The rapid spread of the COVID-19 pandemic and the resultant shock has been unnerving for the private equity/venture capital industry. By February, only a few macro indicators predicted a recession in 2020. As the scope of the pandemic became global, the proportion rose to two-thirds.
Between Feb 10, 2020, and Mar 24, 2020,EY surveyed 317 PE C-suite executives, asking them whether they’ve included a potential downturn in their investment models for 2020 at three different dates. The percentage of those who did incorporate a 2020 downturn surged from 40% to 67% in the period.
No one knows exactly how the private equity/venture capital industry will look like after the end the COVID-19 pandemic. Yet, a close look at the consequences of past economic shocks provides some hints about how the PE funds and their LPs will react to rapid contraction.
The industry is already facing a drastic fall in global buyout and exit transactions. The same is expected in fund-raising and returns.
Investments
From January to April, global buyout transactions saw a sharp drop of 60% and the number currently stands at around one-third of the average of past 5 years.
As for the main forces, GP’s continue to focus on stabilizing portfolios, lenders are engaged with their current loans, and sellers see high risk in unloading their companies due to volatility.
Leveraged lending by banks has already fallen by 80% as they continue to determine ways to assess risk during high macroeconomic uncertainty.
Yet, dry powder remains at an all-time high in markets. $2.6 trillion worth of private equity funds were lying as unspent capital in April. The most obvious area for putting money to work has been on the debt side of the capital structure.
Before the pandemic took hold, the percentage of leveraged loans trading over 90 as a percentage of par was more than 90%. However, the situation was overturned by late March. The market sent 90% of the loans below 90 as a percentage of par. Since then, there has been some recovery, yet around 40% of the loans were still trading below 90.
Various strategies are being pressed by debt specialists such as direct lending, loan-to-own, distressed investments with no control, etc. Use of analytics has increased to get a better grip over fundamental operating strength.
Equity funds are also leveraging creativity in pursing different types of structured equity deals such as warrants to private-investment-in-public-equity (PIPE) and investments in preferred stock. PIPE are special investments that allow public companies to raise capital quickly when financial institutions are not willing to lend easily.
Hence, hedge funds, private equity sponsors and other investors invested over $8.6 billion in PIPE investments. This also included investments worth $400 million in publicly traded Outfront Media Inc. by Ares Management Corp. and Providence Equity Partners by May 12, 2020.
Exits
Since January 2020, the volume of exit transactions has decreased by 72%. In a recent survey conducted by Investec, 83% of the GPs said they don’t intend to exit any of the companies in the portfolio for the next 12 months. However, this can suddenly change as the market conditions get better.
The global financial crisis of 2008 was different from this pandemic; most of the companies in the PE portfolios had recently been bought before the 2008 recession. However, existing GPs are waiting to sell assets in the normal market.
Since the prices aren’t right, they are not prepared to exit until market returns to normal. Given the aging pool of the assets, the market activity is expected to accelerate very soon.
Fund-Raising
Fund-raising numbers have been pretty impressive through April 2020. Over the first quarter of the year, $287billion were globally raised in funds of all types. By the end of 2020, the figure is expected to exceed $860 billion, matching the trend of previous years.
However, other facts predict that isn’t likely to happen. The majority of the funds raised this year are a result of efforts made before the COVID-19 crisis. Plus, over the next 8 months, LPs are expected to curb their capital investments with PE funds for sure.
In a survey conducted by Campbell Lutyens in April, only one-third of the questioned LPs said they plan to continue making new fund commitments as usual. Others intended to hold onto their commitments and proceed with in-process opportunities while not adding to the pipeline.
One reason for this is the denominator effect. In high-volatility markets, the denominator effect causes the proportion of various asset classes in an LP’s portfolio to get skewed. Of the LPs surveyed by the Institutional Limited Partners Association (ILPA) in early April, 11% expressed deep concern that the denominator effect would limit new allocations by pushing them over their PE targets.
Returns
Since market-to-market evaluations aren’t quick in a downturn, returns tend to lag. However, in a recent survey conducted by Campbell Lutyens, the majority of GPs and LPs said they expected not less than 15% write-downs in the first-quarter valuation of funds. To take bulky write-downs, funds tend to eliminate the bad news as soon as possible.
Yet, considering the market volatility, lack of comparable transactions, and cash flow troubles for companies, it’s pretty difficult to value corporations in this environment.
According to recent insights, deals preceding the downturn aren’t performing as good as those made during and after the downturn. Staying on offence is the best tactic to maintain strong returns in the long run.
Final Word
In summary, PE firms have a role to play in helping their portfolio companies in mitigating the effects of COVID-19. With enormous dry powder volumes, PE companies are in a great position to offer expertise and capital, both of which are required in the current environment.