Q&A: Cambridge Associates' Featherby on PE's time to shine

Katharine Hidalgo: How has the coronavirus affected the fundraising market so far?

Josh Featherby: It is too early to tell how coronavirus will affect the 2020 fundraising environment, although I doubt we will see the same level of capital raised as over the past few years. Funds that are in the latter stages of the fundraising process are still planning to close, although perhaps they will see demand soften a little. However, for funds that are closer to their launch, we do expect timings to slip as the logistics of raising capital – never mind the debate around appetite – becomes more difficult. Over the past few years, we have seen an increasing bifurcation between funds that find it easy to raise and those that struggle, and I would expect this to widen further.

There are a few small instances of GPs trying to bring forward their fundraises, whether that be to address an evolving opportunity set or to shore up their capital base before we enter more uncharted waters. However, those tend to be the groups with strong existing investor bases, which allow them to raise capital relatively easily. If you have to travel and build new relationships to fundraise, it's going to be challenging. In all circumstances, when it comes to setting fundraising deadlines, we are encouraging GPs to be mindful of the increased complexities that LPs are facing, be that investment committees with other priorities or less efficient documentation processes given remote working.

All that said, investment opportunities do remain and we continue to advise clients to maintain vintage-year diversification, and look to deploy commitment budgets into high-conviction GPs. For some LPs, this may even be an opportunity to gain access to GPs that previously were harder to access.

KH: How might private-equity-backed businesses prove resilient to this recession?

JF: Historical precedent is typically a useful framework for assessing the potential implications of a downturn, but this crisis is so different to anything we've experienced before, or at least for generations. No industry is going to be immune, and private equity is the same. Valuations will take a hit, some invested capital will be permanently impaired, and I expect many GPs will find their funds on the wrong side of history, in terms of levels of leverage used and valuation multiples paid.

That said, there are some green shoots for private-equity-backed businesses: PE firms tend to have more operational expertise today than they did during the global financial crisis (GFC), which should hopefully mean a greater ability to guide management teams through this crisis; the extraordinary rise of covenant-lite loans may provide some much needed breathing room for companies' balance sheets; and over the past decade the industry has seen a general pivot towards sectors and business models that may prove relatively defensive through this downturn, namely technology, healthcare and recurring revenue-orientated businesses.

Perhaps most importantly, PE-backed businesses tend to have the benefit of time relative to their public peers. Management teams, with the support of their investors, are more able to take difficult decisions away from the spotlight of published quarterly earnings figures and may even be able to use this period as an opportunity to reshape their company for the future, be that organically through a strengthened culture or an evolved footprint, or through transformative M&A opportunities. With the support of their GPs, and hopefully the depth of the GPs' pockets, perhaps PE-backed businesses will prove relatively resilient. I certainly hope so.

KH: What market dynamics do you think will affect deal activity?

JF: We have already seen a mixed response from the buyout world in terms of deal activity, with some latter-stage deals still going through, other deals being renegotiated, and some transactions being cancelled altogether. Modelling pro forma revenues, even with the creativity of many PE managers' valuation processes, becomes difficult when effective revenues sit at zero, as they do sadly for many businesses today.

Unfortunately, it is overly simplistic to think that lower valuations will lead to a flurry of deal activity from PE houses looking to take advantage. Unlike in the public markets where the opportunity set remains relatively stable in terms of the number of listed companies for which you can buy and sell shares, private equity requires a constantly revolving door of corporate transactions. Today is not a great time to be selling a company, certainly a good company, and so if you are a wealthy family or divesting corporate you're more likely to try to ride out the storm and try to sell at a more opportune time. This dynamic helped drive a severe decline in the number of transactions through the GFC and I would expect to see the same today.

Aside from this dynamic, there are several others that will limit deal activity, namely distracted GPs needing to focus their energies on existing portfolios, and the availability of leverage for new transactions. However, unique to this crisis is the limited opportunities for thorough due diligence due to travel and social distancing restrictions. It is hard to do due diligence on a company and its management team if you can't meet them in person or walk the factory floor. If, and how, GPs can get comfortable with a different diligence model will also be interesting to watch.

All that said, history demonstrates that the next few years could be strong vintage years to deploy into and so we are actively looking to commit capital across strategies and geographies. Manager selection, however, remains critical.

KH: What do you think will be the long-term effects of the crisis on the industry?

JF: Private equity has an important role to play in the local and global economy, and I believe this will be as true, if not truer, coming out of this crisis. I hope that PE-backed businesses will be at the forefront of responding to the crisis, in terms of corporate responsibility, employee welfare and combatting the health and societal needs of our populations. We are already seeing that in our venture capital portfolios, whether it be through drug development, telehealth or 3D printing.

Will the current crisis affect PE over the short to medium term? Absolutely; PE-backed businesses are real-world businesses that operate like every other, experiencing significant losses in revenue and with employees that will be worrying for both their personal and professional wellbeing. I expect there will be meaningful write-downs, and write-offs, across many portfolios, and very few managers will have net benefited from this crisis. That said, good private equity managers will have learned lessons from prior crises, will stay close to their portfolio companies, providing support where necessary, and hopefully will be able to take advantage of new opportunities at more reasonable entry valuations.

I believe that private equity will again demonstrate an ability not only to preserve capital but to outperform during periods of stress. With prudent portfolio management, and a continued focus on manager selection, institutional LPs can help position their portfolios for a successful future, with private equity at its core.

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