Beyond COVID-19: investment opportunities for private equity and private debt
The sudden and dramatic spread of COVID-19 has resulted in both a global health pandemic and an economic crisis like no other, triggering an unprecedented global shutdown. As businesses begin to restart and economies recover, there will be opportunity, even if we see a global recession.
A global recession, at least to some commentators, seems to be unavoidable, with many companies facing unprecedented obstacles and challenges to their businesses in the coming months. However, for some there may be opportunities to acquire fundamentally good businesses with distressed balance sheets at significantly reduced valuations.
In this article, we will:
In the UK, the Government and the Bank of England have introduced a number of measures to help keep businesses going, including:
Such measures are intended to provide a safety net for businesses as we enter a potentially global recession in order to bridge the gap so that, when the economy eventually emerges from this crisis, we witness a quicker and more sustained recovery.
The shape of that economic recovery ("U", "V" or "W"…?) has been the subject of intense speculation. Some economists are forecasting, perhaps optimistically, a V-shape recovery with a sharp slowdown through Q2 (which would mirror the path we have seen in China) but with the economy recovering and returning to growth in Q3 and Q4, on the basis that we have witnessed a V-shaped recovery in six of the previous seven recessions. Any recovery will depend on both a sharp rebound in consumer spending and no resurgence of the virus forcing a re-introduction of lockdown measures. Clearly, there is a delicate balance between maximising economic recovery on the one hand whilst protecting public health on the other, but overall we expect to see a sharp contraction in global growth for 2020 with a rebound during 2021. Andrew Bailey, Governor of the Bank of England, has said he expects any permanent damage from the pandemic to be "relatively small" and that the economy was likely to recover "much more rapidly than the pull back from the global financial crisis". Let us hope that he is right.
The global financial crisis in 2008/2009 fuelled a surge in distressed sales and insolvency procedures and we believe that this crisis will be no different in that respect. However, whilst there will be some immediate household name casualties, we believe that there will be a lag between the scaling back of the Government's financial support measures and the influx of distressed sales and corporate insolvencies due to lenders exercising a greater degree of forbearance, at least in the short term.
Ultimately, however, in the wake of the COVID-19 pandemic, we expect to see an increase in the number of distressed sales of businesses to cash-rich buyers pursuing opportunistic acquisitions at a reduced price with companies looking to acquire competitors to increase their market share, create economies of scale or add new products and services to their existing offering. This will include distressed sales conducted outside of formal insolvency processes, loan to own strategies (including debt for equity swaps), pre-pack insolvency procedures and judicial and out of court insolvency processes.
Recent data from Prequin suggests that private equity funds (across all asset classes) have in excess of $2.5 trillion of "dry powder", many having just closed their fundraisings but who have not yet had the opportunity to invest the proceeds. Private equity has never been so cash rich and assets will rarely represent such value for money. This unusual situation will result in large pools of capital being made available for investments across the capital structure. For example, Apollo Global Management's $24.7 billion Fund IX has shifted its focus almost entirely to "distressed-for-control" transactions as the firm seeks to deploy capital into a vastly different market environment to the one in which the fund was raised. Of course, private equity sponsors will want to stabilise the liquidity positions of their existing portfolio companies before launching head long into a post-COVID spending spree, but we expect them to do this quickly and successfully, after which we anticipate that they will move fast to acquire new businesses.
Direct lending by mid-market private debt funds flourished after the global financial crisis, partly thanks to a more favourable regulatory landscape in comparison to "traditional" lenders and partly due to the traditional lenders retrenching to what they considered to be their "core" business. This left vast sections of the SME and mid-market unbankable by traditional lenders and created a target rich environment for the private debt funders. There was also a degree of arrogance from some traditional lenders who felt that the private debt funds would not stand the test of time - eventually borrowers would return to their natural home. However, this did not happen and ongoing competition in the market from private debt funds forced the traditional lenders to loosen credit terms over time.
Over the last decade we have seen increasingly sponsor friendly terms in debt documentation, including aggressive EBITDA addbacks, swelling leverage multiples (6x plus) and the demise of maintenance financial covenants in favour of incurrence financial covenants – dare we say it, in some instances a return to covenant-lite deals. COVID-19 is different of course – it is not a crisis caused by a shortage of liquidity and the Government has created, through its financial support measures, an environment where the traditional lenders can continue to lend. The banks are reportedly generally well capitalised and the Bank of England recently cancelled 2020 stress tests for the UK’s biggest lenders, allowing them to be more accommodating and continue to write loans. Therefore, we expect sustainable businesses in the SME and mid-market to continue to be well served by both the traditional lenders and the private debt funds.
Notwithstanding the above, we expect to see a general tightening of terms and increasingly lender-friendly term sheets when we emerge from this crisis, coupled with credit committees across the board taking a more robust approach, resulting in increased pricing with lenders demanding greater protection in terms of credit support. We believe that private debt funds that have not over-levered their borrowers' balance sheets (and are therefore less likely to experience payment defaults and lower recovery rates) will be well positioned, particularly if they are closed-ended and therefore will not face immediate pressure from investors wishing to exit, allowing the fund to take a more considered approach.
Wars and pandemics change the world and there is no doubt that we will see fundamental changes to human society and in the way companies conduct their businesses as a result of the COVID-19 pandemic. We will unquestionably experience increased public and private debt, a contraction of globalisation and a strong resurgence of nationalism and protectionism. Modern technology will thrive to the detriment of other businesses (office-based culture and commuting will change permanently).
Inevitably, there will be casualties but, as with the dot-com bubble and the global financial crisis, prosperity and growth will follow recession and the COVID-19 pandemic will be no different. In this moment we must seize the opportunities, we must not fight the last war, but must look forward in order to avoid the worst effects of the COVID-19 pandemic and emerge stronger, leaner and ready to take advantage of the next economic cycle.
Robin Spender is a partner and George Murphy is a senior associate in the Financial Markets and Products team at Fieldfisher. We provide advice on acquisition finance (including distressed acquisitions), direct lending, growth capital and venture debt transactions, so please feel free to contact us for any relevant advice that you require.
Introduction
Numerous businesses have closed their doors (some, perhaps, for the final time), many have furloughed staff or made redundancies, with several well-known high street chains such as Debenhams, Oasis and Warehouse already going into administration having run out of cash.A global recession, at least to some commentators, seems to be unavoidable, with many companies facing unprecedented obstacles and challenges to their businesses in the coming months. However, for some there may be opportunities to acquire fundamentally good businesses with distressed balance sheets at significantly reduced valuations.
In this article, we will:
- consider the current economic situation and provide a summary of the intervention schemes introduced by the UK Government and the Bank of England so far in order to alleviate the current strain on UK businesses; and
- look forward to the rebound of the UK economy as lockdown measures begin to ease and discuss some of the investment opportunities, particularly in the private equity and private debt segments of the market.
The Economics and UK Government Schemes
In Q2 of 2020, the Office for Budget Responsibility has predicted unprecedented falls in GDP of up to 35% due to the sharp slowdown in economic activity. We have not seen such a fall in economic activity since the great depression of the 1930s. Even the Bank of England has warned, some might say unhelpfully, that we are facing the deepest recession on record, with the UK economy set to shrink 14% this year.In the UK, the Government and the Bank of England have introduced a number of measures to help keep businesses going, including:
- cutting interest rates to almost zero (0.1%);
- restarting quantative easing, which has now expanded to c.£645 billion with two members of the nine-member MPC recently voting to increase the funds pumped into the Government borrowing market by a further £100 billion, suggesting that the Bank of England may yet do more;
- the Coronavirus Job Retention Scheme (JRS) which has seen over 6 million UK workers furloughed and has recently been extended until October 2020;
- CBILS (Coronavirus Business Interruption Loan Scheme) and CLBILS (Coronavirus Large Business Interruption Loan Scheme) and the business bounce-back loan scheme (100% guaranteed by the UK Government) which, according to latest estimates, have seen over £14 billion in loans provided to UK SME's;
- the COVID-19 Corporate Financing Facility which has helped larger, investment grade, businesses raise £17.7 billion through the issuance of short-term commercial paper;
- the Future Fund which will deliver an initial commitment of £250m of new Government funding which can be unlocked by private investment on a match funded basis; and
- changes to the UK insolvency regime to be introduced by the Corporate Insolvency and Governance Bill, which could result in far greater and longer lasting changes in the way we view corporate insolvency and which some have argued will bring the UK much more in line with US "debtor in possession" Chapter 11 regime.
Such measures are intended to provide a safety net for businesses as we enter a potentially global recession in order to bridge the gap so that, when the economy eventually emerges from this crisis, we witness a quicker and more sustained recovery.
The shape of that economic recovery ("U", "V" or "W"…?) has been the subject of intense speculation. Some economists are forecasting, perhaps optimistically, a V-shape recovery with a sharp slowdown through Q2 (which would mirror the path we have seen in China) but with the economy recovering and returning to growth in Q3 and Q4, on the basis that we have witnessed a V-shaped recovery in six of the previous seven recessions. Any recovery will depend on both a sharp rebound in consumer spending and no resurgence of the virus forcing a re-introduction of lockdown measures. Clearly, there is a delicate balance between maximising economic recovery on the one hand whilst protecting public health on the other, but overall we expect to see a sharp contraction in global growth for 2020 with a rebound during 2021. Andrew Bailey, Governor of the Bank of England, has said he expects any permanent damage from the pandemic to be "relatively small" and that the economy was likely to recover "much more rapidly than the pull back from the global financial crisis". Let us hope that he is right.
Restarting the national economy and investment opportunities for private equity and private debt
The global financial crisis in 2008/2009 fuelled a surge in distressed sales and insolvency procedures and we believe that this crisis will be no different in that respect. However, whilst there will be some immediate household name casualties, we believe that there will be a lag between the scaling back of the Government's financial support measures and the influx of distressed sales and corporate insolvencies due to lenders exercising a greater degree of forbearance, at least in the short term.
Ultimately, however, in the wake of the COVID-19 pandemic, we expect to see an increase in the number of distressed sales of businesses to cash-rich buyers pursuing opportunistic acquisitions at a reduced price with companies looking to acquire competitors to increase their market share, create economies of scale or add new products and services to their existing offering. This will include distressed sales conducted outside of formal insolvency processes, loan to own strategies (including debt for equity swaps), pre-pack insolvency procedures and judicial and out of court insolvency processes.
Recent data from Prequin suggests that private equity funds (across all asset classes) have in excess of $2.5 trillion of "dry powder", many having just closed their fundraisings but who have not yet had the opportunity to invest the proceeds. Private equity has never been so cash rich and assets will rarely represent such value for money. This unusual situation will result in large pools of capital being made available for investments across the capital structure. For example, Apollo Global Management's $24.7 billion Fund IX has shifted its focus almost entirely to "distressed-for-control" transactions as the firm seeks to deploy capital into a vastly different market environment to the one in which the fund was raised. Of course, private equity sponsors will want to stabilise the liquidity positions of their existing portfolio companies before launching head long into a post-COVID spending spree, but we expect them to do this quickly and successfully, after which we anticipate that they will move fast to acquire new businesses.
Direct lending by mid-market private debt funds flourished after the global financial crisis, partly thanks to a more favourable regulatory landscape in comparison to "traditional" lenders and partly due to the traditional lenders retrenching to what they considered to be their "core" business. This left vast sections of the SME and mid-market unbankable by traditional lenders and created a target rich environment for the private debt funders. There was also a degree of arrogance from some traditional lenders who felt that the private debt funds would not stand the test of time - eventually borrowers would return to their natural home. However, this did not happen and ongoing competition in the market from private debt funds forced the traditional lenders to loosen credit terms over time.
Over the last decade we have seen increasingly sponsor friendly terms in debt documentation, including aggressive EBITDA addbacks, swelling leverage multiples (6x plus) and the demise of maintenance financial covenants in favour of incurrence financial covenants – dare we say it, in some instances a return to covenant-lite deals. COVID-19 is different of course – it is not a crisis caused by a shortage of liquidity and the Government has created, through its financial support measures, an environment where the traditional lenders can continue to lend. The banks are reportedly generally well capitalised and the Bank of England recently cancelled 2020 stress tests for the UK’s biggest lenders, allowing them to be more accommodating and continue to write loans. Therefore, we expect sustainable businesses in the SME and mid-market to continue to be well served by both the traditional lenders and the private debt funds.
Notwithstanding the above, we expect to see a general tightening of terms and increasingly lender-friendly term sheets when we emerge from this crisis, coupled with credit committees across the board taking a more robust approach, resulting in increased pricing with lenders demanding greater protection in terms of credit support. We believe that private debt funds that have not over-levered their borrowers' balance sheets (and are therefore less likely to experience payment defaults and lower recovery rates) will be well positioned, particularly if they are closed-ended and therefore will not face immediate pressure from investors wishing to exit, allowing the fund to take a more considered approach.
Summary
Wars and pandemics change the world and there is no doubt that we will see fundamental changes to human society and in the way companies conduct their businesses as a result of the COVID-19 pandemic. We will unquestionably experience increased public and private debt, a contraction of globalisation and a strong resurgence of nationalism and protectionism. Modern technology will thrive to the detriment of other businesses (office-based culture and commuting will change permanently).
Inevitably, there will be casualties but, as with the dot-com bubble and the global financial crisis, prosperity and growth will follow recession and the COVID-19 pandemic will be no different. In this moment we must seize the opportunities, we must not fight the last war, but must look forward in order to avoid the worst effects of the COVID-19 pandemic and emerge stronger, leaner and ready to take advantage of the next economic cycle.
Robin Spender is a partner and George Murphy is a senior associate in the Financial Markets and Products team at Fieldfisher. We provide advice on acquisition finance (including distressed acquisitions), direct lending, growth capital and venture debt transactions, so please feel free to contact us for any relevant advice that you require.