As the U.S. financial system and broader economy swoon from fear of the damage that the coronavirus will leave in its wake, private equity deal flow will soon begin to feel the pinch. Although data for the first quarter of 2020 is not yet complete, indications are that deal flow has slowed based on the dollar value, deal count and average premiums paid in public deals closed by private equity buyout firms.
Private equity firms should prepare for a period of extraordinary opportunity in the aftermath of the crisis.
But it is important that private equity firms or financial service firms that support them retain a robust reserve capacity to adequately meet demand that will come on the other side of the crisis. It is likely that the private equity ecosystem will experience a “V” shaped recovery following the sharp, albeit transitory, shock that the economy is absorbing.
Private equity firms should prepare for a period of extraordinary opportunity in the aftermath of the crisis. While there will be a sizable fiscal stimulus to mitigate the impact of the shock, those efforts are likely to be a day late and a dollar short. For this reason, private equity firms need to prepare for what will be a once-in-a-lifetime opportunity to scoop up value at a discounted price.
Private equity deal activity is pointing to a slowdown…
In the meantime, though, the slowdown is occurring. Beyond public deals, data on private deals (where neither target nor acquirer is public) is slower to be reported, and developments over the past few weeks point to a slowdown there as well.
Contributing to the slowdown are the restrictions that many industries are facing – limits on non-essential travel and employees being told to work from home as social distancing quickly becomes a priority. This limitation in interaction will most likely hamper deal closings as the auction, due diligence and negotiation process is disrupted for deals that were already in the pipeline.
It does not look good for new deals entering the pipeline, either. Confidence is dissipating quickly as financial markets collapse and financial conditions tighten. Since the last week of February, financial markets have descended into outright panic, with U.S equity markets entering bear market territory for the first time in over a decade.
The VIX Index, or the fear gauge, hit the highest levels since 2008-9…
…. as financial conditions quickly tightened
Source: Bloomberg
Private equity managers are messaging portfolio companies to access credit to prevent any liquidity shortfalls amid mounting stress in the markets. Supply shocks, emergency stockpiling, interrupted spending patterns, dramatic swings in commodity prices and lost income will send consumer prices on a whipsaw trajectory over the next several months.
Certain industries like hospitality and energy are most susceptible to loss.
Certain industries like hospitality and energy require the greatest focus of private equity managers and are most susceptible to loss. With this, certain value-creating projects, like systems implementations, recruiting and digital initiatives have been put on hold as managers have reprioritized their operating agendas for survival.
The coronavirus epidemic has begun forcing deal makers to rethink how to manage risk in mergers and acquisitions. Appetite for deal making will continue to slow as both buyers and sellers adopt a wait-and-see approach. Market dislocations such as these present both risks and opportunities. Private equity firms will need to monitor both sides to capture potential gains and protect against loss.
Opportunities to position for the future:
- Lower valuations: The tightening financial conditions should keep valuations contained and present potential acquisitions at attractive prices. When interest rates decline, so do the prices for risk assets. Private equity firms will need to continue to take calculated risks on good companies if bargains are there for the taking. The sectors that undergo the greatest dislocation will also be the ones with the most long-term opportunity. And with record amounts of dry powder available, many funds will be well-positioned to capitalize on struggling companies seeking strategic partnerships.
- Data and intelligence: Private equity firms in recent years have looked to alternative sources of data to help find new opportunities and manage their operations. The current economic dislocation will put these models to the test. There is a golden opportunity to carefully study data from this period, in real time and in greater depth retrospectively, to better understand changing customer behaviors and preferences and challenge existing operating models. Private equity firms will need to figure out how to creatively leverage the results that the current stress test presents in order to improve the businesses in their portfolio and to inform investment decisions in the future.
- Credit and interest rates: Credit markets have already started to tighten and central banks worldwide have responded by easing monetary policy. While lending will slow in the short-run, it will pick up at some point as coordinated monetary and fiscal policy actions work through the system. The low interest rate conditions, however, seem likely to stay. The yield on the 10-year Treasury is below 1% and is expected to stay there for some time. Private equity will need to take advantage of the low rates at the earliest opportunity when credit markets loosen up to optimize financing of deals and portfolio company operations.
Expectations for rate cuts increased as stocks plunged…
Risks to be considered:
- Liquidity management: As credit spreads widen, those businesses that are highly leveraged with floating rate debt or with maturities coming soon will feel the squeeze. Private equity firms will need to act to avoid a credit crisis that may disrupt operations or threaten survival for their portfolio holdings. Understanding or implementing contingency funding strategies is crucial. This may be in the form of follow-on investment from existing fund commitments, drawing on all available lines of credit and exploring alternative sources of financing such as other asset managers, specialty finance companies or government funding programs.
- Contractual obligations: Unusual circumstances that may arise as economic conditions deteriorate could trigger clauses in contracts that may have seemed benign or inconsequential in the past. Firms should take stock of key agreements, particularly debt arrangements and deal documents, both at the fund level and at the portfolio company level, for clauses that impose certain obligations as a result of unexpected failures to perform. These include covenants, material adverse change, force majeure, indemnity and liability clauses that may be tripped up by any disruptions. Understanding these exposures and moving early toward resolution may alleviate the effect of these contracts.
- Cybersecurity threats: In periods of disruption in the economy, security and privacy concerns may not be top of mind for business managers. But that is the environment in which criminals seek to exploit vulnerabilities. It will be essential for private equity firms and their portfolio companies to remain vigilant and continue to shore up defenses as attacks may accelerate during the coming months.
- Political environment may change: A black swan event like the coronavirus will inevitably have political ramifications. If this global pandemic gets worse it would not be out of the question that a Democratic candidate emerges in the U.S., which could mean significant tax policy reform that could include higher tax rates on personal income and capital gains, and, possibly, a wealth tax.
- Alternative asset classes may emerge: Private equity has become the preferred asset class in asset management as it has outperformed the S&P 500 index by a compounded annual rate of 5% since 2000. At the same time, hedge fund managers have had more dollars redeemed than contributed and many have questioned the long-term sustainability of the asset class. With the recent panic in the stock market, a notable change occurred. For the first time since the Great Recession, the Global Hedge Fund Index outperformed the S&P 500 index. If equity markets continue to drop quickly, investors may reallocate capital to hedge funds that could offer better downside risk protection.
Hedge funds have recently outperformed equities…
The takeaway
Private equity deal flow will take a knock from the effects of coronavirus. Even if the full extent of a slowdown caused by the global pandemic is currently not clear, the disruption that will take place over the next two quarters will present a complicated environment with both risk and opportunity. These will need to be carefully balanced for a firm to emerge stronger from any downturn – however long it may be – and be ready to take advantage when the deal making environment turns the corner.
