As the COVID-19 pandemic wreaks havoc on the economy and all businesses attempt to plot a course for survival — or, in some cases, growth — so, too, are private equity managers trying to gauge what the future holds for their portfolio companies.
Industry veterans like Stewart Kohl, co-founder of global private equity outfit The Riverside Co., who have worked through decades of economic turmoil, see this period as different from the others.
"What I think is unique about this one is it combines a massive health care crisis with a massive financial crisis that obviously directly stems from it," Kohl said. "That combination is going to lead to this tremendous pause and reset that's going to have a dramatic impact on revenues and activities for months. It's a truly global phenomenon that cuts across every industry. That makes this unprecedented in my mind."
What does that mean for fund managers?
"There is no question that right now the focus is on survival and liquidity," Kohl said.
Private equity firms are dialing back their growth expectations for at least the next two quarters as the pandemic results in an economy shifting into low gear, which will eat into what had been market-beating returns for the PE sector as a whole.
Playing defense is key today, said Steven Rosen, co-founder of Resilience Capital Partners. That means looking for cost savings, which may mean employee layoffs — though PE firms will want to avoid those as much as possible because of how that dings their reputations. Hiring freezes are par for the course, as are considerations for zero-based budgeting and cancellation of nonessential consulting engagements. The first line of attack is trimming costs. All fund managers are stress-testing their portfolios today and evaluating where tweaks can be made as they manage their investments.
How long the current pandemic-induced downturn lasts is anyone's guess, and that uncertainty adds extra challenges for all businesses — something that trickles up to their backing investors. That makes defensive plays today all the more critical.
The pandemic's effects will be mixed for businesses, but there will be winners, like those backing firms in the industries of mobile conferencing, medical supplies, B2B servicers and e-learning.
Resilience recently acquired the Northeast Ohio makers of MicroShield 360 disinfectant and will ramp up its production in a deal that looks very smart in its timeliness now, but which was in the works months ago and completed recently in light of product demand. It's an example of being "more nimble than brilliant," Rosen said. The firm also owns LUX Global Label of Philadelphia, a labeling and packaging business that has increased shifts.
Economically speaking, though, there will be losers. Right now, those are likely to be restaurant groups that have been forced to close until further notice, along with their suppliers and service providers.
Even businesses not as explicitly shut down are still being affected, though, such as Resilience-backed LKD Aerospace of Washington, which has altered work shifts to decrease the amount of personnel working at one time to reduce potential spread of the coronavirus.
The duality of growth and struggles is present in any economic cycle, for any number of external factors. Picking the right companies and effectively enhancing their growth to capitalize on the financial upside is why private equity firms exist. It's in downturns like this that fund managers really prove their worth.
While some factors are constant, the climate for the PE business is shifting.
Chris Jones, co-founder of Align Capital Partners, said that while some deals that were long in the works closed quickly this month, those that were still early in their vetting processes have stalled out as companies shut down, travel stopped and investment banks processed the shock. Fundraising will likely slow down as well, though groups like Align Capital that recently closed funds — the firm closed its second fund at $450 million in February — are lucky to have finished when they did.
"The world has changed more in a short period of time than any of us has ever lived through before," Jones said.
Bill Manby, co-founder of venture capital firm Akron Fusion Ventures, pointed out that the general decline in valuations today presents both opportunity for buyers — coming out of a period with record-high company multiples — and cause to pause for potential sellers. Those situations, and multiples, will vary greatly from one company to the next.
"Investments that offer services or products/solutions to aid in the pandemic are of heightened interest," he said. "Some exit strategies will be delayed and others are accelerating, especially startups that provide solutions or technology in an area now thrust into a high level of focus."
Mark Krohn, an Akron business attorney who often works on local transactions, said the deals he sees still are moving ahead, with neither banks nor private equity firms balking. Some banks are "aggressively trying to close deals as of now," he said.
While that may be true in some deals that have long been in the works, overall deal flow is poised to take a dive, and financing could be a factor, particularly in the largest and most complex deals requiring multiple lenders.
"I don't think you will see businesses being sold faster," said Terrence Doyle, an attorney with Calfee who works on PE deals. "Struggling businesses will be difficult to sell, and investors will likely want to take a wait-and-see approach for their better-performing businesses in order to maximize value."
In general, private equity funds are well-positioned to take on a recession. This is all the more meaningful as banks pull back on deal financing moving forward as they look inward to their companies and deploy capital to support borrowers as encouraged by federal regulators.
According to market research group PitchBook, at last measure in the second quarter of 2019, private debt funds were sitting on $241.4 billion in dry powder. That positions funds in general to invest through the downturn — something Kohl said Riverside will do, though likely with more focus on add-ons than new platforms.
The new climate may present opportunities to roll up competitors of portfolio companies, for example.
But even with large cash piles, financing is usually a common feature in any deal, and that's already shutting down in many places.
"From an M&A perspective, the financing market is pretty much dried up," Resilience Capital's Rosen said. "The credit window for financing buyouts is closed. How long it will be closed, that I can't tell you."
Today's landscape is prime territory for turnaround investment firms. Riverside doesn't explicitly do that but has a value-investing strategy that could see opportunity in this climate.
With a turnaround strategy in mind or not, some firms are prepared to buy regardless of the circumstances.
"We do have dry powder and we'd been waiting for some sort of correction in the marketplace, so we will continue to look for opportunities," said Richard Hollington III, managing director and CEO of CapitalWorks, which focuses on investing for family wealth.
Hollington's bankers tell him they're ready to go with financing if he needs it, and he said his firm may hold some capital back just in case any of its portfolio companies need it. It's a lousy market in which to raise outside capital anyway, and there's no dire need for the firm to sell out anything in its portfolio.
In the long term, Manby predicted Northeast Ohio may benefit from its longstanding manufacturing sector — an industry that tends to be a major focus for Northeast Ohio private equity.
"When the dust settles, the supply chain will likely shift and benefit areas like Northeast Ohio and other places with a strong manufacturing, health care and consumer product ecosystem," Manby said. "We are also more likely to recover quickly than highly populated and expensive areas."
Ultimately, everything in the PE business will be tied to the economy, and how the economy fares through the pandemic will be influenced heavily by Capitol Hill.
"I have faith in Washington that if everyone takes this seriously, we get testing organized, the government takes care of small businesses and doesn't play politics, we will get through this," Rosen said.
Crain's Akron Business reporter Dan Shingler contributed to this article.
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Private equity braces for economic impact of coronavirus - Crain's Cleveland Business
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