By Vincent Wess (WHU - Otto Beisheim School of Management)
Photo: Fusion Medical Animation (Unsplash)
This report is meant to provide insights on how the COVID-19 pandemic has influenced the private equity industry in the first quarter since the beginning of the outbreak and how the current healthcare crisis will impact the industry going forward. In particular, we will address not only the impact on current buy-out activity but also how other parts of the private equity value-chain, such as fundraising, exits of investments, and fund performance, have been and are going to be impacted.
Section 1: Impact on Buy-Out Activity and New Deals:
In Q1 2020 global buy-out activity measured by deal count has decreased by close to 60% from January to April which compares to a 50% drop in activity in the period following the Financial Crisis
Economic uncertainty, difficult pricing discussions between buyers and sellers, decreases in leveraged bank lending, and lower leverage levels in buy-out deals are the key drivers behind the low levels in buy-out activity in Q1
Section 2: Impact on Investment Exits:
Global buy-out-backed exits have decreased by 72% from January to April in the first quarter of 2020, which compares to a 62% drop from levels seen in 2007 to 2009 in the aftermaths of the Financial Crisis
Declining valuation multiples, uncertainty about the shape of the economic recovery as well as the impact on individual business performance going forward have led GPs to remain on the sidelines when it comes to exiting investments
Section 3: Impact on Fundraising:
In Q1 2020 global funds across all types saw inflows of $287bn which is in line with recent years on an annualized basis
With negative net cash flows to LPs and the denominator effect working against additional capital allocations to PE as an asset class, short-term fundraising conditions are likely to be less favorable than in recent periods
Section 4: Impact on Fund Performance:
In a survey with LPs and GPs globally, Campbell Lutyens finds that GPs and LPs expect write-downs exceeding 15% in funds’ first-quarter valuations
Write-downs at Apollo and Blackstone came in at the low 20 percent levels indicating GPs preference to front-load losses into one quarter
Section 1: Impact on Buy-Out Activity and New Deals
Given the scope of the COVID-19 pandemic and the multidimensional uncertainty that comes along with it, it is impossible to make a precise statement on how buy-out activity will be affected going forward. However, it is possible to evaluate the impact of the pandemic on Q1 buy-out activity and put predictions into the context of the 2008 Financial Crisis, accounting for the material differences between the two crises.
In Q1 2020 global buy-out activity measured by deal count has decreased by close to 60% from January to April. This compares to a 50% drop in activity in the period following the Financial Crisis. However, the full-year effect of the pandemic on 2020 buy-out activity remains highly uncertain as well as the mid-term impact on the industry's performance.
Image: Global Buy-Out Deal Count (Bain report)
What needs to be highlighted is the resilience in activity observed in the European buy-out market, where deal volume in the first quarter has even increased more than 110% year-on-year from €23.2bn in 1Q19 to €48.9bn in 1Q2020, according to data from Mergermarket.
Image: European Buy-Out Activity Quarterly Breakdown (Mergermarket)
Many factors have contributed to the strong decrease in global deal activity. One of the more obvious ones is the overall uncertainty created by the current pandemic. Which investment themes and industries will stand out most positively and negatively in a post-pandemic world is still highly uncertain and so is the shape of the economic recovery from this unprecedented crisis. While it might be easier for buyers and sellers of private companies to agree that the economic recovery is unlikely to be a V-shaped one, the pandemic has created a strong gap in price expectations because buyers’ and sellers’ interests and viewpoints are developed in a highly uncertain business environment. Consequently, different expectations of the persistence of the current demand shock and a low degree of certainty about how to model the impact of COVID-19 on business performance are disrupting many buy-out transactions, especially in terms of pricing.
Another key factor to consider is access to capital. According to Preqin, the private equity industry, including venture capital, sits on more than $1.45tn in cash that needs to be put to work to earn returns for Limited Partners (LPs). In addition to that, a recent Bain report estimates that the uncalled capital in the industry is currently at $2.5tn of which $800m belongs to buy-outs alone. Clearly, General Partners (GPs) have a strong mandate to put this equity capital to its best work by investing in new deals and helping struggling portfolio companies to meet liquidity needs. Conversely, the debt part of the financing structure has become the constraining factor to new deals, with credit markets tightening strongly since the outbreak of the pandemic. Leveraged lending by banks is down close to 80% from the beginning of the year, which compares to a year-on-year drop of only 77% following the Financial Crisis. This is mainly driven by the fact that banks have shifted their operational focus to preventing outstanding loans from default and have become more reluctant to finance transactions with aggressive leverage ratios.
Image: Global Leveraged Loan Issuance (Bain report)
The need to commit more equity capital to a given transaction relative to previous quarters will be further enhanced by a likely contraction in leverage levels. According to Refinitiv, more than three-quarters of US buy-outs showed a leverage multiple of more than six times EBITDA at the end of 2019. This trend is likely to be reversed in the short-term given the tightening of credit markets and a de-risking of loan portfolios by banks.
Image: Share of US Leveraged Buy-Out Market, by Leverage Level (Bain report)
As a report by Bain suggests, the strong contraction in leveraged lending by banks will be somewhat offset by private debt funds lending directly to borrowers in buy-out transactions. Given the rise of private debt funds over the past decade, the importance of private debt and the amount of funding it can provide to businesses has increased tremendously since the Financial Crisis. According to Preqin, private debt funds, as of June 2019, have more than $812bn in Assets under Management of which a significant portion is likely to be allocated to the financing of private equity buy-outs. Additionally, these funds will help private equity-owned companies to raise much-needed cash to manage liquidity risks given the unprecedented pressure on cash flows and working capital. Another interesting observation is that GPs are increasingly engaging in structured equity deals. These structured equity deals allow private equity companies to quickly build stakes in companies at oftentimes favourable conditions relative to the public markets. Especially private investments in public equity (PIPE) are becoming increasingly relevant as it allows public companies to raise cash quickly in order to avoid liquidity issues by issuing equity- or debt-linked securities, such as convertible preferred stock or bonds directly to private equity funds at individually negotiated terms. With recent PIPE deals involving well-known brands such as Dave & Buster’s, Redfin, and EVO, PIPE deals are set to raise more money than in any year since 2008.
Section 2: Impact on Investment Exits
As market volatility and uncertainty has increased significantly in the light of the ongoing healthcare crisis, multiples in both public and private markets have started to decline. As data gathered by Mergermarket on European buy-outs shows, EBITDA multiples have already started to contract by more than 10% from an average of 12 times EBITDA in 2019 to only 10.7 times EBITDA on average in Q1 2020.
Image: European Buy-outs – Median EBITDA Multiples (Mergermarket)
Additionally, it has become significantly more difficult for GPs to exit investments as the more common exit strategies, such as IPOs or sales to Strategic Buyers, have become less viable in the environment created by the pandemic. The focus of Strategic Buyers, on the one hand, has shifted in many instances to preserving liquidity and managing existing operational risks rather than pursuing large-scale acquisitions involving large cash investments. On the other hand, while secondary offerings and PIPEs have become a viable option to raise cash quickly in order to manage short-term liquidity risks for many businesses, IPO activity has decreased significantly in the later months of the first quarter as market conditions remain volatile and institutional investors stay on the side-lines.
Consequently, global buy-out-backed exits have decreased by 72% from January to April in the first quarter of 2020, which compares to a 62% drop from levels seen in 2007 to 2009 in the aftermaths of the Financial Crisis. However, exit activity could pick-up more quickly compared to the period following the Financial Crisis. This is based on the observation that the average age of assets held by GPs is higher relative to the age of the assets held by GPs before the Financial Crisis. Many of the portfolio companies of expiring funds were supposed to be exited in a normal market but GPs are expected to wait for market dislocations to be resolved to earn acceptable rates of returns for buy-out-backed investments.
Image: Global Buy-Out-Backed Exits, by Channel (Bain report)
Section 3: Impact on Fundraising
Contradictory to what one might expect, fundraising in the first quarter of 2020 was solid and consistent with levels observed in previous years. In Q1 2020 global funds across all types saw inflows of $287bn which is in line with recent years on an annualized basis. A good example for the robustness in fundraising is Blackstone, which has just raised a new fund for its core private equity business and was able to raise the entire $5bn in the last two weeks of March despite logistical challenges caused by travel restrictions. However, GPs are likely to see short-term fundraising conditions becoming more difficult as many indicators point to lower allocations from LPs in the coming quarters.
Image: Global Private Capital Raised, by Fund Type (Bain report)
One such indicator is the predicted development of cash flows on the side of LPs where outflows are expected to surpass inflows as exit activity remains low and portfolio companies continue to need liquidity injections from funds provided by LPs directly. This might lead to a liquidity squeeze for some LPs as net cash flows are likely to turn negative with distributions falling short of contributions until the sentiment and uncertainty point to a more exit-friendly environment.
Image: Capital Contributions and Distributions for Global Buy-Out Funds (Bain report)
According to a recent Bain report, the drop in fundraising over the periods following the Financial Crisis is likely to be larger than the drop associated with the COVID-19 crisis. The main reason is that LPs who decided to allocate smaller portions of their Assets under Management to private equity missed the strong returns GPs were able to deliver during the last decade, especially when looking at the returns achieved by buy-out funds.
Looking at LP sentiment, a recent survey by Campbell Lutyens points out that fewer LPs continue to allocate capital to private equity as they used to with less than one-third of surveyed LPs continuing to conduct business as usual. Additionally, the percentage of LPs surveyed stating that no additions to the existing pipeline of GPs are being made has increased from March to April, pointing to smaller funding rounds for GPs relative to previous years in which more recent funding rounds outperformed prior ones often by great margins.
Image: LP Sentiment Update in Percent, by Answer to the Survey (Bain report)
Another more structural factor limiting inflows into private equity as an asset class is the denominator effect observed on the LP level. Given that LPs tend to have a fixed percentage of Assets under Management that can be allocated to private equity as an asset class, once this percentage is reached or exceeded, LPs cannot add new GPs to their pipeline or increase capital commitments. This effect is based on the dynamic that sharp decreases in public equity valuations lead to a sudden drop in the value of the overall portfolio on the LP level while valuations in private companies are updated only on a quarterly level. This means that the private equity share on the LP level increases sharply until private company valuations are updated at the end of the quarter. This leads to a temporary increase in the relative share of the private equity proportion on the LP level. However, this effect is structurally short-lived and will not impact fundraising significantly in the mid-term but could still lead to lower capital allocations to private capital and alternatives for many LPs in the short-run.
Section 4: Impact on Fund Performance
The impact of COVID-19 on private equity funds and their financial performance differs strongly on a fund by fund basis depending on the exposure to different sectors and investment themes. While Blackstone saw a decline of 21.6 percent in Q1 on its corporate private equity portfolio, the portfolio excluding investments in energy would show a decline in value of only 11.1 percent. Apollo’s private equity portfolio saw a decline in value of 21.6 percent as well, while gross losses in KKR’s private equity portfolio for the quarter amounted to only 12 percent. In a survey with LPs and GPs globally, Campbell Lutyens finds that GPs and LPs expect write-downs exceeding 15% in funds’ first-quarter valuations. Since GPs like to report strong decreases in valuations in one chunk as opposed to spreading them out over several quarters to avoid the need to adjust valuations downward again in subsequent periods, valuation decreases reported by the largest funds are likely to be very conservative.
Image: Size of Expected Valuation Write-Downs for the First Quarter of 2020 (Bain report)