As an economic crisis, it is unprecedented in the severity of the demand shock, coupled with a profound existential anxiety that will undoubtedly affect business activity and consumer behaviour for a prolonged period.
Indeed, even as public markets rebound, more than 60% of private equity (PE) professionals say they believe that the fallout from the COVID-19 pandemic will be worse than that from the 2008 Global Financial Crisis, according to Investec’s tenth GP Trends survey, which has captured industry sentiment both immediately before and after the world went into lockdown.
Investments holding strong
However, even as PE managers take extreme measures to support their embattled portfolio companies, firms are also anticipating a once in a generation buying opportunity. Almost three-quarters of respondents – 73% – expect returns made from 2020 vintage deals to be at least as strong as those investments made in 2010. That compares to just a quarter prior to the full outbreak of COVID-19 being felt.
In fact, the industry now finds itself in a buyers’ market: 78% expect this to last for up to two years. Before the crisis hit, GPs had a very different view, with 76% expecting, what was then a seller’s market, to last more than a year. “The strength of the private equity industry model is that it can buy well in a down-market and sell well in an up-market,” says Investec’s Head of Private Equity Client Group Jonathan Arrowsmith. “The overall market and valuation reset will create long-awaited deployment opportunities for the agile GP.”
Of course, those buying opportunities will not be immediate. Government emergency response measures will delay the need for distressed sales, while it will take time for buyers and sellers to recalibrate on price.
Before lockdown, two-thirds of respondents expected returns over the next two years to perform at least as well as 2019. That figure has fallen dramatically, with 85% of GPs now expecting returns over the next 24 months to be worse than last year.
As a result, GPs are focusing on shoring up their portfolios and their own houses. One of the most immediate actions that private equity funds have taken in response to the crisis has been to maximise the liquidity available to them.
Indeed, at portfolio company level, 26% of respondents have already arranged additional financing, with 41% expecting to do so soon. Meanwhile, just under a third – 29% – have arranged financing at the GP or fund level or plan to do so in the short term.
Half of those surveyed have already drawn down on all forms of portfolio financing options, such as revolving credit lines. A further 16% plan to do so by the end of September.
The strength of the private equity industry model is that it can buy well in a down-market and sell well in an up-market. The overall market and valuation reset will create long-awaited deployment opportunities for the agile GP.
“In the current environment, there is, understandably, an increased appetite for borrowing, as firms seek to bolster liquidity levels and protect against the impacts of the COVID-19 pandemic,” says Callum Bell, Head of Growth and Leveraged Finance at Investec. “Whilst certain sectors are feeling the pressure more keenly than others, portfolio companies are acting quickly to draw down on financing arrangements, regardless of the markets they serve. We expect many to require further capital, later in 2020.”
“We are experiencing an increased use of the more commonly available fund financing tools, such as capital call and GP facilities,” adds Jonathan Harvey, Head of Relationship Management at Investec’s Fund Solutions team. “We are also seeing an increase in enquiries around some of the less commonly used financing tools, such as Hybrid facilities being driven by the slower exit market particularly focused on the financing of GPs. In addition to that, we are seeing creative solutions begin to emerge as funds look to create liquidity events, either for protecting portfolio companies or to fund future buying opportunities when they have less cash and only NAV available.”
After all, as with the Global Financial Crisis before it, the private equity industry has been divided by firms’ position in the fundraising lifecycle. The evolution of these innovative fund finance solutions, therefore, could prove crucial in allowing those firms, operating towards the end of a fund’s life, to take advantage of the buyer’s market to come.
A third of GPs surveyed have or expect to suspend or postpone fundraising as due diligence becomes practically challenging and limited partners (LPs) prefer to delay commitments. Meanwhile, 17% of respondents have or expect to suspend the investment period on one or more funds, and more than 10% have or expect to suspend all capital calls.
“The percentage of GPs formally suspending the investment period of their funds is already significant, and this figure doesn’t include those who are not making drawdowns, under pressure from their LPs,” says Harvey. “Where established lines of portfolio financing are already exhausted and additional funds are unlikely to be forthcoming from LPs, GPs will need to be more creative in their approaches to funding activity at both a fund and portfolio level.”
We are also seeing an increase in enquiries around some of the less commonly used financing tools, such as Hybrid facilities being driven by the slower exit market particularly focused on the financing of GPs.
Of course, another potential challenge for GPs raising their next funds will be their ability to finance their personal commitments, which, according to the survey, currently sit at a substantial 3.7%. More than a third of respondents – 36% – expect to use carry to fund this commitment, and yet 83% of GPs do not expect to make an exit in the next year. As a result, carry is likely to be materially delayed, if not reduced or wiped out, meaning GPs will have to come up with other ways to finance their skin in the game.
External debt financing to fund a GP commitment can take the form of a personal loan, for example, whereby the bank takes a long-term view on an individual’s prospects, typically backed up with tangible assets such as a house. Alternatively, the corporate can also act as the borrower, based on the collateral of contractual management fees, in order to provide suitable leverage, which the corporate can then on-lend.
“The good news is that we believe that, in the medium term, fundraising will be less materially affected than it was following the Global Financial Crisis,” says Harvey. “Those investors that withdrew from the asset class last time around have come to regret it because the returns from that period were exceptional. I think they will be less likely to make knee-jerk reactions to the current crisis. There may be liquidity constraints but a key difference between now and 2008 to 2010 is that the communication between LPs and GPs has become much more transparent. I don’t think LPs will make the same mistakes again.”
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