The coronavirus holds the world in a vice-like grip, with far-reaching social and economic consequences. Familiar processes are under the microscope, alternatives to established processes are inevitable. The fear of supply shortages leads to panic purchases, national borders are sealed off and the economy is brought to a standstill, at least in parts – with devastating consequences for society as a whole.
Correlation between stock markets and private equity investments
Initially, the global financial markets hardly responded to the virus, but then reacted all the more strongly to the spread of the virus. Over the past few days, the DAX posted the largest intraday price loss of -12.4%, just three days after the leading German index recorded the largest daily loss of -7.9% in the last few decades. Investors – whether institutional or private – have to come to terms with this development. In the short term, the main focus for those involved in the capital market is on securing the capital employed: investing liquid funds with the greatest possible security, even if there is no or even a negative return expectation.
A decline in investments in comparatively illiquid and long-term investments such as private equity can therefore be expected. Statistics on fundraising volumes of investment companies show a clear correlation between the capital raised and the broader market environment for the period 2000 to 2019: the better the development on the public financial markets, the higher the volume invested in private equity, and vice versa. In the past 20 years, capital commitments have only declined in times of crisis.
Fundraising: Specific reactions from limited partners to the spread of the coronavirus
The spread of the coronavirus is undoubtedly such a crisis named above. Limited partners (LPs) – the most important investors for every private equity fund – will tend to put capital preservation ahead of all return expectations in the coming months.
On the one hand, LPs are often themselves invested in companies via direct and co-investments and will want to hold back funds for this in order to be able to provide direct investments with additional capital if necessary. On the other hand, LPs in their role as multi-asset managers are subject to restrictions with regard to the allocation of capital: if share prices fall and thus the value of the corresponding portfolios, the exposure in other asset classes increases- this happens possibly above predefined quotas, so that no more investments in private equity are possible.
Limited partners can also use the time factor for themselves. Not only can risks be better assessed with increasing visibility, the negotiation of management fees and carried interest regulations is also more advantageous if there is a shortage of capital.
The picture for the current fundraising of private equity funds is therefore extremely poor. It is all the more important to further strengthen relationships with existing LPs in order to create a strong starting position for a recovery after the crisis. For this, strong crisis management at portfolio level and transparent communication with the LPs are of decisive importance.
We will explain in our next blog entries which measures are primarily suitable for this.
The effects of the coronavirus can now be felt in every industry. Apart from a few winners from the crisis, most medium-sized German companies have to contend with declines in sales, the duration and significance of which is difficult to predict. Therefore, entrepreneurs must identify, analyze and consistently implement measures to control costs and secure liquidity.
The challenge for private equity investors is that an exceptional situation such as the spread of the coronavirus affects all portfolio companies. The aforementioned planning of measures with all its imponderables must be implemented by private equity funds in several, sometimes very different, companies.
Private equity: more than just an investor
The current situation also poses an enormous structural and operational challenge for companies that have previously been growing strongly: Entrepreneurs and managing directors, who have previously dealt with new products, geographical expansion or building their own teams, suddenly have to prove themselves in a crisis situation.
Here in particular, 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, in order to actively support targeted crisis management.
Crisis management at portfolio level
For the effective implementation of the measures at the portfolio level, private equity investors must first analyze the starting positions of the portfolio companies, in particular 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, adapted to the changed situation. The term “investment” should be understood relatively broadly. Investors and entrepreneurs should include marketing expenses, costs for hiring additional employees and similar expenses as well as classic CAPEX investments.
Basically, when making the appropriate assessment, a balance must be weighed between securing the company’s activities in the short term and the possibility of leading the company back onto a growth path when the crisis is over. In the case of expenses that are easily scalable, such as marketing, it is generally advisable to first focus on the most efficient activities and sharply reduce other expenses in order to conserve liquidity reserves.
With fixed costs, the scope for action in the event of a crisis is naturally much smaller. This applies in particular to personnel expenses, which usually represent one of the largest cost blocks and therefore quickly become the focus of cost-cutting measures. Temporary adjustments, e.g. by arranging vacation and short-time work, open up important savings potential without affecting the company in the long term. Entrepreneurs should, however, avoid premature “cost slashing” by downsizing. Here in particular, the downstream effects for portfolio companies can be devastating.
Employee departures not only have to be compensated once after the crisis has been overcome, as it leads to recruiting and onboarding costs. The loss of know-how cannot easily be compensated for if the macroeconomic prospects brighten 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 in order not only to cope with the current situation, but also to maintain future potential for value growth. A convincing crisis management also sends a strong signal to the private equity fund’s financiers themselves.
In our next blog article, we will deal with the correct communication of the facts shown in regard to limited partners.
Communication with Limited Partners
For Limited Partners (LPs), the current crisis situation brings its own challenges. LPs are usually professional multi-asset managers who allocate the capital available to them across a wide range of asset classes and fund managers. In the event of macroeconomic distortions, LPs have different effects across the entire portfolio, which must be assessed and incorporated into LP’s own risk management.
Reporting of immediate effects and possible scenarios
As fund managers, 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 about the direct effects or if necessary be informed unscheduled on the individual portfolio companies as part of the fund reporting or. For example, in addition to the quarterly reporting, FLEX Capital has sent a separate report to all LPs to show how the crisis is currently being dealt with.
Regardless of the form in which the information is provided, the focus is on the respective available liquidity, the forecast cash flows and all liquidity-effective savings measures for the individual portfolio companies. It is also advisable to provide a rough description of the catalog of measures that have been worked out and the current status of implementation, which should also be referred to in subsequent reports.
The forecast of future cash flows in extreme situations is naturally the most difficult task. In addition to a base case scenario, down and extreme case scenarios must be considered in order to be able to anticipate possible liquidity bottlenecks.
If bottlenecks emerge, appropriate solutions must be worked out, which in extreme cases also include the injection of further equity by the private equity fund – and the associated capital calls from the LPs.
Outstanding capital calls
Even if the portfolio companies do not need any further equity, the LPs must be able to estimate the volume of further capital calls. While management fees can be calculated without any problems, capital calls for planned transactions are significantly less secure. Private equity funds have to present plans without knowing exactly which ongoing transactions will be concluded or which further deals will arise. The corresponding financing requirements cannot usually be finally assessed either, as LBO financing through 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 advisable to stagger the cumulative capital calls in order to distinguish visible periods such as the current quarter from comparatively 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.