Private equity in crisis? The effects of the coronavirus



The coronavirus has a firm grip on the world, with far-reaching social and economic consequences. Familiar processes are put to the test, alternatives to established processes are inevitable. Fear of supply shortages leads to hoarding, country borders are sealed off and the economy comes to a standstill, at least in parts – with devastating consequences for society as a whole.

Correlation between equity markets and private equity investments

Global financial markets initially reacted little, but then reacted all the more strongly to the spread of the virus. In the course of the past few days, the DAX recorded the largest intraday price loss of -12.4%, and this only three days after the German benchmark index recorded the largest daily loss of -7.9% within the last decades until then. Investors – whether institutional or private – have to come to terms with this. In the short term, the main priority for players on the capital market is to safeguard the capital they have invested: investing liquid funds with the greatest possible security, even if this entails no or even negative expected returns.

This means that investments in comparatively illiquid and long-term forms of investment, such as private equity, are likely to decline. Statistics on fundraising volumes of private equity companies show a clear correlation between capital raised and the broader market environment for the period 2000 to 2019: the better the performance of public financial markets, the higher the volumes invested in private equity, and vice versa. Over the past 20 years, capital commitments have thus only declined in times of crisis.

Fundraising: concrete responses from limited partners to the spread of coronavirus

The spread of the coronavirus undoubtedly represents just such a crisis. Limited partners (LPs) – the most important capital providers for any private equity fund – will tend to prioritize capital preservation over all return expectations in the coming months.

First, LPs are often invested in companies themselves through direct and co-investments and will want to retain funds for this purpose in order to be able to provide direct investments with additional capital when needed. On the other hand, LPs in their role as multi-asset managers are subject to restrictions in terms of capital allocation: if share prices and thus the value of the corresponding portfolios fall, the exposure to other asset classes increases in purely arithmetical terms – this may be via predefined quotas, so that no further investments in private equity are possible.

Similarly, limited partners can use the time factor for themselves. Not only can risks be better assessed with increased visibility, but negotiating management fees and carried interest arrangements is also more advantageous when a capital shortage occurs.

The picture for current fundraisings of private equity funds is therefore extremely poor. This makes it all the more important to further strengthen relationships with existing LPs to create a strong starting position for post-crisis recovery. Strong crisis management at the portfolio level and transparent communication to LPs are crucial in this regard.

We will explain which measures are the main candidates for this in our next blog posts.

Portfolio company

The impact of the coronavirus is now being felt in every industry. Apart from a few crisis winners, most companies in the German SME sector have to contend with declining sales, the duration and significance of which are difficult to forecast. Therefore, entrepreneurs must identify, analyze and consistently implement measures to control costs and safeguard liquidity.

The challenge for private equity investors is that an exceptional situation such as the spread of coronavirus affects all portfolio companies. The aforementioned action planning with all its imponderables has to be implemented by private equity funds in several, sometimes very different companies.

Private equity: more than just a provider of capital

Even for previously high-growth companies, the current situation represents an enormous structural and operational challenge: Entrepreneurs and managing directors who have so far been busy with new products, geographical expansion or building up their own team suddenly have to prove themselves in a crisis situation.

This is precisely where private equity investors can make an important contribution that goes beyond the mere provision of capital. Investors serve as sparring partners for developed catalogs of measures and establish direct contact between the management teams of the individual portfolio companies in order to exchange ideas and experiences. Private equity funds can also coordinate support from external experts, such as management consultants and lawyers, to actively support targeted crisis management.

Crisis management at portfolio level

For the effective implementation of measures at the portfolio level, private equity investors must first analyze the initial positions of the portfolio companies, especially with regard to available liquidity and future cash flows. These evaluations should then be repeated, at least on a weekly basis, and incorporated into the decision-making process.

Planned investments must be checked for their validity in times of crisis and, if necessary, adjusted to the changed situation. The term “investment” is to be defined relatively broadly in this context. Investors and entrepreneurs should include marketing expenses, costs for hiring additional employees and similar expenses as well as classic CAPEX investments.

In principle, the relevant assessment must weigh up the need to safeguard the company’s activities in the short term against the possibility of returning the company to a growth path when the crisis ends. In the case of relatively easily scalable expenses, such as marketing, it is generally advisable to focus initially on the most efficient activities and make severe cuts in other expenses in order to conserve cash reserves.

With fixed costs, the room for maneuver in the event of a crisis is naturally much smaller. This applies in particular to personnel expenses, which are usually one of the largest cost blocks and therefore quickly become the focus of cost-cutting measures. Temporary adjustments, e.g. by ordering vacation and short-time work, open up important savings potential without affecting the company in the long term. Entrepreneurs should, however, avoid anticipatory “cost-slashing” through employee layoffs. Here in particular, the downstream effects can be devastating for portfolio companies.

Staff departures not only have to be compensated after the crisis has been overcome, which leads to recruiting and onboarding costs. Nor is the loss of know-how easily compensated for when the overall economic outlook brightens and new opportunities arise for the companies concerned.

Crisis management at portfolio level must therefore take into account not only various possible scenarios but also the medium- to long-term development prospects of the individual company. Close cooperation between private equity investors and portfolio companies is consequently crucial not only to cope with the current situation, but also to preserve future value creation potential. Appropriately focused, convincing crisis management also sends a strong signal to the private equity fund’s investors themselves.

In our next blog article, we will deal with the correct communication of the facts shown in the direction of the limited partners.

Communication with the Limited Partners

For limited partners (LPs), the current crisis situation brings its own unique challenges. LPs are typically professional multi-asset managers, so they allocate the capital at their disposal across a broad range of asset classes and fund managers. In the event of macroeconomic dislocations, LPs face disparate impacts across the portfolio that must be assessed and incorporated into LP’s own risk management.

Reporting of immediate effects and possible scenarios

As a fund manager, private equity firms are responsible for active crisis management, which must be implemented together with the managing directors of the respective portfolio companies. The limited partners should be informed of the direct impact on the individual portfolio companies as part of the fund reporting, or on an unscheduled basis if necessary. FLEX Capital, for example, sent a separate report to all LPs in addition to its quarterly reporting to show how acutely the crisis was being handled.

Regardless of the form in which the information is provided, the focus must be on the liquidity available in each case, the forecast cash flows, and all savings measures affecting liquidity for the individual portfolio companies. It is also advisable to provide a rough outline of the developed catalog of measures and the current status of implementation, which should also be referred to in subsequent reports.

Forecasting future cash flows in extreme situations is naturally the most difficult task. In addition to a base case scenario, downside and extreme case scenarios must be considered in order to anticipate any liquidity bottlenecks.

If bottlenecks become apparent, appropriate solutions must be worked out which, in extreme cases, may also include the injection of further equity capital by the private equity fund – and the associated capital calls on the LPs.

Outstanding capital calls

Even if the portfolio companies do not require further equity, the LPs must be able to estimate the volume of further capital calls. While management fees can be calculated easily, capital calls for planned transactions are much more uncertain. Private equity funds have to submit plans without knowing exactly which current transactions will come to a close or which further deals will arise. The corresponding financing requirements cannot usually be estimated definitively either, as LBO financing by banks and debt funds is only possible to a limited extent in times of crisis.

Nevertheless, private equity funds should provide their LPs with at least a rough estimate of the amount of expected capital calls. For this purpose, it is useful to stagger the cumulative capital calls in order to distinguish visible periods such as the current quarter from comparatively more uncertain, long-term calculations.

With such quantitative forecasts, private equity funds can actively support their LPs in crisis management – even if the corresponding forecasts are associated with certain uncertainties and may therefore have to be revised in future periods.

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