Analysis: Private Equity in the aftermath of Covid-19

While the amount raised and invested by private equity funds capped six years of unprecedented growth in 2019, the health and financial crisis brought about by Covid-19 has put paid to the idea that the good times might continue into the new decade.

While the amount raised and invested by private equity funds capped six years of unprecedented growth in 2019, the health and financial crisis brought about by Covid-19 has put paid to the idea that the good times might continue into the new decade.


Certain trends – such as increasingly picky LPs and the incorporation of ESG, P2P, buy and build and extension of share ownership – should intensify in the aftermath of the pandemic, while others – the surge in the value of multiples, jumbo funds, increase in leverage – are likely to fade or disappear completely.

It might seem like an age ago, but back before the coronavirus – and its attendant consequences for the world of investment – hit, the PE industry seemed to be in decent shape. But while capital amassed remained at a high level, a plateau had, in fact, been reached and the industry was almost certainly entering the end of a cycle.
 

Survival of the fittest
In 2019, institutional investors deployed $894 billion in private capital through private equity, real estate, infrastructure or natural resources funds. If that amount was a slight increase on 2018’s $861 billion, it nevertheless failed to threaten the high water mark of $930 billion in 2017. Only the buy-out segment has continued an upward trend since, registering $361 billion in engagements – the best performance in this category since records began.

Another characteristic of private equity in 2019 was the speed with which deals were concluded, with 70% of GPs concluding their leveraged buyouts in less than twelve months! The availability of cheap debt, one of the main drivers of PE activity, even led to a number of GPs putting together jumbo-funds – Advent ($7.5bn), Cinven ($11bn), Thoma Bravo ($12.6bn), TPG ($14bn), Permira ($12bn), for example – which goes a long way to explaining this phenomenon. In any case, happy are the managers who closed their outstanding deals before the turn of the year, because it will take some time to before PE reaches such elevated levels again. This is due to Covid-19 yes, but not entirely.

"Given that PE was performing at historically high levels in relation to other asset classes before the pandemic, LPs will be unwilling to turn their backs on this type of activity"


At the start of April, around the time the gravity of the pandemic was sinking in, 3,620 investment vehicles were at the commercialization stage. That is not a negligible amount and points to a fundraising logjam: between January and March, only 267 GPs managed to close their investment vehicles, and only 52% of these took less than 18 months to finalize – two metrics that were well down on previous years. In Europe, for example, Apex paused its buy-out vehicle at €1.2 billion in order to allow however much time was necessary to reach the hard cap of €1.5 billion.

Given that PE was performing at historically high levels in relation to other asset classes before the pandemic, LPs will be unwilling to turn their backs on this type of activity. That said, nothing is stopping them from reducing their exposure. And they seem to be doing just that. Preqin recently revealed that 56% of LPs prefer not to invest more than $50m in any one non-listed fund (up from 47% the previous year). What’s more, as one mid-cap manager told Leaders League “LPs prefer to analyze the share portfolio reports of their GPs rather than explore new investment opportunities at the moment, with fundraising activities postponed, at the very least.”

This wane in optimism looks set to reinforce the current hyper selectivity of LPs, where a ‘winner takes all’ logic informs their choice of which transactions to pursue. As Bain & Co. partner Jérôme Brunet explains, “a large percentage of the capital being raised is concentrated in a small number of funds.” To put it another way, never have so few GPs raised so much money in so little time. This trend, which began well before Covid-19 hit, has led to the accumulation of unprecedented levels of dry powder among leading private equity firms like Warburg Pincus, Platinum, KKR and Apollo.
 

Deals: back to normal valuations soon?
A tempting logic is leading firms to think about valuation multiples in relation to Ebitda generated by the investments of private equity funds. Namely that valuations are set to continue to decline for months to come, and, following this line of thought, if turnover continues to collapse, it will eat up all or the majority of expected profits. The reality, however, is more complex.

Still, lacking clarity on how the economic relaunch is going to pan out, for investors it is time to take a wait-and-see approach to making investments. “Only deals that are at a very advanced stage are being closed at the moment,” adds Brunet. Indeed, many negotiations that were in their infancy when the crisis struck have since been postponed, because the interests of the seller (who wants a valuation based on pre-virus ebitda levels) and the buyer (who prefer to assign value based on ebitac – with the ‘c’ representing the coronavirus and its impact on economic activity) stand little chance of being in alignment in the current climate. But as summer turns to autumn, something will have to give.

And then there is the sectoral aspect. The coronavirus has pushed values both up and down depending on the sector. According to Refinitiv, a financial-markets analyst, companies in the healthcare, high tech and consumer goods sectors are now valued at more than 18 times their ebitda, while companies relying heavily on the physical presence and efforts of their workforce, such a construction businesses and brick and mortar stores – not to mention financial firms – have current ebitda multiples of less than seven. Those companies hardest hit by the crisis currently have a coefficient of only 1.7.

The main reason for this is, of course, is the lockdown, wherein measures taken by governments across the world to curb the spread of the virus put sectors dependent on physical activity into a state of suspended animation.

All these depreciations have had a ripple effect throughout the global M&A market. For example, when it comes to an LBO, the ebitda multiple of a European company sits at 8.8 today, compared to 10.9 in 2019. And for Céline Méchain, the managing director of Goldman Sachs France, “If the fall in prices continues, it is not beyond the realm of possibility that new, value sharing clauses, between buyers and sellers will be drawn up, in order to find some middle ground. We can also expect to see an explosion of earn-out clauses, with financial clauses, for the most part, needing to have a flexible conversation rate depending on the KPIs of the target.”

In addition, independent from the debate about Covid-19 winner and loser sectors, we will need to wait until the level of competition regarding the most qualitative assets is sufficient high once more, i.e. regarding primary LBOs, scalable activities, fragmented markets etc.


Dry powder past its sell-by date
This is all the more true for funds with an excess of dry powder. In December 2019 the amounts raised but not invested reached an unprecedented $830bn, with more than half of that attributed to North American GPs. With such vast reserves of money and given the effects of the current crisis on the PE market, the risk of a sharp drop in prices rendering all that dry powder next to worthless is very real. This could force funds to ask their LPs for more time before being required to deploy their reserves of capital, in the hope that the market can eventually bounce back. It is for this reason that the market can expect to see some very aggressive moves on the part of GPs on the most attractive prospects of the carve-out variety, while more ‘vanilla’ operations, such as third or fourth rate LBOs will have to settle for the current market value.

"The market can expect to see some very aggressive moves on the part of GPs on the most attractive prospects of the carve-out variety"


Two other trends have a good chance of sticking around: Large cap and public to private (P2P) transactions. In the case of the first, 2019, decent though it was, could hardly be called a banner year for buyouts, with the mean price of the 3,600 to take place across the world set at $551m, which was slightly down on the average price in 2018 and significantly less than 2006-7 figures. It was only at the very start of 2020, that the blue touch paper was lit, with the blockbuster deal reached by Advent and Cinven to acquire the elevator business of Thyssenkrupp for €17.2bn – a sum not seen in over a decade, which certain observers believed would usher in the era of the €20bn transaction.

Large levels of available liquidity, coupled with the growing appetite of LPs (chiefly family offices and pension and sovereign wealth funds) for co-investment opportunities, could mean that the mega deal does not completely disappear from the investment landscape in 2020.

In the image of the Advent and Cinven buyout, to the detriment of a less than optimistic stock market debut, P2P operations – or de-listings – are another PE growth area in terms of asset class. Indeed, the level of de-listings has not reached these heights since 2007, with eight of the ten most imported deals of 2019 being de-listed. And considering the current state of the world’s stock exchanges, it is not unreasonable to believe that funds will renew their interest in public equities as soon as macroeconomic indicators are able to paint a clearer picture.


Proximity and patience
Of course, Covid-19 is not the first crisis to ever hit the private equity industry. A decade ago, in the US, the sub-prime mortgage crisis unleashed a tidal wave of uncertainty on the market. Then, as now, investment funds had to adjust to the new reality. At the same time, In Europe, M&A has continued to outperform the share market. 

In reality, the one figure that will send a shiver down the spine of investors is the six percent point drop in expected returns on buyouts between 1999 and 2019. Yet the number of private equity funds reaching maturity does not alone account for the clouds on the horizon, especially given that certain elite PE funds have found a way to mitigate this downward: focalization.

But funds will have to demonstrate their capacity to bend and not break, to engage in some serious introspection in order to see if it isn’t possible to spread the wealth for the greater good of all stakeholders, while limiting the excesses traditionally associated with the use of debt, in particular. In the year of the virus, this imperative remains. Yet in a more complex and competitive market the margin for error has been considerably reduced, especially for those less responsive companies.

Now more than ever, funds are going to have to pay close attention to their equity interests and, beyond their role as pure investors, GPs will have their CEO’s ear when it comes to overall strategy.

The crisis will be an opportunity to prove that PE has not lost its luster and can still outperform other asset classes, something Eric Bismuth, the founder and CEO of Bismuth Investment, believes it can do. “Going through this testing time alone, as lots of SME bosses are having to do, is a real challenge. The majority of them have had to take decisions over these past few months that they never dreamed they’d have to take. At a time like this, private equity has a chance to prove its worth to society.”

GPs have already rolled up their sleeves and put in place teams dedicated to treasury management and labor law. At UI Gestion, for example, tax, labor and insurance hotlines have been set up so directors can get an answer to their questions in under 24 hours. Lawyers, financial advisors and banking partners are the lifeblood of this service and help ensure that everyone involved in an investment is on the same page.

Promoting a more even distribution of value (and risk) between the different stakeholders echos the recent trend in private equity toward embracing environmental, social and governmental (ESG) criteria. These criteria constitute perhaps the biggest challenge the PE industry has faced in modern times, but they also have the potential to be a growth vector and even transform the industry for the better. This is widely acknowledged to be even more the case in the post-Covid era, where traditional ways of consumption, communication, work and mobility have been disrupted.

The place ESG criteria occupy in LP-GP and GP-corporate relations has grown beyond all recognition over the past decade and making M&A a more intelligent and eco-friendly pillar of post-Covid society would be a step in the right direction, according to Candice Brenet, director of sustainability and digital activities at Ardian. “These days, an ESG strategy is the sine quoi non of many deals.”

"Whether we are talking about gender equality, social inclusion or green equity, all companies have to grapple with ESG concerns"

Whether we are talking about gender equality, social inclusion or green equity, all companies have to grapple with ESG concerns. Some prefer to internalize this function, will others rely on the counsel of external experts, and that’s without even mentioning management companies that focus on high-impact activist investing, or those with vehicles dedicated to advancing specific causes, such as the energy transition or reversing rural depopulation, for example. It remains to be seen whether the ideals driving these strategies will be in line with the financial performance shareholders expect. 

In a scenario where ESG does not manage to spearhead the growth of the PE industry, new growth avenues will have to be found. And the danger here comes from an unexpected source, private equity’s erstwhile friend – the stock exchange.

According to a study carried out by State Street, Bain & Company and professor Josh Lerner of Harvard Business School, for the first time since 2009, in the US share dividends are at the level of buyout funds, at around 15%.

But there is no need to press the panic button. The bounce back of the stock exchange is less down to the performance of listed companies, than it is to the very low perch markets were taking off from. 

One thing is clear, funds are, for once and for all, going to have to define their strategic positioning, since, with clients now in a position to demand more, they are going to find it increasingly difficult to stand out as just one of many smid cap operators, interested in any and all sectors. Without sending a clear signal about what added value a fund proposes (professional expertise, country-specific knowledge, permanent capital offer, recourse to co-investment by LPS or ability to execute buy and build programmes) GPs are destined to disappear, and in today’s climate that will happen faster than ever.       

 

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