Covid-19 impact expected to be more severe than GFC – survey

Dechert held a webinar in December to coincide with the release of its Global Private Equity Outlook. Panellists from Dechert were partners Ross Allardice and Siew Kam Boon, as well as Markus Bolsinger, partner and co-head of private equity. Guest speakers were Greg Belinfanti, senior managing director at One Equity Partners, John Bolduc, executive director at HIG Capital, and Emilio Pedroni, managing director at First Atlantic Capital.

Comparing Covid-19 with the GFC, 44% of those surveyed think that the pandemic will affect the market more severely, while 32% say it will only be slightly more severe. Meanwhile, 24% expect the effect to be of a similar severity to the GFC. Almost all of the GPs expect distressed deals to increase (90%), while 82% cited more deal delays as a feature that will emerge from the crisis. A further 64% expect to see more fund restructurings, and 55% expect to see a suspension of fundraising.

"The number one obstacle for deal-making is valuation," said Belinfanti of One Equity Partners, commenting on the challenges in the current market. "Availability of debt has increased dramatically – there was a tremendous amount of uncertainty in March and April, so some people made investments and took opportunities not to lever. Now we are in December, debt markets are open and basically back to their 2018/19 levels. But the combination of extremely available debt capital markets and robust public market valuations makes valuations challenging. In recent memory, this feels like 2000 from a valuation perspective."

"The market has been extremely efficient in overcoming most of the obstacles that existed," Belinfanti noted. "LPs have been incredibly pleased with the resilience of PE portfolios. And people are very accustomed to the virtual world, and I think a lot of what was done in person will continue to be done on platforms. So the main obstacle is now valuation."

"We still see a lot of pain in the economy," said Bolduc. "There is a real difference between how Wall Street and Main Street are faring. Large percentages of the economy, which comprise a large percentage of GDP, are scarred. In addition to retail, hospitality and travel, even the companies serving these industries – those who provide services such as repairing cruise ships, for example – are facing problems. So we will see a lot of stressed and distressed deals in sectors with secondary effects that have been hit hard."

Exit opportunities are expected to remain "very unfavourable" or "somewhat unfavourable" by 61% of the survey participants. Securing a buyer willing to pay the desired valuation and determining the right type of exit were two factors cited by 20% of GPs each, although the most common challenge was determining whether to hold a portfolio company for longer, to take advantage of expected growth or until the market recovers (22%).

In spite of market and geopolitical uncertainty, as well as the lack of certainty on the rate of vaccine deployment, the panellists remained optimistic for deal-making opportunities in 2021, with dry powder cited as a key factor. SPACs were highlighted by Belinfanti as both a potential PE buyer and an exit alternative, while Dechert's Boon said the number of corporates competing with PE funds is likely to increase, as will the growth of tech-oriented funds and the consolidation in the distressed space.

Deep pockets
The survey revealed that PE players in Europe, the US and Asia-Pacific have $1.7tn in dry powder. Dechert's Bolsinger said: "The past decade has seen the global PE industry build up a substantial war chest. It's now essential to focus on industry verticals – the days of the PE generalist are over, people need to operate opportunistically, embracing different deal structures and diversified asset classes. Growth capital, carve-outs, buy-and-builds, and partnering with strategic buyers will be important in this uncertain but competitive environment."

Of the GPs who told the survey that they were currently fundraising, the greatest challenges cited in this process were convincing investors that their capital would be put to work quickly (26%) and LPs' inability to conduct sufficient due diligence (also 26%). Other challenges cited were large LPs concentrating their investment relationship on a smaller number of funds (17%) and competition with other funds for LP capital (13%).

Many GPs are considering expanding into new asset classes, albeit a smaller proportion than the last time the survey was conducted. Of the GPs surveyed, 57% said they would certainly or most likely diversify their asset class exposure; of this group, 29% said they were seeking advantages of larger scale, while 24% cited seeking higher returns or specific opportunities in new asset classes.

LP interest in co-investment remains significant, with 74% of GPs reporting that the level of interest in co-investments and joint ventures among their LPs has increased in the last 12-24 months. LPs' desire for greater control on the direction of portfolio companies was cited by 30% of GPs as a driver for this, while a further 28% said LPs seeking to average down the overall cost of investing was a factor.

Dechert's survey also assessed GPs' appetite for selling stakes in their own firms to third parties. Although the majority of GPs surveyed had not sold a stake in their firm in the past three years, 37% of GPs said they would consider doing so, with succession planning cited as a motivation for 41% of this group. In the previous survey, 45% cited gaining access to growth capital for new lines of business, while this year just 34% named this as a driver.

Creative deal structures
GPs are increasingly prepared to embrace less straightforward ways of deal-making in order to deploy capital. Of the 36% of GPs who said that they generally retain a minority stake when exiting a portfolio company, 50% said that their targeting of minority investments, including retaining a stake on exit, had increased. Making lower-risk investments or diversifying risk was cited as a motivation for this by 32% of these GPs, while 24% said such arrangements can be attractive to founders who are resisting a control investment.

Dechert's Allardice said: "There is a clear shift towards certain groups of sponsors participating in minority stakes." He also noted that many GPs are taking a long-term view on distributions and investments. "We have seen a rise of secondaries and continuation vehicles, so that funds can distribute to existing LPs but retain the asset. Sponsors are taking a long-term view on certain portfolio companies: if now is not the right time to sell, this makes sense."

Partnerships with strategic investors are also key to the deal structures that GPs are considering. More than half (54%) of those surveyed said they are very likely to increase these deals in the current environment, while 44% said they were "somewhat likely" to increase their activity in such transactions. Two thirds of the PE players surveyed also said they expect carve-outs to increase in the next 12-24 months, with corporates selling business units to pay down debt highlighted as the most important driver by 33% of participants.

One Equity's Belinfanti noted that communicating and partnering with large strategic players to assess their portfolio and how to create value is a key part of the firm's strategy, enabling them to access carve-out deals. Pedroni agreed that carve-outs are a key source of opportunities for both platform investments and add-ons, but also noted that partnering with strategic investors in acquisitions is likely to mean that GPs have to agree on an exit price and limit exit options.

Buying and building
Data from Mergermarket cited in the survey showed that there were 1,249 add-ons completed in the Q1-Q3 2020 period, an increase of 28% compared with the same period in 2019. Although the size of these deals did decrease, the panellists agreed that GPs continue to view buy-and-build as a compelling value creation strategy.

Bolsinger also set out the key advantages of pursuing a buy-and-build strategy: "Buy-and-build is a proven strategy that results in EBITDA expansion and multiple expansion of the add-on business by folding it into a larger and more stable enterprise that demands a larger multiple; and there is revenue expansion by cross-selling. If executed well, it is a win-win for the companies you are bringing on board, as well as the platform companies."

GPs in the survey were asked to select their top two challenges in executing buy-and-build. Almost a third (32%) cited generating and/or raising acquisition capital, including debt, within the portfolio company as a top challenge. Formulating a strategy for synergies and growth was also cited as a top challenge by 31% of participants. Of the factors that came in second place, integrating the add-on and identifying sufficient suitable targets during the holding period were both cited by 22% of GPs, with gaining buy-in from the management of the target companies in a close third place (21%).

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