Middle Market Private Equity: Where Do We Go From Here?
COVID-19: One Year Later
Closing in on one year since COVID-19 first appeared, uncertainty has been, and remains, a constant theme. The broader economic picture seems tenuous at best, but M&A activity rebounded strongly in the last quarter of 2020, with all signs pointing to further resiliency in the period ahead. Still, while transaction volumes have recovered, it may be a long time before we see a return to some sort of pre-pandemic normalcy.
Many of the key players in middle market PE have been making adjustments that will likely remain in place for the foreseeable future. Whether this reflects a growing realization that dramatic economic, geopolitical and social events have in the past often led to new paradigms or is simply an instinctual response to unfamiliar circumstances, is an open question.
What we do know, however, is that middle market private equity has been significantly impacted. While final data is not yet available, reports from the ground and feedback from a broad range of Configure Partners contacts indicate that transaction activity in the segment was down sharply in the second and third quarters relative to their respective year-ago periods, and PE exits have been rare. Amendment activity has been substantial, but defaults have ticked only slightly higher. Perhaps unexpectedly, Configure Partners’ Credit Resolution practice has been relatively quiet in comparison to our Debt Placement practice.
First Things First
In our view, the current situation largely reflects two developments. First, sponsors have directed more of their attentions to strengthening and restructuring portfolio companies to help them address near term liquidity pressures, revenue shortfalls, and delivery risks. While aggressive central bank interventions and fiscal policy initiatives have been supportive, they have not been a panacea, especially for businesses operating in vulnerable sectors or without sufficient scale to weather the current storm on their own.
Many of our PE clients have contributed additional capital to their portfolio companies – in the form of equity, debt or hybrid financing – to help them bridge through liquidity constraints. Going forward, however, the key issue becomes one of securing appropriate relief from covenants and the runway to a permanent capital structure resolution.
Making matters more challenging, many of these same portfolio companies had been grappling with a shifting landscape even before COVID-19 erupted, and the crisis has basically accelerated what was previously a gradual transformation. Under the circumstances, pandemic-driven capital constraints have come at a particularly inopportune time. Management teams that already had their hands full must now adapt to a quickening pace of change in the operating environment, including major shifts in consumer behavior and an intensifying focus on technology-powered strategies and solutions.
Adjusting to changes over time requires consistent strategic focus but can usually be funded from operations. Coming to grips with warp-speed disruptions often requires significant investments and capital expenditures that cannot be financed in the same way, as well as an incremental liquidity runway that allows for operating initiatives to take hold. Historically, delays in making the necessary strategic and operational adaptations have proved costly, especially when those delays emanate from capital constraints. Many portfolio companies are experiencing a need for strategic realignment at the exact moment that COVID-19 has inhibited capital resources.
Looking Toward the Horizon
Portfolio diversification levels and target sectors have driven something of a bifurcation among sponsors: some funds have had little choice but to remain in triage mode for longer than anticipated, while others have been able to quickly shift focus toward identifying new opportunities. For those with one or more heavily exposed portfolio companies, tactics have included drawing down revolvers and furloughing employees. In cases where liquidity could not be preserved, or sourced internally or at the fund level, some have turned to NAV-based loans to support the affected portfolio companies.
Despite the hurdles, most PE firms have adapted. Sponsors are proactively developing revised operational plans, reformulating value-creation strategies, and pinpointing the capital structures needed to support these shifts. With stability returning in some segments, management teams and investment professionals are also turning their attentions to revised growth plans, focusing on the impact of remote work, de-risking supply chains, acquiring smaller competitors, and other initiatives made for a post-COVID-19 world.
When it comes to new opportunities, many sponsors are putting greater emphasis on including operational improvement strategies — and the teams to support them — as part of the broader investment thesis. As we saw during the last big downturn following the global financial crisis, a similar adaptation enabled many funds to post outsized returns in the years that followed.
What Lies Ahead
To be sure, the biggest source of uncertainty going forward is the depth and breadth of a pandemic-driven economic downturn. As we saw with the global financial crisis, the “last man standing” effect was the primary driver of post-crisis returns. The businesses that are able to survive a decline will likely face a smaller number of competitors when the economic cycle is back on the upswing. Often, particularly in the middle market, the last ones standing are the companies with professional management teams and capital resources from institutional investors.
Ironically, another major challenge for most of our private equity clients stems from the success that they had achieved before the pandemic struck. A decade of strong returns attracted significant and growing interest from across the LP universe, and managers must now deploy a sizable amount of dry powder, which is more difficult in the current environment.
That said, investors have been remarkably resilient through the years. Faced with challenging economic, financial and geopolitical conditions in the past, sponsors have been able to reorient strategies, refresh models, and realign operations to make the most of the situation.
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