Private equity (PE) firms are seeing two key developments as business plummets amid the COVID-19 pandemic. First, funds are working more closely with their portfolio companies to manage the business. Second, the economic fallout is disrupting the deal pipeline throughout the market.
In reality, not all business is plummeting. While most industries face severe dips in revenue and are managing cash flow crunches, some are seeing increased or at least stable revenue. Those companies—healthcare supply and remote-work technologies stand out—must manage new challenges around supply chains and employee safety. Their management, including their PE sponsors, must respond accordingly.
As firms continue to grapple with this crisis, BDO's Private Equity team gathered private equity leaders for a virtual roundtable. Participants shared how they are dealing with the COVID-19 crisis, how they are helping their portfolio companies weather the storm, and how they think private equity will fare in the coming months. This article cites their comments by name for information that is not confidential.
Difficult HR decisions: Act now or wait and see?
PE firms at our roundtable are bracing for difficult decisions to protect their portfolio companies' liquidity during the economic downturn. Most are either considering workforce cuts or have already made some. Future actions depend on how long physical distancing lasts and—more importantly—when and how the economy recovers.
“Our approach is really to manage as if this is going to be a long-term situation,” said one participant. “I think our cuts have been fairly sizable, with a desire to conserve cash over the long-term. Our concern is six months from now, banks may not be as forgiving as they are today, and you're going to be stuck with some tough situations. We'd rather be proactive.”
What concerns PE firms and their portfolio companies is striking the right balance.
On the one hand, management teams have spent their entire careers building profitable, sustainable businesses. They don't want to terminate valued employees or disrupt high-performing teams. On the other hand, as one participant pointed out, terminations now may be necessary to remain liquid.
“You'd rather be scrambling to find resources to build back up than not have that opportunity because you didn't take some pretty tough decisions today.”
Staying connected with portfolio companies
Participants reported a specific challenge when staying connected with their portfolio companies: Just when management needs their guidance the most, communication has become more remote. PEs are adjusting to the new reality.
“While we haven't been able to go on site as much as we'd like to,” said Mark MacPherson of Argyle Capital Partners, “we certainly have had quite a bit of contact with the teams. Before it might have been one day a week and now it might be every day with folks.”
For the funds' mid-market portfolio companies, the PE firm's guidance is especially critical whenever business is not as usual. Smaller companies often lack the internal expertise on niche but key subjects. During the COVID-19 crisis, firms see their role as supporting management through these niche subjects, so they can focus on running the day-to-day of the business. Functions can range from staying up to date on government programs to talking with human-resource consultants to working with financial institutions.
“We're big believers in meeting face to face,” said one roundtable participant, “because we think that's the best way to try and develop relationships and help our management teams. But what's interesting is because we're so connected by phone and video conference, I feel more connected with our team today than I've ever felt.”
The Great Recession revisited? Banks redeem themselves
Financial institutions have shown patience during the coronavirus crisis. At this point, they have been flexible on covenants and payment terms in the corporate and commercial sector—in a way that many observers say was lacking during the previous financial catastrophe.
“I feel like the last 12 years the banking system has really tried to fortify itself for another ‘08-‘09 recession,” said Mark MacPherson. “This is their Super Bowl Sunday. They're stepping up and being proactive and saying, whatever you need, just let us know.”
That being said, at least some U.S. banks may take a less forgiving approach than their Canadian counterparts.
“I have heard of a little less patience regarding what's happening south of the border,” said Sunil Sharma, partner and Managing Director in BDO's Transaction Advisory Services. “It's not necessarily overly surprising given how aggressive the U.S. banking system can be at times, but it's something to be aware of.”
Sharma co-moderated the roundtable with BDO's Adam Mallon and Jamie Windle. Mallon is a partner and Managing Director in Transaction Advisory Services; Windle is a partner and the firm's National Private Equity Leader.
Landlord vs. tenant
Landlords have not been quite as supportive as financial institutions. Responses have varied from deferring and adjusting lease payments to insisting companies live by the letter of the contract.
“There is a minority that are pushing us to be on time, and being really tough on us,” said one roundtable participant. “But the majority have shown some amount of flexibility on deferral of payments, at least over the next 90 days.”
The variability may depend on the type of landlord and the type of tenant. Specialized real estate offers fewer alternatives in tenants than, for example, a big box-distribution centre. The demand side may force landlords into even more flexibility in the months to come.
“I do wonder if we'll see landlords maybe loosen up as we go further into this,” said Adam Mallon, who is based in Edmonton. “We saw that in Alberta through 2014 and 2015, where a lot of landlords had to offer rent holidays because they were not going to get another tenant. And I imagine if the banks do tighten up at some point and more companies start tilting over, that maybe landlords will have fewer options.”
Outlook on PE
Private equity firms can expect an unpredictable 12 to 18 months, based on the consensus of the roundtable participants. Deals initiated pre-coronavirus may need adjusting—if not in purchase price than in structure.
The uncertainty may also stall transactions, as management teams resist guaranteeing financial performance.
“I think it's going to really change on the M&A front how you run sale processes,” said Cody Church of Clear North Capital, “because it's going to be very difficult to run with bids and deadlines and everybody running to the finish line when everybody is scared and visibility is low.”
There is still no shortage of capital available, as PE firms in Canada have recently closed or are in the process of raising new funds. With the cost of capital still low, an increase in deal activity is more a matter of when, not if. Deals may in fact materialize because of COVID-19, as the downturn compels some struggling business owners to sell and nudges some older owners into retirement.
Also, depending on their fund structure, some PE firms in both Canada and the U.S. need to find investment opportunities and close deals. If they don't invest money within their allotted investment horizon, they will lose that opportunity, as they need to start returning funds to their investors. These firms are facing a narrowing window and may need to take on more risk than standard operating procedure dictates.
Whether PE firms look to invest or to advise their portfolio companies, they will need to remain at the ready—alert to opportunities and prepared to take action to protect what they have built.
Learn how BDO's Private Equity practice can help
your business during the time of COVID-19