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Covid-19 and the private equity sector

Covid-19 and the private equity sector

Industry experts: An interview with our Head of Private Equity

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Tilman Ost

Partner, Deal Advisory Private Equity Group, Head of Private Equity Germany

KPMG AG Wirtschaftsprüfungsgesellschaft

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Keyfacts

  • In the interview, our Head of Private Equity, Tilman Ost, describes how private equity firms remain optimistic and define measures to emerge from the crisis even stronger than before.
  • Consequences: Depending on the industry of their portfolio companies, private equity firms are affected to a varying extent by the Covid-19 pandemic.
  • Measures: Active portfolio management is the order of the day.
  • Outlook: As we emerge from the crisis, private equity firms will increasingly prove themselves to be reliable partners for companies of all shapes and sizes  - whether through creative financing solutions or their expertise in operational improvements. This may open promising investment opportunities for private equity firms. 

Interview

Mr Ost, the coronavirus has had an impact on almost all industries, albeit to varying degrees. How has it affected private equity firms?

Generally, it can be said that the more than 500 private equity firms (PEs) in Germany invest across all sectors of the economy. The impact of the Covid-19 pandemic is therefore varied.

In principle, PEs are impacted in all three of their core areas of activity:

  1. Portfolio management: Depending on the industry, portfolio companies are suffering to varying degrees due to the current shutdowns.
  2. Transaction activities: Due to uncertainty in the market, a large number of corporate transactions have been cancelled or postponed  - in light of the current record level of "dry powder", that is, committed but uncalled capital, many PEs are under increasing pressure to invest.  
  3. Fundraising: Institutional investors are currently being very cautious  - new capital commitments for PEs are being scrutinised or even suspended.

How are private equity firms responding? What are they focusing on?

Without a doubt on portfolio management. Almost everyone in the sector has confirmed to me that the current focus of crisis management is primarily on their investments  - PEs are even assigning staff to individual portfolio companies. We are providing our clients with intensive support on their portfolio management. This includes monitoring and optimising liquidity as well as applying for governmental aids such as short-time work, temporary tax reliefs and governmental guaranteed loans. Drawing on such funds at an early stage ensures the necessary headroom to work constructively on sustainable solutions.

Following this first stage of "react & protect", the situation has stabilised. Now it's a question of thinking ahead, which involves adapting business models and value chains. The perfect storm that we are currently experiencing has disclosed inherent weaknesses. PEs have drawn their own conclusions from this and already move on to optimisation.

With regards to transactions, the initial shock-induced paralysis appears to have been overcome. The crisis is increasingly being perceived as an opportunity which may give rise to numerous investment opportunities. This is all the more promising as business valuations are declining and corporates are temporarily not competing as bidders. However, for this to happen, financing options, including new capital commitments from investors, must return. Many private equity managers are currently in close communication with their investors, as a number of them have become increasingly protective over their investments.

Are we more likely to see an increase or a decrease in private equity activities?

PEs are currently expanding their list of potential purchases, the transaction pipeline. However, the potential sellers will of course not immediately adjust their price expectations. They are claiming: Why should my company be worth less now, although it was perfectly healthy before and is only suffering due to the temporary, government-mandated shutdown at the moment? For private equity transactions to increase, the valuation multiples  - simply put, prices  - first need to drop. However, companies in liquidity crunch will be less hesitant and may represent  good investment opportunities for PEs. There is an increasing focus on "loan-to-own", that is, on loans that can be settled with shares if repayment is not possible.

Are there any structural changes emerging?

Yes, in many aspects:

  1. The active portfolio management induced by the crisis will continue. PEs will move even closer to their portfolio companies and actively attempt to exploit hidden potentials as well as increasingly take measures for operational value creation. Only a few years ago, PEs restricted themselves to purely optimise financing structures. Interventions will be more extensive from now on. Sourcing and supply chains will become significant areas of focus. We will see a partial relocation of value chains back to Germany and Europe to reduce the dependence on China. PEs will actively push ahead with these changes in their portfolios.
  2. Due diligence will be enhanced. In the future, PEs will apply even more critical scenario analyses (based on big data) before carrying out transactions. They will increasingly challenge the sustainability of business models.
  3. Specialisation is paying off, which is why a focus on and expertise in specific sectors within the investment teams will continue to grow in importance. This is intended to ensure a robust assessment of the respective business models.
  4. Fundraising will become even more competitive in the future. Institutional investors will act more selective and especially consider the performance of individual PEs for their future investments, while also incorporating other "soft" investment criteria into their decision-making process. 

What is giving you hope?

Private equity - in general - is a very optimistic industry that looks ahead in search of opportunities. We are confident that many firms have already overcome the stabilization phase and entered a new phase of actively developing their portfolio and are proving themselves as a reliable partner for companies  - whether as a temporary alternative to government financial aid, as a catalyst for realising operational value potentials after the crisis (e.g. through digitalisation) or as a potential buyer of promising and sustainable business models. Of course, we are still in the midst of a crisis of unprecedented magnitude, but we believe that after a brief pause we will observe a high level of PE activity in the market. PEs are problem solvers and have worked hard to establish a strong reputation as partners to SMEs and large corporations in recent years. Based on this trust, we are going to see many creative and previously unseen forms of collaboration.

Short-, medium- and long-term measures

What measures should private equity firms take now?

Short-term:

  • Active portfolio management
  • Ensure liquidity of portfolio companies

Medium-term:

  • Active pipeline development taking into account the ongoing crisis
  • Adapt value chains and business models at portfolio companies

Long-term:

  • Increase sector-specific expertise within the investment teams
  • Focus on operational value enhancement and sustainable investments

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