Can PE firms benefit from the COVID–19 downturn?

June 8, 2020 2:20 PM

Private equity (PE) firms with larger exposure to severely-affected sectors are the hardest hit and they need to act swiftly to minimize the impact and help portfolio companies sustain.

Private equity, PE firms, hardest hit, COVID–19, PE investments, SHIELD FRAMEWORK, crisis management structureIn this crisis, most PE firms have been reacting positively. However, are they taking comprehensive steps to minimize the negative impact and being proactive in capturing the upside in the current downtrend?

Recessions are a prominent part of the economic cycle and usually lead to crashes and bear markets. However, the current recession is different from others to date as it is not confined to any single sector or geography. It has gripped the entire globe and affected all sectors. Private equity (PE) firms with larger exposure to severely-affected sectors are the hardest hit and they need to act swiftly to minimize the impact and help portfolio companies sustain.

Analysis of historical PE deal activity suggests that large PE investments have been in industries vulnerable to economic downturn caused by COVID–19. Hence, it will be safe to assume that most large and mid-sized PE firms have been impacted by this historic downturn.

IMAGE 1: PE Investments by Sectors Impacted

Note: Sectors dependent on trade and free movement of people are most impacted versus sectors such as healthcare service provider is the least impacted

Ironically, recessions can be a lucrative investment opportunity for those who have the foresight to leverage it to their advantage.

The underlying reason behind the outperformance potential of PE firms is their ability to plan and invest for the long term. Historically, they have outperformed public equity firms during recessions and rebounded quickly as well (refer to Image 2). The main factors are as follows:

1. In uncertain times, cash is always king. PE firms employ this adage and help portfolio companies sustain during a grim period by injecting the required working capital. With this help, the companies can capture market share and manage to stay ahead of competitors.

2. The downturn represents a buying opportunity for PE firms with high dry powder. They have an edge over their competitors and, thus, can plan and deploy funds at attractive terms or valuations over the long term. Their ability to act fast and take a long-term view gives them some important advantages.

In this crisis, most PE firms have been reacting positively. However, are they taking comprehensive steps to minimize the negative impact and being proactive in capturing the upside in the current downtrend?

SHIELD Framework, a six-point crisis management structure developed for PE firms, contains guidelines to help PE firms respond effectively to the crisis and ensure that key issues are not overlooked.

SHIELD FRAMEWORK

1. Set Up a War Room: A dedicated team to govern and execute the necessary initiatives needs to be created. The team should coordinate daily and be equipped to take decisions on the go. It is also important to have in place a common crisis response mechanism for portfolio companies.

2. Help Portfolio Companies Sustain: Operational risk assessment for portfolio companies to identify business disruption is a must. They need to review and revise the valuation model to assess the overall impact on the business and infuse funds, if required, to meet working capital requirements.

3. Introspect & Reassess: It is important to undertake diagnostic analysis of the fund and, if required, revamp the fund’s investment strategy. PE firms must also design business continuity plan for portfolio companies and help them adapt to changing market and consumer dynamics.

4. Engage with Customers & Stakeholders: An immediate step for a PE firm is to map critical stakeholders and develop a communication plan to maintain the trust and reputation of both, the fund and portfolio companies. Constant communication through formal and informal channels will enhance transparency.

5. Liquidity Control Measures: Maintaining positive cash flow should be the top priority and all actions to ensure this should be taken. The balance sheets of portfolio companies should be reviewed as this will assist PE firms in taking important decisions regarding cash flow. Their performance must be monitored regularly, and any urgency should be responded to at the earliest.

6. Devise a Recovery Plan & Deploy Dry Powder: PE firms must develop mitigation plans for stabilizing businesses and preparing them for a rebound in the medium term. They must plan strategically to use the crisis to their advantage. Moreover, they must carry out post-recovery exit assessment for companies closer to the end of the holding period.

PE firms should find ways to leverage the crisis. The PE community at large should consider adopting the SHIELD framework to help portfolio companies effectively manage the ongoing economic downturn and use the dry powder available with them to invest in profitable companies or sectors trading at attractive valuations.

(By Siddharth Jaiswal (Sector Specialist – Financial Services), Business Research & Advisory, Aranca)

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