In late May 2020, BDO Canada and Fasken hosted a conversation with leading private equity (PE) firms on the slumping market conditions around the COVID-19 crisis. The panel identified two discrete steps in the PE response:
- Navigating current market conditions
- Emerging from these conditions to thrive
The webinar discussion featured Chad Danard of TriWest Capital Partners, Sameer Patel of Angeles Equity Partners, and Ted Mocarski of Novacap.
1. Navigating current market conditions
The PE-portfolio company relationship
PE investing is a relationship-driven business. During times of uncertainty, strong integration between the firm and portfolio company is especially critical. To lead portfolio companies through a pandemic, PE firms have found it helpful to increase the frequency of communication touchpoints with management teams. This allows them to proactively address market softness and liquidity constraints.
In the near term, companies and firms can expect to switch from offensive to defensive strategies. Instead of focusing on growth opportunities, PE firms will add value by leveraging their past experience in economic downturns and offering advice related to capital preservation.
Firms should support these relationships with data-based decision-making through constant access to KPIs and performance dashboards.
Human resources balancing act: Present vs. future
It is necessary to “right-size” any business to adapt to current conditions, possibly reducing staff to match current levels of activity. However, firms should protect a company’s employee base as much as possible. Keeping the labour pool intact will ensure that companies are able to grow when the broader economy rebounds.
This balancing act requires regular dialogue between firms and management teams. Failing to adapt sufficiently may compromise the business’s survival prospects, but cutting too deep will impede its ability to take advantage of the ultimate economic recovery.
Additionally, this crisis highlights the importance of effective succession planning, management team structures, and corporate culture, all of which can and should be revisited during this period.
Improving working capital
Cash preservation is critical during a crisis, and portfolio companies have employed many strategies. Companies should be mindful of aging accounts receivable, take advantage of flexibility offered by lenders and landlords, and investigate any available government subsidies.
It may be prudent to re-evaluate relationships with vendors to identify opportunities for extended payment terms; however, a company must not adopt a blanket approach that could risk the integrity of its supply chain as the economy recovers.
For select businesses, the outlook is even more positive. Some companies, especially those with recurring revenue-based business models, may have found that due to slowed growth opportunities but guaranteed revenues, working capital has in fact improved.
2. Emerging from the crisis
Diversifying supply chain diversification has become top-of-mind
One of the most salient risks of this crisis is cross-border exposure. Border closures could have a devastating impact on PE portfolios, as is the case for any globalized business.
To combat this risk as companies plan for recovery, some have opted to increase inventory on-hand. While this may seem counter-intuitive with liquidity at a premium, it may be prudent to take action now rather than risk missing out on sales when the economy rebounds.
In the future, investors will seek diversification within a supply chain, not only with respect to the number of suppliers, but also to the geographic location of those suppliers. This will eliminate an overreliance on any one partner. Of course, this diversification will come at a cost of lost bargaining power and increased administrative workload, but it is a trade-off that must be managed at an industry and company level.
Future diligence will consider COVID-19
Now and into the near future, investors and lenders will maintain an increased focus on risk, rendering some businesses more attractive than others. Any business model that is predicated on a full return to the business environment of 2019 will face a high degree of scrutiny. Investors will seek elastic business models that are adaptable to unforeseen marketplace changes.
Specifically, companies that have endured this crisis and escaped mostly unscathed will become attractive, as will those with strong diversification among customers, suppliers, products, and geographies.
Investors are also likely to highly value companies that are early and effective adopters of technology and those that have been able to implement an effective virtual operating environment with robust internal and external communication channels.
Opportunities persist for value creation
It has become more difficult for PE firms to conduct due diligence as it was traditionally performed—on-site visits to manufacturing facilities and evaluating management capabilities are just two items that are more challenging on virtual basis. On the other side of the bargaining table, business owners may feel less comfortable selling to PE firms without having developed an in-person relationship.
Nonetheless, meaningful opportunities for value creation persist.
Despite current levels of uncertainty, underwriters will continue to have opportunities to make data-backed decisions, even if those decisions are subject to heightened risk that must be thoughtfully addressed.
Additionally, PE firms should consider optimizations that could take place within their existing portfolios, including private-to-private combinations. These transactions can unlock scale and take advantage of synergies arising from any necessary retooling taking place during this time.
PE firms are entrusted with creating value not only in times of market growth but also in times of softness, and this crisis represents an opportunity to demonstrate this value to business owners, shareholders and limited partners.
In many ways, COVID-19 has brought the future to us more quickly. While many businesses were already grappling with a number of these considerations, they now have to adapt sooner than ever expected. Maintaining focus not only on short-term requirements, but also on longer-term opportunities, will ensure that PE firms and portfolio companies are well positioned to weather this storm and take advantage of the inevitable economic recovery to follow.