Article by Isabel Rodríguez and Arie Scharf, partner and associate respectively, King & Wood Mallesons
The impact of the coronavirus (Covid-19) pandemic on the financial markets has been extreme and, in most cases, has negatively impacted the value of assets, economic activity and investment opportunities. However, as is the case in every major financial crisis, some asset classes have performed better than others.
We would emphasize that private investments tend to be better insulated against overreaction caused by fear, and given their long-term investment horizon, private equity houses are well-positioned to take advantage of the opportunities that arise, as well as to benefit from any rebound that might occur during the subsequent recovery.
The private equity sector has proven able to withstand previous economic crises, and we believe that this time will be no different. Seasoned management teams learned several important lessons during the 2008 global financial crisis and have developed the skills, knowledge and experience to deal with the current extraordinary situation.
Private equity funds faced multiple challenges following the outbreak of Covid-19. Fund managers had to make coordinated and extraordinary efforts to help the companies in their existing portfolio minimalize the impact of the Covid-19 pandemic, as well as protect their value.
As a consequence, traditional deals activity has slowed down during the Covid-19 pandemic as the center of attention during lockdowns has been on supporting the liquidity of existing portfolio companies. In recent months, however, there have been signs that deal flow is slowly picking up, as managers begin to better understand the economic impact of Covid-19.
Large amount of dry powder
Despite the challenges, the private equity sector has built an unprecedented reserve of available liquidity, and therefore the current scenario offers interesting investment opportunities.
Fund managers will be seeking to deploy capital in industries which have either been relatively unaffected by the Covid-19 pandemic, or have experienced growth, such as healthcare, life sciences, infrastructure, and the “stay-at-home” and technology sectors, as well as follow-on opportunities for their successful portfolio companies. Distressed opportunities will also be, without a doubt, very significant.
In relation to the above, we strongly believe sector expertise will become more crucial than ever.
As a result of the large quantities of dry powder, it is reasonable to expect fund managers to propose extensions to the investment period of their funds in order to ensure deployment of undrawn investment commitments.
In this sense, the ancillary effects of the amendment of the terms and conditions of funds’ legal documents will have to be observed in detail.
We expect the extension of investment periods to have a direct effect on management fees. We foresee that the calculation of management fees will be performed by an alternative method during extensions, such as one based on the total amounts invested, rather than the traditional approach based on total commitments.
Doubts about investor protection
This will also raise doubts with regards to the impact on investor protections provisions, such as key person, change of control and successor fund clauses. It might be expected that these will be affected by the investment period extension. These are just some of the trends we envisage in the coming months.
At the other end of the spectrum, divestments from funds have drastically reduced (an estimated 70 per cent decrease globally) in an effort to mitigate the impact that the depreciation of the portfolios could have had on the rates of return. As with investments, there is reason to believe that as soon as market conditions improve, exits will rebound.
For managers with funds approaching the end of their term, the key question may be whether to extend the term in order to allow the valuations of the final remaining portfolio investments to stabilize.
Alternatively, a GP-led secondary transaction may provide a liquidity solution towards the end of the fund term, possibly with investor optionality to exit with cash or roll into a new fund vehicle. We have witnessed certain GP-led secondaries aborted in the wake of the coronavirus crisis due to the harsh impact on the valuation of assets. However, we expect them to be resumed in the upcoming months as we are starting to notice some preliminary interest as well as activity related to secondary funds structuring. Secondary transactions could increasingly become the main option for obtaining additional resources in a time of crisis.
With regard to funds in their fundraising stage, since the onset of lockdowns, our experience has been that, despite the lower volumes, closings are still taking place.
However, with the objective of reaching their target fund sizes, we have witnessed fund managers extending the final closing dates of their funds in order to give investors who hesitated during the first lockdowns the opportunity to invest.
‘There have been signs that deal flow is slowly picking up, as managers begin to better understand the economic impact of Covid-19’.
Early-bird discounts on management fees
Moreover, with the intention of attracting investors and maintaining the dynamism of the sector, those investors that subscribe in the first closings of the funds are benefitting from significant ‘early-bird’ discounts on management fees.
We have observed that institutional investors have maintained their confidence in the private equity sector but are paying special attention at how fund managers have handled the crisis and added value to their distressed portfolio assets.
In this sense, some investors learned the lesson about the importance of vintage-year diversification, particularly in past economic crises, and have maintained the pace of investment commitments in recent years. Investors that shied away from the private equity sector in the wake of the 2008 global financial crisis regretted it when the economy rebounded during the ensuing recovery and are looking to avoid making the same mistake twice. All things considered, it is clearly easier for managers with established track records – rather than newer managers who have found it particularly difficult to attract investors for their first-time funds.
Likewise, specific risk-factor language regarding the potential impact of Covid-19 has also been incorporated into funds’ offering and operating documents.
In short, the private equity sector, while not being exempt from the consequences of the pandemic, is a key sector for the economic reconstruction and reactivation of the economy and we expect it to outperform other asset classes. It is not yet certain what the longer-term implications of the crisis will be, especially taking into account the second wave of coronavirus infections and lockdowns, as well as the recent positive results in the development of a vaccine, but some are already becoming clear.