How will the covid-19 impact on the private equity industry? The only possible answer is that no one knows. As a healthcare crisis, it is unusual in its global impact. As an economic event, it raises many unknowns about how the sudden demand shock will affect business activity. Moreover, it raises the question of how will it affect consumer behaviour. In our previous article, we discussed the covid-19 impact on private equity markets in CESEE countries. Nevertheless, we will cover in this article global implications on the private equity industry.
That said, if we take a closer look at previous economic crises, we will be able to better understand private equity funds. Covid-19 impact on private equity is raising concerns on businesses and economies. 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.
Private Equity firms may be facing a situation in which they have multiple companies with hundreds of employees looking for guidance during this crisis. Cybersecurity is always a priority for PE firms and their portfolio companies. However, they may face additional threats and vulnerabilities now. That is because they will have significantly higher levels of remote access to core systems.
Without the right monitoring and planning, PE firms could be overloaded with issue after issue. Additionally, HR policies may be inconsistent across the underlying entities.
Dealmaking fell off sharply when the global financial crisis hit in 2008, and this crisis should also trigger a substantial contraction. Credit markets, meanwhile, have tightened up but haven’t frozen completely. See the graph below that shows deal activity sank by half during the global financial crisis.
Banks will put lending for new deals on hold as they focus on working with existing borrowers to avoid default. It will also take time for lenders to work through how to assess risk today. Scrutiny during underwriting will increase dramatically as they work out how much to lend and at what price.
While many factors suggest that dealmaking and lending activity will slow in the months ahead, there are some significant differences in the current market that could limit the downdraft in the activity.
First, PE funds have a record $2.5 trillion in uncalled capital—more than $800 billion for buyouts alone—and are on the clock to spend it. Private debt funds have emerged since the global financial crisis as a major force in the market. Also, they have more than three times the assets under management they had in 2008. They might provide financing for new deals. The firms with the largest direct lending funds also have extensive distressed debt and special situations capabilities.
With the public markets depressed and potential corporate buyers holding onto their cash, PE funds are well-positioned to be the buyer for any asset that does come up for sale.
Economic challenges for the private equity industry
With broad government-mandated policies related to the covid-19 coming into effect, massive crashes are set to hit the global economy.
The travel & leisure industries have already seen demand plunge, while retail foot traffic is down dramatically and the service industries. Outside of the consumer space, many manufacturers and retailers have seen disruptions to international supply chains. Oil demand had already declined due to Covid-19, but because of this supply shock, prices plunged below $30 to the date.
These forces point toward negative revisions to global corporate earnings expectations. Cash-flow profiles will likely decline as revenues drop.
Exits will inevitably drop, and holding periods for some assets will extend, as sellers sit tight and wait for the markets to recover. But activity may not fall off as steeply as it did in 2008 and 2009.
Cost reductions may mitigate cash-flow declines, but many businesses will find themselves looking for capital to help cover negative cash flow. Moreover, many public companies and various private equity firms have asked their portfolio companies to do the same.
Now, the industry is coming off many consecutive years of strong dealmaking. Meanwhile, GPs are sitting on assets that they would be expected to sell soon in a normal market. They won’t exist if the price isn’t right. But there is reason to believe that as soon as market conditions improve, exits could rebound faster than we saw coming out of the global financial crisis.
At the same time, high-yield bonds have skyrocketed as investors look to sell risk assets with heavy velocity. As of the beginning of March, roughly $860 million in leveraged loans came to market. That is reflecting a decline of more than 99%, according to LCD.
Credit markets creating private debt
Given the fall-off in demand for risk assets, there is a tightening in the credit markets applicable to the upper end on private equity. In times of heavy market distress, it is important to emphasize two central components for valuing a business. Those are free cash flow projections and the weighted average cost of capital. As we see earnings fall and the cost of capital rise, asset prices will decline across the board, hurting exit multiples.
In addition, we think well-funded PE vehicles will be forced to inject more liquidity into portfolio companies. That will reduce the leverage in the LBO market.
Firms may have to underwrite deals to lower return profiles, which might remove a significant portion of viable target companies overnight. That said, certain assets trade at cheaper prices, PE might be able to make transactions work. However, PE will have the intent of re-levering later in the holding period.
In the end, private equity may have more levers to support portfolio companies than ever. That is if we consider the well-capitalized state of current private capital markets. PE firms might also hold on to their most prestigious assets as they look to weather an economic shock and look for multiples to regain steam.