It feels much longer than the 3-4 weeks that have passed since I set out my initial thoughts concerning COVID-19, Being Robust in Trying Times. While the previous note was almost entirely dominated by the initial reaction to the virus, I find it remarkable how quickly the conversation has turned to thinking about the future. As such, my comments naturally reflect this change in balance.
I previously highlighted that the immediate requirement consistently across the sector was to assess the existing portfolio rapidly, and deal with the most impacted businesses as quickly as possible. Key action points included maximizing existing facilities, resetting cost bases and cash flow optimization, seeking government support measures where relevant and available (including assessing effects of any conditionality), and improving the frequency and robustness of cash flow forecasting. It is a testament to our clients that we have seen careful consideration as to whether there is a real need to access government support measures, and frequently decline the opportunity where it is not essential to the survival of a portfolio company. A number of high profile funds have declared (as we have in our own business) that they will not access public funding across their entire portfolio. For many funds this initial exercise is largely complete and there is a good understanding of the key pinch points, action plans are in place, and a sense of stability is starting to take shape.
The immediate future for many portfolio companies will involve covenant reporting for Q1 (recently reported) and Q2 onwards, the latter likely to be potentially more problematic. Discussions with lenders have in many cases taken place in a very proactive and transparent way, and if businesses are fundamentally sound, we expect to see reasonable lenience and understanding. Banks have been preoccupied with their most troubled clients with reports of significant losses on their books before they get to the more “straightforward” discussions with the majority of PE (Private Equity) investments, even where perhaps some restructuring and further funding is likely to be required.
Naturally the lock down measures are having a significant delaying effect on investments and exits. While we have seen disruption some processes are continuing, several are being prepared in advance of lock down measures ending, and many funds are looking at “all-equity” deals, delayed IPO’s, public company situations, and of course we expect Credit and Special Sits funds to invest in liquidity opportunities arising from the current situation. A number of “market dislocation” funds have been activated by clients specifically to take advantage of this kind of situation, and several have deployed significant capital already. With exits, PE funds have the ability to hold assets until market conditions recover as we saw post the 2008 financial crisis, so we can anticipate a lull in volumes followed by something of a catch up period.
I believe that investor sentiment will not be permanently affected as the asset class has a good track record of out-performing other asset classes over an entire economic cycle. Portfolio company valuations will likely be materially corrected in Q1 and Q2, however, these obviously do not represent realized losses. Investors understand that valuations will likely recover as the public markets recover, and that in any event only cash proceeds count for real returns. The ability to control exit realization timing and hence crystallization of losses and gains is a key benefit of this asset class (part of the ‘resilient operating model’ we talk about) and allows managers to take steps to preserve the money multiple if not the IRR. Again, this was clearly evident following the 2008 financial crisis. Capital calls will no doubt be constrained for the time being due to the reduced investment activity, but also GPs will bridge existing commitments where possible, as they seek to minimize the cash demands from LP’s, being sensitive to the LP’s own cash management priorities. We can expect to see a rather soft fundraising market in the short term but going into COVID-19 investors in aggregate consistently reported that they were under their target asset allocation to PE and that more planned to increase their allocation than to decrease it. Hence, this should support a recovery in fundraising in due course.
The widely reported medical view is that the effect of COVID-19 will be with us for the foreseeable future. Until there is a confirmed cure/vaccine, a variety of lock down and distancing measures will be required, and we expect this will place a drag on the pace of economic recovery. As a result, the impact of the issues set out above may reduce in the coming months, but will not disappear for some time to come.
In the meantime, it is important to look carefully at the differing paces of recovery both by sector, and by geography. In addition, some sectors and geographies may well recover to different levels from pre-COVID-19 (i.e. the ‘new normals’). Increasingly sophisticated economic forecasts are being developed by KPMG professionals (see by way of example from Chief Economists Yael Selfin (KPMG in the UK) and Constance Hunter (KPMG in the US) and their economics teams) using an enormous variety of structured and unstructured data points, not only by country and sector, but by sub-sector and region of major countries.
Clients are doing the same, and developing new and/or updated investment themes for the future. For example, around the defensive nature of food, basic household goods, and key healthcare products. Another key theme is likely to seek to leverage the impact of more social distancing and more time spent by consumers and employees at home in areas such as leisure products, technology and communication, the latter two highlighting again the importance of digital and AI.
As an increasing number of organizations start to stabilize and understand how they can operate through the immediate few crisis months, they are quickly turning their attention (and indeed devoting dedicated resources) to thinking about how they will operate most successfully in a post COVID-19 world. Careful planning in this regard is essential, to protect the employee workforce, and ensure a sustainable and robust path to recovery. PE will have a key role in this, not only within its existing portfolio but as an attractive capital solution with the unique advantage of having the expertise and knowledge to assist companies with major transformation programs as they adapt and evolve their business model to operate in a post COVID-19 world. There will be some challenges and no doubt losses along the way, but the industry is very much geared to be hugely active and significant deployers of capital over the coming two to three years.