At the onset of COVID-19, fears were rife of a GFC-style near shutdown of PE deal-making. Four months into the crisis, a more nuanced and positive picture is emerging: funds remain under pressure to deploy capital and realise high-returning investments, debt markets are still open and LP expectations remain high.

PE funds, like all other companies, had several immediate priorities following the onset of COVID-19: secure the health and safety of their own and their portfolio companies’ staff; adapt and implement operational resilience plans to ‘keep the lights on’; and limit the short-term and long-term commercial damage that the virus could wreak. For most funds, this ‘emergency rescue’ process took about four to six weeks for the majority of portfolio companies; albeit that the collapse in many underlying product and service markets will continue for months and years to come ― we are not out of the woods yet.

Outside these operational considerations, the initial market reaction from private equity firms and sector commentators was to wonder whether COVID-19 could cause a credit crunch-style shutdown in the debt markets underpinning the viability of leveraged transactions; this in turn could result in a huge reduction in deal volumes and/or a collapse in valuations. Tightness in some areas of debt provision, notably but not exclusively securitisation markets, immediately followed, along with some assumptions that debt markets were closed.

Four months on, however, sentiment has improved considerably, and is both more nuanced and markedly more positive for three principal reasons.

  1. The ‘wall of cash’ has not gone away: the very high amounts of ready-to-deploy committed funds held by PE firms remain in place.
  2. Debt markets are still open: the overarching sentiment from PE funds themselves and from banks and other debt providers is that debt finance is still available for good deals. There may be a higher level of scrutiny from credit committees, and pricing may have gone up due to higher (perceptions of) risk, but leveraged transactions are still possible, i.e. the financial infrastructure required to execute deals remains in place.
  3. LPs are demanding returns ‘today’: many funds are under pressure from their limited partners to get on with deploying capital and realising returns on existing investments. This often includes clear direction that simply ‘sitting it out’, as many funds largely did through the GFC, will not be acceptable. Furthermore, demonstrating strong performance from a ‘COVID cohort’, i.e. the ability to deploy capital during the crisis itself and generate strong returns,  will be a requirement for LPs to consider committing their money in the next round of fundraising, which is fairly imminent for many funds. The imperative to do business, i.e. the demand for assets to invest in and the supply of assets to be sold, is therefore very strong.

Of course this situation does not at all automatically translate into business as usual. There is near-uniform consensus that a severe and potentially lengthy recession has already begun, with the likelihood for distress for many industries and the firms within them. Both the underlying health crisis and governments’ response to it are highly uncertain. And the challenge to many of the industries in which private equity invests is both considerable in scale and unprecedented in nature: many previously successful business models will be hampered or could even become obsolete, and new ways of doing business will emerge. Risk will therefore be very high and investment committees will face tough decisions, albeit ones with potentially correspondingly high rewards.

So who will win in this complex situation, and what might be features of successful strategies? In many ways, the drivers of success will remain the same as ever, but we expect several elements to be especially important.

  1. Reinvest in your strengths: deep strategic and operational understanding of assets and the markets in which they operate is a must in this uncertain situation. Bolt-on acquisitions and deployment of further growth capital in existing strong assets should be a high priority. Investment committees will also find it easier to double down on an existing winner than to back an unknown, however promising.
  2. Develop and maintain specialist expertise: specialist funds, or funds consisting of parallel expert teams, will be advantaged in this high-risk environment, for both ‘vanilla’ and distressed assets. These specialisms could be sector expertise, operational skill or technical capability, e.g. digital. The cost of mistakes could be very high and debt providers are likely to cut their losses earlier if assets get into trouble. Being sure of operational resilience and downside protection, and being able to demonstrate them, will be key.
  3. Emphasise deal deliverability and be flexible on structure: every deal will feel riskier than usual to the seller. Access to committed and reliable funding on both the equity and debt sides, and the ability to be quick and flexible in reaching agreed terms, will be at a higher premium than ever. ‘Whole stack’ funds, and those that have recently raised funds that give them committed firepower into the medium term, will be advantaged in specific deal deliverability and can afford to be pickier in deal selection.

These principles may seem obvious, but there is an increasing expectation in the market that funds with truly generalist investment teams competing opportunistically and those without significant operational expertise are likely to suffer, and many may not survive. Bolstering capability will be an urgent priority for some funds.

In summary, the outcome of the underlying health crisis itself is still highly uncertain, and it is impossible to be certain that its economic consequences and those of government policy will not cause a significant tightening of credit conditions, at least temporarily, leading to GFC-like conditions. However, for now, the market for private equity transactions appears set to continue in 2020, albeit at somewhat lower volumes and at potentially significantly higher risk than in the ‘old normal’ ― for the great majority of funds, non-participation is not an option.

L.E.K. Consulting works with private equity clients to provide comprehensive support across the full transaction cycle, from identifying attractive companies to commercial due diligence, portfolio company value growth and exit support. Today we are one of the largest and most experienced strategy consulting firms serving private equity.

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