COVID-19 and Private Equity: Three Reasons Why Deal-Making Will Prove More Resilient than Feared
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.
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.
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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