Middle Market LBOs in a Post-COVID World
Private equity sponsors are looking backwards and forwards
With 2020 in the rearview, it is time to focus on what’s to come in 2021, and the story is all about the lasting economic impacts of COVID-19. Comparisons have been made between the global financial crisis (“GFC”) and the COVID pandemic, but the two events have little in common other than the widespread nature of the impact. The fallout from the pandemic has not fully developed, but it is clear that it has reached across all segments of the economy. Configure Partners occupies a center seat in the deal ecosystem, which has afforded us some unique perspectives over the last several months.
Private equity investors and their portfolio companies have been remarkably nimble, focusing initially on portfolio company liquidity, preserving option value, and extending runway with their lenders before shifting attentions to the opportunity set presented by the economic disruption. There is reason to be optimistic, but in some ways the road ahead will likely be more challenging and less familiar than the one behind.
This seems especially true in the middle market segment, which had been a bastion of strength before COVID-19, largely owing to developments that stem, ironically, from the last crisis. Increased regulatory scrutiny in the banking sector and more stringent capital adequacy rules forced some banks to exit or rein-in certain lending activities, which created an opening for nonbank lenders to step into the void, gradually becoming the dominant players.
A relentless hunt for yield among individual and institutional investors also resulted in a significant increase in fundraising across the landscape of alternatives, especially in middle-market PE, engendering intense competition that has boosted purchase multiples and facilitated more borrower-friendly terms, including a proliferation of cov-lite deals.
A Sudden Stop
Things changed, however, in the immediate aftermath of the COVID eruption. M&A volume nearly came to a halt. When deals did occur, valuations were down sharply, largely impacted by economic uncertainty and doubts surrounding the length and depth of the pandemic-driven crisis. While public markets soon rallied in the wake of central banks’ response and fiscal initiatives such as the CARES Act, middle market M&A lagged. Sellers were hesitant to move forward amid a widespread decline in pricing expectations, and many sales processes were put on hold.
That pause did not last long. For the most part, the crisis did little to curb appetites for higher-yielding assets, especially with the Federal Reserve backstopping a range of corporate and high yield fixed-income markets. With funds holding significant amounts of dry powder, demand for companies deemed “COVID-resilient” rebounded quickly. In recent months, purchase multiples have recovered to — and in many cases exceeded — pre-pandemic levels. Leverage levels as a multiple of EBITDA have also recovered for these businesses, though the purchase-multiple expansion has resulted in lower loan-to-value (“LTV”) ratios.
The appetite for deals seems to have recovered, but there remains something of a mismatch. While there is as much — or more — capital targeted to the middle market as there was before the crisis, some new obstacles have been introduced. First, some sellers are concerned about pricing expectations and uncertainty about the longer-term outlook have led many to delay a potential sale, at least for now. At the same time, private equity sponsors are increasingly “picking their spots” as they try to identify which sectors will thrive in a post-COVID world, resulting in a more discriminating investor universe. Logistically, social distancing restrictions have also made it more difficult for buyers to conduct traditional due diligence.
An Entire Year…in the 4Q
Perhaps the most significant challenge to closing acquisitions right now is the sheer volume of deals that sponsors are trying to get done prior to the 2020 year-end, which may stem, in part, from concerns about a more challenging tax and corporate policy environment beginning next year. At this point, lenders are resource-constrained, and many sponsors are facing something of an uphill battle in gaining the attentions of the right individuals at the right lenders to maximize interest and drive optimal credit terms. Several lenders are effectively “closed to new business” as they work through their backlogs.
As 2021 unfolds, transaction volumes, including for companies that were adversely impacted by this year’s events, will almost certainly increase. Like private equity sponsors, lenders will likely be focused on industries and sectors where they believe they understand the pandemic impact, the nature of the subsequent recovery, and the fundamental drivers. The buyer diligence process will almost certainly involve heightened scrutiny, potentially accompanied by increasing pressure for seller indemnification coverage.
Goodbye 2020, Hello 2021
Against this backdrop, maximizing interest in acquisition financing will require a different paradigm than what we have seen in recent years. In particular, optimizing terms will require an increased understanding of which lenders are interested in which sectors, as well as their degree of comfort with various credit challenges.
We expect to see a few key trends impacting sponsor-backed transaction activity. Sponsor exits of portfolio companies will likely decrease in 2021 as sponsors opt to return capital through dividend recaps rather than sales at depressed multiples. Where a dividend recap is not possible, a growing number of sponsors will seek to refinance portfolio companies to extend capital structures and post-COVID runway in an effort to put the crisis firmly in the rearview mirror before evaluating a potential exit. The objective will be to exit those companies — with better financial performance — a few years down the road.
Other sponsors, meanwhile, have begun shifting internally to a strategy of value creation in their portfolio companies through roll-ups and bolt-on acquisitions. They are evaluating the capital structures of those businesses and their ability to accommodate such transactions.
In the end, while the COVID-19 crisis and the GFC may differ greatly, odds are that investment decisions made over the next several months will have an outsized impact on fund returns, mirroring what we saw in the wake of the earlier upheaval. That said, capitalizing on opportunities as and when they present themselves will likely be more competitive this time around. But as in the past, private equity will undoubtedly adjust to accommodate the new normal of 2021.