Interview with Dominik Bub - Investment Director (Yielco Investments / Germany)
"Some PE firms forgot the importance of having enough operating resources"
Leaders League. Yielco focuses on alternative investments that generate attractive, predictable long-term returns. What’s the story behind these returns, and do you offer any particularly innovative products?
Dominik Bub. We offer access to longterm predictable income with significant components of running yield through our investment programmes and managed accounts within the infrastructure and private debt asset class. Within infrastructure we aim to build diversified portfolios focusing on both core and coreplus mid-market investment strategies to combine absolute return-driven strategies while keeping a yield component of circa 5-7% per year. One of our most innovative products is a fund concept that targets niche lending opportunities: Yielco Specialty Lending (YSL). Its objective is to supplement and further diversify existing private debt allocations, which are predominantly oriented towards traditional EBITDA-based lending strategies. By focusing on market segments and deal situations that are neglected by the banks and traditional direct lending funds due to their high complexity, small size and required know-how with regard to specific sectors or financial structures, attractive risk-adjusted returns can be achieved that show a low correlation with mainstream direct lending. These may include, among others: asset-based lending, leasing and equipment finance, financing of highly granular loan portfolios (e.g. credit card receivables, student loans), growth situations and special situations. A common characteristic of these strategies is the comparatively high complexity of the financing, which results in a yield and return premium despite low LTVs [loan-to-value ratios]. At least as important for the existence of this premium are limited capital flows into these less transparent market segments, which, in contrast to the direct lending market, are characterized by a capital shortage. The mandate will be geographically balanced between North America and Europe (at least 50%). The target return net to investors is an IRR of 10% per year, most of it generated by current interest income. In addition, most of the strategies mentioned offer built-in upside optionality, and thus the potential to generate capital gains.
How would you describe the German PE environment and the approach and culture of German PE firms?
Historically, Germany has been less open for private equity, with penetration rates still being significantly below levels of France or the UK. German entrepreneurs, particularly within the Mittelstand [SME] segment, used to build companies over generations; selling to external investors was not part of their mindset. However, the market is developing continuously and a new generation of founders is now approaching an age, i.e. their 50s, where they consider opening up for a private equity partner as a first step of succession planning. With that background in mind, the culture of German private equity firms, particularly in the lower end of the market, is frequently oriented towards partnering with the founding family or existing owners. It remains difficult for foreign players to penetrate the small and mid-cap market here without local help. At the larger end of the market, most deals are the result of larger processes, where to be “local” and understanding the culture e are less important than pricing and execution capabilities. In recent years we have seen a positive number of new teams setting up small PE funds, which was rather unusual in Germany.
What are the biggest challenges the coronavirus crisis has thrown at private equity?
Based on current developments, the following conclusion seems to be certain: since March 2020, investors have been faced with completely changed conditions for existing portfolios and new investments. Our expectations, that the private equity fundraising volume will decline significantly in 2020, were confirmed in the first half of the year. Successful launches of new funds of blue-chip names, as demonstrated by CVC, EQT or Silver Lake, have not faced serious difficulties; we have also seen smaller players with clear niche-developed strategies like Boyne, One Rock or Sherpa very well positioned to raise and close new funds during the current environment. However, these are still the exceptions in the market. Generally, delays in ongoing fundraising processes and postponements of launches of new funds have been noted. At the same time, we expect, despite the high proportion of capital available for new investments, a considerable decline in the total transaction volume over the next two years, especially in “traditional LBO” transactions. In Q2 of 2020, PE transaction volume collapsed by around 50% across Europe and North America. With this immediate decline being mainly driven by a lack of economic visibility within companies, reduced financing opportunities, travel restrictions and widely differing price expectations, many managers will have to focus on the challenges within their existing unrealized portfolios, which have grown over the last few years. The successful development and future realization of these portfolios is expected to be a substantial challenge for many private equity firms, as existing portfolio companies were bought at peak valuations and very high leverage levels. In the current recession, portfolio companies will face pressure from three sides: declining EBITDA, potentially tighter refinancing markets and an overall lower valuation environment.
How has the crisis impacted Yielco’s organization?
While from mid-March to April most of our employees worked from home, we gradually returned to an almost regular set up. Since the beginning of June, the Yielco teams based in Munich and Zürich have returned to the office. Visits to investors and managers, however, still take place primarily via electronic media. We have continued to be very busy since the outbreak of Covid-19, with a high number of new commitments executed in all three asset classes. At the same time, we have spent a lot of time monitoring our existing portfolio and understanding the potential economic impact of the pandemic in every single investment.
What do you see changing or transforming after the crisis? How will it affect PE long-term, if at all?
We believe that private equity will continue to be an attractive asset class. After the Great Financial Crisis [GFC], most successful PE firms transitioned to a more operational approach to value creation. We believe that these operational capabilities going forward are going to be even more important. The backwind we had enjoyed in the previous cycle made some PE firms forget how important it is to have enough operating resources to actively develop their portfolio companies. On the investor side, we have not noticed any reduction in investor appetite for the asset class. In fact, investors continue to grow their allocations and their programs.
The virus aside, what will private equity look like in three years?
Most crises bring a shakeup of the players in the field. We will have an additional track record point to validate the quality of the manager when looking at how they navigated their portfolio through the crisis. In general, we expect the size of the market to continue to increase. Healthcare, software and IT deals will gain market share, while “older economy” areas might decrease. The results of the private debt funds during the crisis will also define what the financing market will look like for private equity going forward.
You have longstanding experience in restructuring. What do you forecast for this sector in the coming year?
In the current market environment, we increasingly see attractive investment opportunities in special situations resulting from liquidity bottlenecks due to falling sales and/or shifts in working capital. Despite public stimulus packages, sufficient financing is frequently not secured. Here, various interesting investment opportunities in the form of “rescue capital” are available. In many cases, PE firms will be forced to provide additional equity to ensure the necessary liquidity. Situations in which external investors are required may arise, because (i) the fund is already fully invested, (ii) concentration limits within the respective fund will be exceeded, or (iii) existing co-investors are not willing or able to support the planned capital increase. Furthermore, investors can increasingly acquire distressed debt in order to gain access to equity (“debt for control”) within a restructuring process. According to LCD [Leveraged Commentary and Data, the loan market research division of Standard & Poor’s], the share of loans that are traded at less than 80% of their nominal value in the US has increased from 2% in March 2019 to 38% in March 2020. However, due to the Federal Reserve’s sudden and unexpected purchases of highyield bonds in the US, activity in the distressed debt market was limited to a short window of opportunity in March. As a result, the expected wave of distressed debt for control transactions has been delayed. In a second phase, estimated from mid2021, we expect to see a significant increase in traditional balance sheet restructurings, even at companies with fundamentally healthy business models. The expected decline in operational performance over the next months will lead to a further increase in debt levels and the associated risk of breaching covenants. Corresponding balance sheet restructurings will become necessary and frequently might not be refinanced by traditional debt capital only. Flexible capital solutions such as mezzanine loans, PIK [payment-in-kind] notes and preferred capital will become increasingly relevant, as valuing the company will be difficult. When new financing partners are added to the capital structure, a common basis of company valuation for the capital increase must be found. Previous owners typically tend to value the company higher (in order to keep the potential dilution of their shares low), while new parties involved in the financing round are usually guided by the lower valuations and the correspondingly reduced operating results. This discrepancy can be resolved by flexible capital structures with instruments that do not represent a direct acquisition of shares in the company, but typically have a fixed yield component and a senior position compared to traditional equity.
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