The coronavirus pandemic has sown uncertainty across markets and sectors worldwide. Although many countries are now seeing an alleviation of government-imposed restrictions, activity levels in many industries remain depressed.

Institutional investors, such as private equity and venture capital firms, have not been immune to the instability caused by the virus, but the way in which a particular institution is affected will depend on a number of factors.

We examine these briefly here, focusing mainly on the private equity market, and look at how buyouts and investments may evolve in the short to medium term.

Portfolio composition

Whilst the COVID-19 pandemic, and the response to it, has affected businesses in all sectors, certain industries have borne the brunt.

Hospitality, real estate, tourism, transport and non-essential retail have all seen sharp falls in activity. Investors with portfolios that are focused on these sectors will naturally be experiencing the worst of the crisis, and their immediate focus will understandably be on shoring up their portfolio companies.

In a survey of 56 private equity firms conducted by the British Private Equity & Venture Capital Association (the BVCA), 61 per cent of firms expected to have to inject more funds into their portfolio companies as a result of the COVID-19 pandemic.

The hardship suffered by many PE-backed companies is compounded by the fact that they are ineligible for the UK Government’s Coronavirus Large Business Interruption Loan Scheme due to EU ‘undertaking in difficulty’ rules, which restrict state aid for companies in financial distress. Due to the highly leveraged financing structures that PE-backed companies often have in place, they can fall technically foul of these requirements. We understand that the BVCA, and its European counterparts, are in discussions with the EU regarding temporary changes to these rules.

Conversely, investors with a portfolio weighted away from sectors in crisis (or those investors with fewer portfolio companies to manage) may have less to do in terms of portfolio triage, and will therefore have more scope to spy out fresh opportunities at an earlier stage.

Our new series of Business Law Updates cover issues such as stress-testing existing financing arrangements and duties on insolvency, and are aimed at assisting companies grappling with issues caused by the COVID-19 pandemic. In case helpful, they can be found here.

Fund lifecycle and ‘dry powder’

Also of critical importance will be whether an investor’s fund is at the beginning or nearing the end of its life cycle and, accordingly, how much ‘dry powder’ (i.e. uncalled capital) that investor has to deploy.

Preqin estimates that, as of April 2020, private equity firms globally are sitting on $1.48 trillion of uncalled capital. However, those investors with funds well into their life span will have less firepower to both support their existing portfolio companies and acquire new investments at opportune valuations. These firms will have deployed the majority of their fund’s capital at the top of a business cycle, and will soon come under pressure to realise their investments and return capital to investors. They will therefore be in the unenviable position of having to look for exit opportunities in an uncertain IPO market and depressed market for sales.

On the other hand, those firms who have recently raised a fund will have a large amount of capital to deploy and less time pressure to do so.

Across the industry, the sheer amount of ‘dry powder’ means that there will be plenty of cash chasing opportunities. This will help support valuations of quality assets in growth sectors (particularly technology and healthcare) in the short and medium term, despite the uncertain climate.

For sectors struggling with the impact of the pandemic, distressed debt investors are likely to be in the vanguard of the return to deal flow. Institutional investors will also have an advantage against strategic buyers, who are more likely to be struggling to stabilise their balance sheets and have less cash to deploy on acquisitions.

Availability of financing

In the immediate aftermath of the global financial crisis of 2008–2009, the credit markets seized up and were slow to return. This had a significant impact on the ability of private equity to debt finance acquisitions and, accordingly, those PE acquisitions that did involve debt required PE funds to inject greater amounts of equity.

The COVID-19 pandemic is unlike the global financial crisis in that it was not born and raised in the banking sector. As a result, lending is not expected to suffer in the same way as during 2009 and beyond.

In addition, a host of alternative debt providers such as private credit funds have proliferated since the global financial crisis, partly in a response to the inability of traditional lenders to provide finance. This means PE funds will have a wider range of funding options than they did following the global financial crisis – Preqin estimates that private debt funds are themselves sitting on $292 billion of ‘dry powder.’

Terms, they are a-changing – impact on transactions

It is too early for there to be an abundance of data on how the COVID-19 pandemic will have impacted financing rounds and buyouts in Q1 2020 and beyond, but indications are that there has been a significant drop-off in deal flow.

According to Preqin, buyouts in Q1 2020 have seen a decrease of 12% compared with Q1 2019 and venture capital investments have fallen by 23%. The way that deals are done – and the terms on offer – is also likely to change.

Due diligence

• Investors will be reviewing their diligence processes with an eye on those areas that have been found wanting during the pandemic. Investors are likely to increasingly focus on robustness of a target company’s supply chain and the termination and force majeure provisions of its contracts, as well as a company’s overall preparedness for a crisis and business continuity plans. More time is likely to be devoted to reviewing a company’s insurance policies and stress-testing its coverage.
• Depending on the extent of ‘social distancing’ requirements in the aftermath of the first wave of the pandemic, the way that due diligence is conducted is likely to change, with management presentations moving onto Zoom and virtual site visits becoming the norm. The lack of face-to-face contact may also mean that deals are less likely to be done, as investors backing a management team can no longer ‘look them in the eye’ and build trust and rapport in the same way.
• As a consequence of the above, due diligence will simply take more time, and so sellers are more likely to consider putting in place vendor due diligence to help oil the wheels of a potential sale process.

Pricing mechanisms

• We could see a drop-off in deals being priced on a locked box basis (despite this traditionally being the mechanism of choice for private equity), given the current volatility around many companies’ working capital flows, with completion accounts structures likely to be preferred by acquirers. Locked box accounts drawn up to 31 December 2019 will not be an accurate snapshot of a business as it is now.
• Earn-outs and other forms of deferred or contingent consideration are also likely to become more common to help de-risk a purchase for a buyer.

Risk allocation provisions

• Inevitably there will be a greater focus on risk and how it is allocated between buyer and seller. We may see liability caps increase, time limitations on warranty claims pushed out and buyers seeking more indemnity coverage for specific issues or including upper range estimates for debt-like items in the EV to equity bridge.
• We may also see new or enhanced warranties around topical areas of focus such as robustness of IT systems and other business continuity issues to help support the due diligence process and management confirmations. For areas of particular concern or importance, we may also see warranties elevated to fundamental warranty status (with higher liability caps) alongside the title and capacity warranties.
• Warranty and Indemnity (W&I) insurance may also be frequently employed to give investors greater comfort on their ability to recover for loss, particularly where they are across the table from a venture capital or private equity seller who will be unwilling to stand behind warranties beyond title and capacity.

Equity & investment terms

• Whether as part of a fund-raise or a management incentive plan, institutional investors may feel they have more latitude to insist on more investor-friendly terms. Investing capital in tranches instead of upfront, anti-dilution provisions, participating liquidation preferences (perhaps at a greater than 1x multiple) and more onerous consent rights may become more common.
• However, their room for manoeuvre may be limited when vying for the highest quality assets: the $1.48 trillion of private equity money looking for a home is likely to mean there will still be pockets of competition, particularly in well-run auction processes.
• Investors may shy away from a robust approach in any case, given the importance of reputational considerations. Investors taking a hard line with management teams now may find themselves treated with more apprehension when they look to make investments in future.

What’s next?

Many investors have been focusing and will continue to focus on stabilising their portfolios at this stage. However, those investors that have the capital and the inclination can expect a deal landscape embroiled in volatility but bubbling with opportunity, with depressed valuations and more investor-friendly terms on offer.

For many investors, reputational considerations will incentivise them to continue to take a balanced approach towards investee companies and management teams.

As we move through 2020, and the valuation expectations of buyers and sellers, or companies and investors begin to re-align, those sectors that are perceived to have borne the pandemic well or are expected to benefit, including health-tech, automated logistics, streaming services, edtech and e-commerce, are likely to be a key focus for investors flush with cash that they are on the clock to spend.