Leo magazine n°12
Union Investment: Why we chose Luxembourg
What do Hertz, J Crew, Debenham’s, and Nieman Marcus have in common? All were, in some way, shape or form part of a private equity deal in recent years. They have also all filed for bankruptcy during the Covid-19 crisis. Pundits often drag these names out as a precursor to arguing against private equity and its so-called black box of financing. However, while regrettably solutions could not be found in these cases, demonising private equity ignores the many benefits that it brings, the jobs it creates, and the stability and expertise that it can provide to companies.
We saw private equity houses use the traditional green, yellow and red traffic light system to indicate the level of engagement and support each business was expected to need.
The Covid-19 crisis has presented far-reaching and unprecedented challenges for the global economy. Once fairly safe assumptions surrounding the economy shifted rapidly as businesses, cities and countries were shuttered to prevent the spread of the disease. In light of the sudden shift, operational teams in private equity houses were rapidly deployed in order to assist portfolio companies.
“We saw private equity houses use the traditional green, yellow and red traffic light system to indicate the level of engagement and support each business was expected to need,” Elena Cuesta Urquia, Private Equity Specialist at Indosuez Wealth Management in Luxembourg, highlights. “Making the right decisions in terms of protection for teams and their employment beyond the crisis called for genuine strategic thinking support in the early days of the crisis,” states Anne Canel, Director for HLD Associes Europe.
Making the right decisions in terms of protection for teams and their employment beyond the crisis called for genuine strategic thinking support in the early days of the crisis.
When the crisis first hit, the driving need was to assist companies in ensuring employee well-being, a natural precursor to securing operations. “The reality quickly set in that some companies would not survive with months of deteriorated income or low liquidity, so teams worked with portfolio companies on modified business plans that often far surpassed downturn scenarios” explains Cuesta Urquia. In order to account for this, HLD Associes Europe looked to “keep bank confidence and obtain ‘covenant holidays’ and accompanying measures” for its portfolio companies, which were successful in part due to the firms projections as well as the “guarantee of a committed stakeholder” notes Canel.
The flurry of initial reaction has since settled into day-to-day support for many portfolio companies, as well as the shifting of business models for others as industries adapt to changing consumer behaviour. Despite the challenges, private equity backed firms have historically weathered crises better than similar ones according to a study performed by Kellogg Business School. This may be due to the fact that they have access to a healthy pot of capital to draw on in times of need, despite usually having large amounts of debt on their balance sheets.
For Cuesta Urquia, private equity firms also have the luxury of time, with “many companies simply having stayed in the portfolios of funds longer than expected until they manage to recover.” This has been observed across the industry, with many exits being delayed until the companies are once again healthy. Canel highlights that AIFMD was also a beneficial introduction prior to the crisis, as “extreme debt situations are rare in Europe given the regulations that have been set up in the sector.” Further to this, the industry was sitting on record levels of dry powder that could be tapped in the case of the need to refinance.
Canel, however, notes that given the high level of government support available during the crisis, not much of the dry powder has been used. “Dry powder remains at this point a guarantee, however we will face the ‘day after’ the crisis in the months and years to come when the industry will need to tap this and will need to be cautious in the companies that are selected for refinancing.” Given the financing packages and government aid during the crisis, managers must ensure they do not confuse the availability of liquidity with healthy balance sheets and successful business models, as doubling down on the wrong business could cause confidence issues.
Despite this, the Covid situation has provided some opportunities for private equity firms as well. “Some unexpected opportunities have appeared, with decreases in excessive prices, new challenges in technology versus the complexity in real estate as an example,” states Canel. Capitalising on these opportunities will, however, require significantly careful decisions and choices. Near-term uncertainty in various sectors, as well as valuation challenges will mean that managers are likely to be slower in deploying capital given more meticulous due diligence requirements. Cuesta Urquia highlights that “opportunities will arise from the crisis, but private equity is a long-term asset class, and managers need the time to find the right opportunities.”
This crisis is definitely an opportunity for the best private equity managers to express their vision and talents.
Covid has acted as an accelerator of certain trends, meaning that the right opportunities could be found in varying sectors. “Certain sectors have thrived during the crisis, such as parts of the healthcare or logistics sector, even some tech companies, and there have been some promising deals done up to this point,” Cuesta Urquia goes on to explain. Companies that have weathered the Covid crisis could make attractive targets, however sectors are likely to be markedly different post-crisis. Canel echoes the Chinese proverb of never letting a crisis go to waste, emphasising that “this crisis is definitely an opportunity for the best private equity managers to express their vision and talents.”
But where will this vision and talent take the private equity industry in the coming years? The industry is well known for its ability to adapt and evolve and find new ways to generate value. For Cuesta Urquia, private equity firms have a unique ability to “take positions in struggling sectors and help transform and develop businesses steadily, over a time horizon of several years, which is quite particular to the industry.”
Private equity firms have a unique ability to “take positions in struggling sectors and help transform and develop businesses steadily, over a time horizon of several years, which is quite particular to the industry.
As we move post-Covid, long-term sustainable development will play an increasingly larger role. There are many ways for a company to finance its growth, from bank loans to listing on a stock exchange for larger companies. In Europe, until the CMU is completed, SMEs will find the latter more difficult to achieve. In light of this, private equity continues to play a pivotal role in financing the expansion of a key-driver of the global economy. In fact, given a short-termism that often plagues public markets, we could see more and more companies looking to private equity for their medium-term business plans. Canel points out that financial institutions increasingly adopt ESG into their organisations, “private investments will be central to reorganizing the financial scheme.” Cuesta Urquia highlights that investor interest will also continue to ensure private equity has a role to play noting that more are looking to private equity for alpha generation “and also as a way of investing in real economy.”