Preparing for the turnarounds wave

In March 2020, following years of record-high fundraising and investment activity, and soaring valuations, the European private equity industry had to face the end of a boom. While many sponsors scrambled to manage portfolios, some were already positioned to make investments in the turnarounds and distressed opportunities a downturn can create.

In the five years prior to 2020, an average of five funds with mandates to invest in turnarounds closed each year. In 2020, four such funds have already closed to date.

Prior to the coronavirus crisis, European turnaround funds had raised more than $5bn, according to proprietary research from Unquote Data. That number increased dramatically with the inclusion of US-based funds with a mandate to invest in special situations and complex transactions in Europe. Recently closed funds include KPS Special Situations Fund V, which closed in October 2019 on $6bn and OpenGate Capital Partners II, which closed on $585m in November 2019.

At the onset of the crisis, in addition to this already committed capital, placement agents noted increased interest from LPs in turnaround, special situations and distressed debt funds, where allocations to other strategies, including traditional buyout funds, had often been postponed or cancelled.

In April 2020, one Europe focused placement agent said: "It is obviously a hot space given the market. We certainly see an attractive market and we are going to see a comparatively positive vintage year for turnarounds."

A number of investment opportunities should emerge from the crisis, including opportunities with companies with immediate cash needs" – Francesco Aldorisio, Unigestion

Preparing for battle
In May, a Cebile Capital report showed that 57% of LP respondents felt that the pandemic would impact their relative portfolio allocations in favour of distressed, turnaround and special situations. Through April and May, some LPs began materially shifting or expanding in these areas.

Essling Capital, for example, shelved its fund-of-funds activities, and the subsequent reorganisation increased emphasis on co-investments and direct investment strategies, leaving open the possibility of also including distressed debt and equity offerings.

Speaking to Unquote in April, Hanna Ideström, senior portfolio manager for alternative investment at Swedish pension fund AP4, said: "Our long-term strategy is unaffected in real assets, as well as private credit and private equity. However, we think opportunities could materialise within, for example, secondaries or distressed assets, which we would then actively evaluate."

Sponsors and advisers also began hiring experienced professionals in anticipation of a wave of distressed assets coming to market. Searchlight Capital Partners, a GP with a diverse mandate that includes special situations, appointed Andrew Crowston as a senior adviser in early April. Crowston was previously co-head of Goldman Sachs' European distressed team. Throughout the spring, McDermott, Alantra and Ronald Berger all made hires on their distressed and credit advisory teams.

Fundraising activity for turnaround vehicles also continued in earnest throughout Q2 and Q3. Several funds launched after the outbreak of Covid-19, including ICG Recovery Fund II, which was announced in July 2020 with a €1bn target. LPs in the fund include the Teachers Retirement System of Louisiana with a $50m commitment.

In the lower-mid-market, Spanish sponsor PHI announced its third-generation fund in March 2020 with a target of €50m. The fund invests in distressed companies requiring substantial investments, structural and management changes, and a restructuring strategy to return to profitability, with revenues of €20-250m.

Nevertheless, despite the dry powder available, deal volume continued at a low pace throughout spring. March 2020 saw one turnaround or special situation investment in Europe, while April saw two, according to Unquote Data. In May, sponsors were still waiting for the promised wave, with five deals occurring against four in May 2019.

Francesco Aldorisio, a Unigestion partner in private equity, speaking on the firm's Small and Mid-Market Private Equity webinar in May, reaffirmed the direct investor's interest in turnarounds: "A number of investment opportunities should emerge from the crisis, including opportunities with companies that have immediate cash needs, spinouts from distressed conglomerates, and portfolio companies of GPs that need to generate liquidity for their LPs." But he also implied those opportunities had yet to emerge in large quantities.

In June, four turnaround investments occurred, and both July and August saw six deals each. While this illustrates a slight increase, it does not represent the wave of dealflow that turnaround investors may have been expecting. September saw just two turnaround investments, according to Unquote Data.

We think opportunities could materialise within, for example, secondaries or distressed assets, which we would then actively evaluate" – Hanna Ideström, AP4

Showing its value
The aggregate deal value of turnarounds did increase throughout the year, with Q1 seeing a total of €748m, rising to €901m in Q2. While the third quarter had an aggregate deal value of €2.88bn, against Q3 2019 figures of €110m, this was primarily driven by KPS's stalking horse purchase agreement to acquire Garrett Motion for approximately $2.6bn. The Switzerland-based transportation systems manufacturer had entered into a restructuring support agreement with holders of 61% of its outstanding senior secured debt in September.

Several market dynamics have stymied the flow of turnaround opportunities. Furlough schemes put in place across Europe, such as Germany's Kurzarbeit and France's chomage partiel, limited many businesses' operating costs almost immediately. These, together with government lending schemes introduced to mitigate the effects of the coronavirus crisis, such as the UK's Coronavirus Business Interruption Loan Scheme, have delayed the potential for restructuring or insolvency proceedings for many businesses.

Market participants have suggested that businesses with a healthy pre-pandemic balance sheet could access such assistance more easily than already struggling assets. One UK-based restructuring adviser from a major consultancy says: "What Covid-19 did was accelerate restructuring discussions that were going to happen anyway."

The likelihood of these types of assets finding an investor has been shown to be lower after the crisis than it was before it. Of a sample of 36 companies that have garnered private equity interest since falling into administration or launching a process to find investment between April and September 2020, only 13 have since linked up with an investor, according to Unquote sister publication Mergermarket.

During the Covid-19 crisis it could be more difficult to agree a price – buyers want to know more about the company, and sellers want a higher price than the buyers do" – Gilles Collombin, Charterhouse

For otherwise sound businesses that saw revenue drop overnight, but may not require restructuring yet, disagreements on valuation can also hinder transactions.

When discussing interest from turnaround funds for the assets in his books, the restructuring adviser says: "There is plenty of interest from turnaround funds in distressed assets, but there is a difference between what people will be okay to sell for and what the value of the company is. Funds are waiting for valuations to come down."

Charterhouse head of investor relations Gilles Collombin said in June when discussing buy-and-build strategies: "During the Covid-19 crisis it could be more difficult to agree a price – buyers want to know more about the company, and sellers want a higher price than the buyers do. You may need to wait a few weeks or months before the buyer and seller can agree."

Market participants have also commented on the uncertainties blocking visibility on a target's financial resilience to the current conditions. Says the restructuring adviser: "Everyone has difficulty understanding how companies are rebounding. You would need to get two or three months' worth of data on what sales could look like and then a buyer would be more informed."

The current macroeconomic instability can make valuing even the most stable business challenging. For turnarounds, where risk is already elevated, waiting for more data on a target's resilience to the pandemic is an attractive option.

Barriers to entry
This environment is difficult for new players to enter, despite the potential for a wave of opportunities. Commentators discussed the difference between skill sets required for traditional buyouts versus turnarounds, saying the latter could be more onerous.

Garry Wilson, a managing partner for turnarounds-focused investor Endless, says: "Often, when we come to acquire companies, they are in the intensive care unit. It takes a wealth of experience and a steady hand to guide these companies. It would be difficult for new entrants to opportunistically acquire distressed companies in this environment. We do not expect a full recovery for many sectors for another few years, so you do not have a strong macro trend to rely on for a quick turnaround."

Ken Terry, CEO of lower-mid-market firm Elysian Capital, says: "I worry about competitors in the lower-mid-market investing in turnarounds. There are not that many GPs in the sector who have in-house operating partners who can do the heavy lifting required. It is a different game and I think it is risky."

Accordingly, debut turnaround funds and existing firms without a dedicated strategy now shifting towards distressed investments have proved few and far between. Nordic private equity firm CapMan, for example, launched its first CapMan Special Situations fund to focus on turnarounds in June 2020. However, Joakim Frimodig, the firm's CEO, said CapMan had been discussing launching the fund for almost two years and it was not a response to the Covid-19 pandemic, although that may have accelerated the process.

Indeed, most turnarounds and distressed funds recently launching, or closing, are from veterans, including Sherpa Special Situations III from Southern European GP Sherpa Capital. The fund was announced in May 2020 and held a final close on its target of €120m in June.

Central and eastern Europe has also seen some notable fundraising activity. Jet Investment, one of the largest private equity firms in the Czech Republic, plans to begin fundraising €300m for its third fund, Jet 3, in H2 2021 or Q1 2022, according to partner and board member Marek Malik. The new fund will target buyouts as well as turnarounds, distressed companies and insolvent situations in the Czech Republic, Germany, Poland, Austria and Slovakia, with typical investments of €50-100m.

A lot of investors are sharpening their knives, and there is a lot of excitement, but there has not been a lot of action" – Justin Holland, DC Advisory

Darkest before the dawn
With such slow dealflow, it is unclear when funds will be able to deploy this capital at pace. The consensus is that a wave of turnarounds is still yet to come.

Speaking in August, Justin Holland, managing director for DC Advisory's debt advisory and restructuring team said: "We did not have a real wave. We had a bunch of companies who needed money or needed advice on capital structures. The wave has not actually started yet. It is much more likely to start later this year. A lot of investors are sharpening their knives, and there is a lot of excitement, but there has not been a lot of action."

One UK-based private equity lawyer agrees: "There is a reasonable amount of activity, but it is at an early stage."

Competing market dynamics could suggest that heavy distressed dealflow may not be imminent. Governments are considering extending support schemes and lenders have been amenable to supporting existing customers to maintain liquidity and renegotiate covenants.

However, the European Commission is currently forecasting an 8.7% contraction of the euro area economy in 2020, with Spain, France and Italy's GDP growth each contracting by 11% or more. This will have a knock-on effect on distressed companies in sectors not yet affected.

The UK-based lawyer suggests high-end hospitality could suffer. "The sector was not struggling pre-Covid-19, but with no business for six months, we will see casualties."

Holland points to the automotive sector: "It is very tightly knotted, so if you shut down the assembly line, it has a knock-on effect throughout the entire supply chain. Companies with high operating leverage and high fixed costs will run into a lot of trouble, but many have not restructured yet."

This stalwart sector of DACH-based industry has already seen one casualty in the aforementioned sale of Switzerland-based Garrett Motion to KPS out of bankruptcy.

Buy-and-build has been an important part of investing in struggling businesses throughout the pandemic, and this is expected to continue. Paul Mann of Squire Patton Boggs says: "If you think about a family-run and/or owner-managed SME business, say with £1-2m profit a year, these may well prove to be attractive bolt-on acquisitions in this market, whether that be for acquisitive corporates, or also for private-equity-backed groups. The owners may have originally expected a higher valuation than they are able to achieve now and could be willing to look at different structures to achieve an exit. I am confident that there will be more of these transactions out there."

Down but not out
While many interesting bolt-on targets looking for buyers through the pandemic may not have been going into administration, they may have been struggling or concerned for the future.

Searchlight-backed Global Risk Partners, an insurance broker, has made eight acquisitions since March. Searchlight founding partner Oliver Haarmaan says of the targets: "The company is buying smaller businesses, where the owners are worried about longer-term volatility, or feel like they do not have enough resources to invest in the business if the crisis persists. But these are high-quality assets, with good customer bases and good technology."

Elysian's Terry seconds the firm's interest in struggling businesses as an add-on opportunity. "What we do not do is buy businesses, which, for example, are going bust in four weeks and need to be rescued immediately," he says. "Acquiring a turnaround might work better if it was an add-on."

A number of external shocks over the past decade have led market observers to predict a turnarounds resurgence, but private equity's increasing reliance on lower-risk, high-performing assets to guarantee stable returns has repeatedly foiled such a shift. While it might take some more time to materialise, the post-coronavirus landscape certainly seems poised to offer the strategy its best opportunity to shine in years.

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