Private equity will need to adapt and learn a few things to succeed and thrive in a post COVID-19 environment.
By Ted Koenig, President & CEO, Monroe Capital –
Private equity, in most cases, was left out in the cold from the CARES Act and Paycheck Protection Program (PPP) – a victim of the SBA’s affiliation rules that deem most private equity-backed companies ineligible for government aid. While some businesses are certainly better positioned than others, the coming liquidity crunch will become more palpable across private equity and their portfolio companies as government stimulus fades and the impact on the consumer spreads to other sectors, even those not directly in the path of the COVID-19 disruption.
This is not to say the private equity asset class hasn’t already felt the squeeze. Data from Burgiss Group for instance, documented that following the global financial crisis (GFC) from 2007 to 2009, valuations of existing private equity-backed assets fell by 35% on average, suggesting a similar markdown could be in store. And publicly reporting managers Apollo Management and Blackstone Group have already documented matching 20.6% drops in the value of their private equity portfolios in the first quarter.
In the teeth of the 2008 credit crisis, it was impossible
to understate the importance of liquidity.
With the government tap largely closed to private equity, sponsors are counting on private debt to help shore up their balance sheets. The catch is that while many will talk about a “V” shaped recovery, those who have been through multiple cycles aren’t as optimistic, at least not until some semblance of normalcy returns and allows lenders to model out how a recovery could take form. Today, we think the recovery will look much more like a Nike “swoosh” logo than the letter “V” or “U.”
To be sure, there are similarities to past “black swan” events, but other than the scale of the dislocation, the current backdrop is more notable for its differences. That’s not to say, however, that lessons that the private credit industry learned from the GFC don’t apply. Private equity firms are well-advised to learn from these same lessons and take note.
Lesson One: Liquidity is Key
In the teeth of the 2008 credit crisis, it was impossible to understate the importance of liquidity. Failures at the time didn’t stem from degrading net income or lower gross margins, but rather asset-liability and liquidity mismatches stemming from the capital markets freeze. Rent, payroll, and compensating critical suppliers are the first, second, and third priorities today for many companies and their private equity owners. As such, private equity investors should recall and heed the significant premium on liquidity.
It is imperative that private equity sponsors engage in an active dialogue
with their lenders at this crucial time. Surprises are in nobody’s best interests.
The market, today, is seeing the same scenario play out. It will only become more pronounced as the government band-aids give way to a new reality in which unemployment levels reset far higher than year-ago levels, fueling consumer-spending decreases amid economic uncertainty. The market will get a better sense in 60 to 90 days when the PPP program lapses, but companies should be planning for what happens if the pandemic and its effect on business activity outruns government stimulus.
For private equity, which by and large isn’t privy to government funding, many sponsors are already facing hard decisions. Through this lens, many are dividing the world into two categories: portfolio companies facing temporary disruptions and those with a less-certain path forward. The push into “experiential” categories, for instance, was driven by a secular tailwind that, overnight, reversed course and turned into a cyclonic headwind for investors. In certain cases, this shift may be more permanent, putting into question whether these businesses can survive. Moody’s baseline forecast, as of early April, predicts the global corporate default rate will jump from 3.5% to over 11% over the next 12 months. Unemployment in the U.S. today is already estimated at over 35 million, a staggering number by any read of past historical precedents.
Lesson Two: Attentive Engagement is Critical
Amid such widespread economic disruption, clarity around the direct and secondary impacts can be hard to discern. The best way to serve stakeholders is through staying active, present, and by “over-communicating.”
To help companies manage through the coming liquidity crisis, essentially everything is on the table. For assets positioned to re-emerge and resume 2019 growth trends, lenders are working with private equity sponsors to ease or waive covenants or defer interest or principal payments, in some cases. This cooperation is even a bigger factor in the small and middle market, where the absence of covenant-lite loans can trigger these conversations sooner, allowing investors to pull the appropriate levers and improve recovery rates and minimize losses. It is imperative that private equity sponsors engage in an active dialogue with their lenders at this crucial time. Surprises are in nobody’s best interests. Lenders have their own lenders with their own formulas and models. Ignoring the concerns of your financing partners or showing arrogance will almost certainly result in loss of control and other undesirable results. Lenders are going to have a much shorter fuse in this current environment and will tolerate far less in terms of denial from private equity sponsors or a lack of action.
The key to success is that private equity sponsors will need to come to the table with collaborative solutions that don’t merely shunt added risk onto their lenders and other creditors.
Lesson Three: Differentiation Through Portfolio Management
Nobody could predict that a pandemic would trigger a global recession, but careful underwriting, conservative capital structures and active portfolio management would have at least prepared investors to confront the unexpected.
Those funds that have liquidity and dry powder to deploy will make
lemonade out of lemons as they will be able to actively support
their investments and play offense in this current market.
But beyond just diversification and managing risk, most overlook the role of portfolio management to take advantage of the opportunities presented by a dislocation. At the tail end of any cycle, for instance, there will be a tendency for some private equity firms to loosen terms or overlook historic underwriting standards to put capital to work. There was just too much dry powder and too many seductive deals to pursue. Those who were too aggressive at the peak, however, are now in triage mode and can’t react to the current pipeline of dealflow that is generally far more attractive on a risk-adjusted return basis.
Even in this environment, when there is a significant premium on liquidity, private equity sponsors who are active in the market will likely focus on quality and diversifying new commitments across industries and transaction types, as well as providing support to existing portfolio companies.
Lesson Four: Dry Powder Enables an Offensive Approach
Many may forget, but the GFC effectively gave birth to the private credit asset class. With long-term, locked-up capital, private debt was much better equipped than commercial banks to be flexible in volatile markets, whether to provide relief to existing borrowers or take advantage of mispricing opportunities as liquidity dries up. And those with dry powder, to be expected, will be opportunistic. This is taking form today as distressed or rescue-financing arrangements, debtor-in-possession loans, and discounted secondary purchases of performing first-lien loans. This same thought process can be applied to private equity. Private equity funds at the end of their life or targeting very narrow specialties, with high concentrations in one or two sectors, are going to struggle in today’s environment. Those funds that have liquidity and dry powder to deploy will make lemonade out of lemons as they will be able to actively support their investments and play offense in this current market.
The best vintages for both private equity and private debt funds
have historically followed periods of disruption.
However, not all of the recent entrants into the private equity space will necessarily survive. A large proportion of the newer names, for instance, have built up considerable concentrations in industries that are likely to be affected (such as physician- and dental-practice management rollups or retail and consumer-oriented investments, among others). To put capital to work, and “win” these deals, many transactions were supported by high leverage multiples, paid for at very high multiples, with addbacks and adjustments unlikely to ever be realized. Again, this is why portfolio management and diversity of investment is so important to help balance out the risk of unexpected market shocks.
The good news is that institutional investors are again looking to grow out their private equity allocations in a post Covid-19 environment to capitalize on an opportunity set that only emerges about once every decade. The caveat is that they will be discriminating in selecting managers with the requisite track record and experience. The private equity industry should pay attention and learn the lessons the private credit industry is willing to teach.
Anecdotally, those private equity firms with capabilities around distressed debt, specialty finance, or other “opportunistic” strategies — uncorrelated to traditional leverage buyout exposures — are seeing more interest from asset owners who are carefully choosing their spots amid the volatility. It’s also not lost on anyone that the best vintages for both private equity and private debt funds have historically followed periods of disruption.
It’s been nearly two months since California became the first state to issue a stay-in-place order. As others who followed suit now begin to lift these restrictions, investors still have very little clarity around what a recovery will look like.
Coming out of the global financial crisis, businesses drove the rebound through technology spending and expansion activities. This time around, the consensus is that it will be the consumer who will be counted on to spark a recovery. That being said, there are so many variables that lenders in the near term will focus on credits with the fewest unknowns. For private equity, when deal activity does resume, this will translate into something of a reset as it relates to leverage levels, terms, and purchase prices. But private equity sponsors should rest assured that the private credit market will endure and will step in to help the private equity asset class regain its footing once clarity returns.
About the Author
Ted Koenig is the president, CEO and founder of Monroe Capital and the chairman, president and CEO of Monroe Capital Corporation (NASDAQ: MRCC). Monroe is an active provider of senior and junior debt financing to middle market businesses, special situation borrowers and private equity sponsors. Investment types include unitranche financings; cash flow, asset-based and enterprise value based loans; and equity co-investments. The firm was founded in 2004 and is headquartered in Chicago with additional offices in Atlanta, Boston, Los Angeles, New York, and San Francisco. Mr. Koenig is a frequent lecturer to various business and financial organizations and has published numerous articles in the areas of mergers and acquisitions, corporate and leveraged buyout finance, and general business and economic trends.
Private Equity Professional | May 22, 2020