The private equity industry has been affected by the COVID-19 outbreak, in common with most other industries. But how insulated is it? And what changes in practice have we seen?

External uncertainties

In addition to COVID-19, this all has to be set against the background created by both Brexit and the tremendous political uncertainty created by the 2020 US presidential election. 

We live in interesting times. 

It is arguable though that, whilst banks have found themselves increasingly tied up in regulation since the financial crisis of 2007/8 and the returns of public markets have fallen when compared with the PE market generally over the last 10 years, the PE market today is in prime position to stand tall and grow in its attractiveness for investors. 

Over recent months, however, there has unquestionably been a slowdown in deal activity and, partly as a consequence, focus has switched towards existing investment portfolio management. A case of seeing if more value can be squeezed from existing investments rather than seeking new, more risky ones. 

There is also another pressure point for those PE houses which raised funds shortly after the 2007/8 financial crisis: the private-asset managers managing the funds (the general partners or GPs) are finding themselves under increasing pressure to crystallise investments and share the resultant fruits with their limited partners (the suppliers of capital) as these funds gradually mature. 

Changes

So what changes in behaviour have we been seeing in recent times? As a result of this more uncertain environment, we are seeing three main changes.

There is increased pre-investment diligence, particularly for investors wanting to assess the likely (but difficult to predict) impact on target businesses being caused by Brexit at the same time now as trying to understand and quantify the long-term implications of the COVID-19 pandemic. 

Challenging to even the most adept of economic forecasters.

Of course, every cloud (and all that) means that market uncertainty can and does throw up new opportunities, particularly for cash-strapped businesses. 

We are also seeing issues surrounding directors’ potential liabilities becoming ever more prevalent – there is growing pressure in the UK and across the rest of Europe on directors and how they operate and make decisions, particularly in relation to bribery and corruption, money laundering, modern slavery, sanctions and tax avoidance and evasion. It is quite obvious that directors are being held to a higher standard of responsibility, in some cases even to a criminal level, for acts which previously might have fallen behind the corporate veil. This impacts the private equity industry by inevitably resulting in an increased focus on internal compliance processes and procedures – increasing costs and time spent in evaluation. 

We have also seen the debt: equity balance alter over the last 10 years with debt forming a larger part of investments. Lending has been moving away from traditional lending banks to more specialised private-credit firms. The industry has seen a growth of closer relationships between the PE houses and these more specialist lending firms as they are more in tune with the PE market they serve. This evolution, coupled with the terms of the lending used to back PE deals seeing a shift to more ‘covenant-light’ agreements, has resulted in investee companies being able to withstand bigger falls in performance without triggering penalties from their lenders. This ‘elasticity’ has limits though and falls in performance during these difficult but hopefully short-term times has resulted in an increasing willingness by PE houses to ‘cure’ the problem of lenders getting concerned by injecting cash for fresh equity. 

Watching brief

It is going to be very interesting to watch the PE market in coming months – there is undoubtedly a growing pile of cash (or to be more accurate – committed but unspent capital, otherwise known as ‘dry powder’) ready to be applied towards new investments. Whilst some of this is currently going into supporting existing investments, helping them through this trying and quite unusual period, there remains much to be spent on new investments. And with prices depressed, we expect to see PE houses start reacting more quickly than trade buyers to these new opportunities. This could be an excellent time to buy.