Private equity: riding the COVID-19 crisis
15 May 2020
Private equity, with its long term investment horizons and with funds typically having lives of 10 years or more, is usually less susceptible to the ups and downs of economic cycles. The asset class successfully weathered the 2008 financial crash, although debt was initially hard to come by, and with far fewer failures than had been predicted by some observers. The asset class soon resumed its historic, superior returns of around 15% each year. But will this resilience be apparent with the COVID-19 pandemic? Perhaps less so – until things are back to normal, or at least a “new normal”.
What is private equity?
Private equity is medium to long-term finance that is invested by professional fund managers in unquoted companies in return for equity stakes in those companies. It includes equity finance for established businesses often provided to assist management teams to buy out businesses from their existing owners, or growth capital for expansion and early stage finance, otherwise known as venture capital (VC), to help companies grow quickly and scale successfully. This is regarded as a key component both in the development of an entrepreneurial economy and in the innovation process.
Many private equity and VC funds are constituted as limited partnerships whereby investors, such as pension funds, banks, insurance companies, family offices, sovereign wealth funds and endowment funds (the limited partners, or LPs), commit capital to funds which are managed by fund managers (the general partners, or GPs). In 2019 private equity funds raised globally were some $595 billion, down 5% from the largest ever peak in 2018, with almost $1.5 trillion accumulated in funds now awaiting investment. It is too early to tell whether fundraising has been impacted severely by COVID-19 in 2020 to date; certainly both the number of funds and amount raised in Q1 2020 has fallen by 32% and 29%, respectively, compared to Q4 2019, but this is not unusual with the relatively slower fundraising that always occurs at this time of year. Currently there are 3,620 funds in the market globally targeting $933 billion.
There has been a trend in recent years of limited partner investors (LPs) targeting fewer fund managers with larger commitments. This is likely to continue. There may be some rebalancing of asset allocations to private equity and other asset classes in the light of stock market falls. Whilst LPs remain committed to private equity their commitments are likely to fall, with buyouts remaining investors’ preferred fund type over growth and venture capital. Co-investment, where LPs invest in portfolio companies alongside their commitments through a GP-managed fund, may decline as LPs focus on their existing co-investments and shy away from new single company investments. LPs may also be called upon to commit additional capital to shore up existing companies in GPs’ portfolios. Teams trying to raise a fund for the first time may find the fund raising process takes longer than usual, maybe even into two years, due to limitations on travel and fewer opportunities to develop relationships face-to-face in what is very much a people business. Where LPs were already well into due diligence on prospective funds prior to the lockdown this is likely to continue to completion.
On the investment side there is evidence that GPs are cancelling deals or at least delaying them. In 2019, funds invested $393 billion in management buyouts, down 20% from a record high in 2018, and $224 billion in VC deals, down 17% from the prior year. This downward trend, caused partly by high valuations and increasing competition to do deals, is almost certain to continue further into 2020, with GPs now focusing their efforts on safeguarding existing portfolio companies and less time on sourcing new deals – if they plan to do any deals at all. Buyout investments in Asia declined significantly by value in Q1 2020 though the number of deals held up; possibly due to GPs not completing the larger deals due to the COVID-19 crisis. VC deals fared worse in Q1 2020 both in terms of the decline in number of deals completed and the overall value of deals with Greater China suffering the most. PE and VC portfolio companies are cancelling, or at least postponing, their capital spend, reviewing their supply chains, renegotiating rent and leasing agreements, furloughing staff and overall cutting costs where possible and, above all, preserving cash. Investors may be prepared to provide additional capital and, in the UK, there are of course the new government assistance schemes including CBILS (80% guarantee by the government on each loan offered by selected lenders through the state-owned British Business Bank), the Future Fund which matches up to £250m of private investment, and the job retention scheme. Of course there are those who might query why the government should provide support to the portfolio companies of relatively wealthy PE and VC partner led firms, particularly with the large wall of money still awaiting investment as noted above. We have heard of some partners donating their own base salaries to support portfolio companies.
Private equity often benefits from a crisis and change; in time there will be opportunities for PE firms to take public companies private at lower valuations, buy up underperforming corporate subsidiaries and profit from “special situations” (rescues and restructurings) as long as there are no severely underfunded pension schemes involved. Debt providers may be prepared to arrange interest payment holidays, relax principal repayments and suspend covenants. However, exits, essential for PE funds to show returns to their LP investors and to generate carried interest for the GPs, are likely to be delayed with much longer holding periods, a dearth of M&A activity and non-existent IPOs. Fund managers will need to be openly transparent with their LP investors with frequent communication on capital calls, delays in distributions and plans to mitigate the impact of COVID-19. Private equity has successfully weathered economic shocks before and the signs are that it is well prepared to do so again despite the immediate cutback in activity. Some of the best performing vintages were in periods of economic crisis.
(Data derived from Preqin reports)