 digital dentistry partners and more than 35,000 licenses installed worldwide to the deal, according to San Jose, Calif.-based Align.

Baxter International’s acquisition of Sepra Products business of Sanofi — $350 million 

According to Reuters, Medical supply company Baxter International Inc, said to buy Safoni’s Seprafilm unit, which makes specialist surgical products, for $350 million in cash.

According to PWC’s research, in Q2 2020 deal values versus Q1 2020, three sub-sectors saw increases: Behavioral Care (900%), Hospitals (11%), and Physician Medical Groups (6%). 

Moreover, due to the pandemic, there are a few interesting healthcare asset types that seem more attractive. That is; accelerated growth of remote work, virtual healthcare, home health, and behavioral health. In terms of consumer needs, health services companies must deploy technology that enhances experiences while improving efficiency.

Moreover, there are yet more opportunities for healthcare environment deals to shine. 

Foreign Direct Investment flows

Foreign Direct Investment flows

During the time of COVID-19, Foreign Direct Investment flows are expected to fall by 30% in 2020. Despite the government support and policy measures to help against COVID-19 pandemic, FDI flows are expected to drop.

According to the latest report from OECD, FDI could play an important role in supporting economies during and after the crisis. The FDI help could include financial support to their affiliates, assisting governments in addressing the pandemic, and through linkages with local firms.

Public health measures have caused economic disruptions that impact the foreign direct investment decision of firms. We learned from the past crisis that small and medium-sized enterprises show greater resilience due to their linkages with the financial resources of their parent companies.

According to the OECD Investment Policy Response, FDI is expected to decline sharply as a consequence of the pandemic and the resulting supply disruptions, demand contractions, and pessimistic outlook of economic actors.

In addressing the medical supply shortage, governments should leverage investor networks and investment promotion agencies. Some governments have already embraced imports of essential good, while some businesses have started producing medical essentials such as medical masks etc.

Moving forward, cross-border partnerships and collaborations between companies can facilitate finding long-term business solutions, such as ways to resume production while protecting workers’ health.

FDI is expected to face major drops as the supply chains are facing disruption. Meanwhile, capital inflows will be impacted as companies put some mergers and acquisitions (M&As) on hold.

As an example of earning in 2020 of large MNEs are expected to fall. According to the latest statistics data gathered from Refinitiv, there will be large year-over-year drops in earnings in the energy, consumer discretionary sector, industrials, and materials sectors. On the other hand, it is expected that there will be year-over-year increases in earnings in the health care, technology, and communications sectors.

Source: OECD, from Refinitiv M&A database

The latest data from Refinitis M&A database shows a significant drop in completed M&A deals in the first quarter. However, there is no evidence on the deals withdrawn. That leads to the conclusion that investors are focused on closing deals rather than withholding from it. In the short term, equity capital flows will fall due to so many deals being put on hold, but it could mean that there will be an increase in the future as these deals are completed as the economy recovers.

To read the full report and in-dept insight into FDI investments, please visit the OECD official website.

Private Equity in CEE overview

Private Equity in CEE overview

Private Equity in South-East Europe is alive and well. There are few talks in media on the recent acquisitions in the South-East region. One of them includes Nikos Stathopoulis, chairman of BC Partners’ portfolio management committee. Moreover, Nikos is also a chairman of Serbia based United Group and leads media and telecoms. Last year, there were two major acquisitions in the region. One was Tele 2 Croatia for an enterprise value of €220 million. While the other one was for Bulgarian service provider Vivacom for a reported enterprise value of €1.2 billion.

Meanwhile, a Pharmaceutical company Zentiva Group completed the acquisition of Alvogen’s CEE business in Romania, Bulgaria, Croatia and several other countries.

Private-equity (PE) investors own companies but are not like those that raise money by selling their shares in stock exchanges. There is a big difference. Public companies are those that shareholders list on publicly available registers. Secondly, listed companies make regular announcements. If they’re backed by private equity, there’s no need to do so: it’s all private. Therefore, Private Equity backed companies tend to value that freedom.

Private equity investments in CEE companies

Private equity and venture capital investment into companies in Central and Eastern Europe (CEE) reached a record €3.5 billion in 2017, according to data from Invest Europe.

Source: Invest Europe / EDC

From the Invest Europe, 2018 Report, 3,750 European companies exited in 2018, a 3% decrease on the previous year. By the amount of former equity investment (divestment at cost), the total value was €32bn, a year-on-year decrease of 28%. The most prominent exit routes by the amount at cost were trade sale (32%), sale to another private equity firm (31%) and public offering (10%).

Buyout funds in the region raised a total of €1.1 billion, whilst CEE venture capital funds attracted over €500 million of investor cash for the second year in a row.

The number of private equity and venture capital-backed exits in CEE reached an all-time high with a total of 128 companies divested in 2018. With an exit value of €575 million, Poland accounted for nearly half of all exit activity. The biotech and healthcare sector took the lion’s share of CEE private equity investment, making up just over 30% of the total value for the year. Consumer goods and services companies also fared well, receiving 27% of the overall funding.

What is private equity looking for in 2020?

According to online media, private equity markets are looking for technology companies where covid-19 is not worthy of mention.

It will be some time yet before the bargain hunters are searching for opportunities in manufacturing industries with complex, international supply chains. Meanwhile, creditors will be more focused on a conservative business plan for the underlying companies.

Overall we maintain a positive outlook for the performance of new commitments to private equity in 2020. Investors’ emphasis on ESG will increase further in 2020. That also aligns well with private equity’s long timeframes and higher engagement. This is becoming especially important for private equity in CEE; Central and Eastern Europe.

As we mentioned in the previous article on ESG growth, heightened awareness of climate change are important drivers of change. Nevertheless, the European Commission’s Sustainable Finance initiative is as well, highly important driver.

According to Pitchbook, private equity is on a long-term growth trend, and there seems to be little that will stop it. Private equity has long been an important contributor to value creation in the real economy and for investors’ portfolios alike.

Changes in the M&A world: Tech sector

Changes in the M&A world: Tech sector

While the crisis has not yet passed, M&A discussions are already increasing. Many firms that were once in a stable position last year are now looking for an exit strategy or need to merge for growth or survival.

In the latest Economic Outlook chapter, economic experts describe a baseline scenario. In the scenario the pandemic fades in the second half of 2020 and containment efforts will slowly loose. Moreover, the global economy could show growth by 5.8 % in 2021 as economic activity normalizes, helped by policy support.

Source: IMF

When looking at the latest chart from the IMF Economic Outlook, a high rise in GDP is expected for the countries with advanced economies. With this in mind, companies can incorporate the latest data related to covid-19 into their equation. With coronavirus, the acquired or merged-in firm’s revenue stream may not be as predictable as in the past. The quality of the firm is not the question. Moreover, a firm’s value can drop if the incoming firm’s client revenue shrinks.

What are the remaining challenges in the M&A?

No matter the covid-19, the selling factor remains the same. In M&A challenges, there is an ongoing concern of whether or not the team can bring in sales. Partners do not want to risk payout on a team with no record of selling.

Here’s how to look at the firm value in any CPA M&A deal, pre- or post-pandemic. Value has been, and will always be, what the buyer/acquirer feels it is worth.

Make sure that there is no risk of revenue loss. In that case, the seller or upward-merger firm should not be worried about getting paid in full.

How do you increase the value of your firm? To maximize value, you need to understand the market value of your firm in today’s environment and the drivers that increase or decrease firm value.

Software industry changes in the M&A

In the software industry, private equity-backed providers are helping in subtle ways. They are offering their products and services to government agencies to help them respond to the pandemic or track its spread.

The world of private equity ownership often provides for higher authority over a company’s strategic management. That said, businesses can promptly shift direction to respond to market challenges. Moreover, the technology sector shows that a lot of companies are constantly producing innovative technological solutions.

A recent example of the tech company is digital assistant Andrija, developed in Croatia to help fight against coronavirus. This “virtual doctor”, powered by artificial intelligence, has been developed by Croatian IT companies in cooperation with epidemiologists.

The idea of ​​the assistant is to assist healthcare professionals, doctors and epidemiologists in controlling the development of the Covid-19 epidemic. In addition to that, users are able to determine if they are covid-19 positive.

In short, many software companies are looking for new ways to thrive after the crisis. The post-pandemic situation will bring some economic difficulties for many companies. Meanwhile, tech giant Facebook is already working with health researchers and nonprofits. Facebook will provide anonymized and aggregated statistics about people’s movements. The project is called desease-prevention maps.

Changes in the M&A: Investors still on the hunt

With 170 deals completed in the first three months of 2020, deal volumes are significantly down. If we compare with the previous quarter, deal volumes are the lowest since early 2014.

Moreover, covid-19 crisis has significantly disrupted the normal flow of M&A deals. With the global economy change in mind, companies are more likely to prioritize short-term actions over long-term initiatives. However, those that are able to stay on the course, will more likely establish foundation for continued success once the crisis ends.

Although M&A activity as a whole is expected to be down this year, the deals that get done are expected to involve the same technology disrupters that make attractive targets in scope acquisitions. In the survey, company Baker McKenzie predicted global M&A drop 25% this year, from $2.8 trillion to $2.1 trillion. However, the deals that will get done will involve technology of disrupters. In the repor, data shows that across all sectors, companies will seek to acquire the advanced digital technology.

To sum up, technology sector will continue to receive increase in interest from financial buyers. Moreover, the changes in the M&A will result in fewer acquisitions. In addition to fewer M&A acquisitions, the buyers will take companies in a new directions.