In a time when the economy has slowed, private equity is busier than ever managing through the COVID-19 crisis. From portfolio company cash flow and myriad operational threats to planning the next mergers and acquisition transaction, private equity firms are in overdrive. RSM has leveraged its vast private equity network to gain insight into what is on the minds of private equity professionals.
Portfolio company cash flow
Companies need to evaluate how to manage near-term cash flow, assuming sales and receivable collections dramatically slow. Taking time to review and assess portfolio companies’ financial forecasts for current economic conditions, as well as the period of uncertainty (e.g., minimum of 12 months, preferably longer) allows for proper planning and execution, including the ability to develop and discuss scenarios to work through issues with all stakeholders. Examples of strategies used by some of our clients follow:
Debt: Stress in the credit markets has emerged because of lender trepidation. The Federal Reserve has taken steps to alleviate that stress (read about them here). Portfolio companies should actively manage debt to bridge any shortfall in operational liquidity.
- Draw on lines of credit. Many PE firms are asking their portfolio companies to draw on their lines of credit to increase cash on-hand.
- Covenant freezes. Companies with debt covenants must assess which terms may not be achievable in the short-term and work with lenders to freeze those obligations temporarily.
- Temporary holds on principal and interest payments. Some PE firms have notified lenders that they should not expect any principal or interest payments in April and May (potentially longer). It is imperative for PE firms and companies to work collaboratively with lenders to mitigate long-term negative consequences of such actions.
Rent abatement: Some PE firms are negotiating rent abatement or deferral with property owners.
Extended payment terms: Portfolio companies are maximizing payment terms and, in some cases, negotiating payment term extensions.
Receivables strategies: Companies may want to evaluate their customer mix and related COVID-19 impact to assess whether to implement strategies to promote collections (e.g., early pay discounts).
Legislative relief
The U.S. federal government has enacted several relief programs to address the economic fallout from COVID-19. The following programs aim to provide relief to middle market businesses. Read more about these programs and their requirements here.
Coronavirus Aid, Relief and Economic Security Act (CARES ACT): Signed into law on March 27, 2020, the CARES Act provides two loan options for middle market businesses.
- Businesses with 500 to 10,000 employees that are affected by COVID-19 may be eligible for a loan with an annualized interest rate no higher than 2% and no interest or principal payments for a minimum of six months.
- Businesses with fewer than 500 employees that are affected by COVID-19 may be eligible for loans of up to $10 million with an annualized interest rate no higher than 4% and no interest or principal payments for a minimum of six months. Debt funds used in the first eight weeks following the loan origination will be forgiven if the borrower retains existing employees at or near current salary levels and the funds are used for certain payroll, lease, utility and mortgage expenses.
Coronavirus Preparedness and Response Supplemental Appropriations Act: Signed into law on March 6, 2020, the act provides eligible businesses up to $2 million in loans to businesses affected by COVID-19 at an annual interest rate of 3.75%. While eligibility differs by industry, most manufacturing businesses with fewer than 500 employees and most nonmanufacturing businesses with less than $7.5 million in annual revenue can qualify.
Of particular consequence to private equity regarding the CARES Act and the Coronavirus Preparedness and Response Supplemental Appropriations Act, the U.S. Small Business Association (SBA) requires applicants to aggregate their operations with those of any affiliates, as defined by the SBA. Private equity-owned companies may be considered affiliated when all of the other portfolio companies and employee numbers are combined.
Portfolio company operations
Key considerations for managing portfolio company operations through COVID-19 include:
Reevaluating forecasts: Analysts and associates at private equity firms are reworking models and forecasts. There will be a hypersensitivity to three-, six- and 12-month forecasts while companies manage out of the crisis. Updated forecasts are likely to affect operational decisions, capital investments and exit strategies. Smart businesses are evaluating revenue and expense metrics and using frequent updating techniques (e.g., real-time cash flow dashboards) to guide strategies.
Compliance with local, national and international COVID-19 guidance: Businesses are forming crisis teams consisting of C-level suite, general counsel, financial and other outside advisors, etc. Regardless, many companies are struggling to comply with COVID-19 guidance amid “stay-at-home” orders. Some private equity firms are working with attorneys to continue operations.
Supply chain disruption—it is important for companies to communicate with their supply chains to assess weaknesses and consider alternatives, if necessary. Regular communications and negotiations with vendors are critical.
Loss recovery claims—companies may be able to make claims for losses, including claims through insurance and forthcoming legislative programs. It is imperative for businesses to consider the measuring techniques used to support loss claims.
Cybersecurity concerns—COVID-19 has brought with it an influx of cyberattacks. While none of these methods are new, they use slight twists related to COVID-19 to prey on stressed systems. It is critical for businesses to educate employees on what these attacks look like and how to avoid them.
- Phishing campaigns. Phishing campaigns based on emergency themes target newly displaced workforces (e.g., spoofing communications pretending to be an authoritative body, like the Centers for Disease Control and Prevention).
- Process attacks. Process attacks target a company’s internal processes in an environment when certain systems and controls may not be available (e.g., circumvention of a payment approval process, claiming that the normal approver is out of pocket).
Attend RSM’s weekly series of coronavirus webcasts for insights into best practices to weather the storm.
Managing active deals
We are seeing the full spectrum of how COVID-19 affects deals, from terminating completely to pushing ahead at full speed. The larger percentage seems to be in the middle, with deals slowing down or hitting pause while buyers and sellers stay engaged. This deceleration results from disruption to everyday life, disruption to target operations and an underlying tone to wait out the pandemic to assess the full impact.
For those deals that remain active, there are key considerations that private equity investors should be thinking about now:
Working capital impact of COVID-19: The working capital impact of COVID-19 might be felt for the next two years, but there are things you can think about right now. Any deals that close in the next six months are likely to experience a COVID-19 impact on closing working capital that is not fully reflected in a trailing 12-month average. For example, a sales decline will likely translate to a reduction in accounts receivable, or supply chain constraints may result in a reduction of inventory. Conversely, receivables and days sales outstanding (DSO) may increase as customers conserve cash and stretch payables. Whether buying or selling a business, it is important to get ahead of working capital issues caused by COVID-19.
Purchase agreement issues
- Earn-outs. Given the potential impact COVID-19 will have on near- and medium-term results, previously inked deals are likely to have earn-out implications. Buyers and sellers for in-process deals will need to consider whether to modify for prospective earn outs.
- Material adverse changes (MAC) clause. A MAC clause allows a party to a purchase agreement to renege on the agreement in the event of a material adverse change. It is yet to be seen whether parties can or will attempt to enact this clause, but buyers and sellers should be aware and discuss with legal counsel.
Preparing for a sale and the valuation impact
Many private equity professionals believe the private equity market will rebound well. As a result, potential sellers are getting ready to hit the market fast when lending opens back up. The following are key considerations for companies preparing to sell in the next two years.
Tracking the EBITDA impact of COVID-19: It is too early to assess the impact COVID-19 will have on EBITDA, but it’s not too early to set the foundation for tracking the data needed to support associated adjustments. The longer COVID-19 affects operations, the more important supporting EBITDA adjustments will become. However, analyzing the impact and gathering the supporting data takes time. Competing for that time is the disruption COVID-19 has caused on operations (e.g., forced mobile working environments, disruption to supply chains, contract terminations, cash constraints, pipeline fallout, etc.), not to mention the impact on personal lives.
Given the uncertainty of the total impact, as well as time constraints, it is important to consider critical items today and contrast those with analyses that can be performed once the dust settles. Companies should think about the information that is available today but possibly unavailable (or may be less reliable) tomorrow. The list will differ for every business and depends on the operational processes already in place. The following are select examples.
- Backlog and pipeline. Companies often do not do a good job maintaining historical backlogs and pipelines. It’s even rarer for them to track underlying explanations as to why sales opportunities are not converted. Given the impact COVID-19 could have on conversion rates, it is critical to track those data points now (and gather information that may be needed to recreate those data points for the time prior to COVID-19).
- Customer retention metrics. For businesses with recurring or reoccurring revenue, tracking customer retention is critical. Just as important is gathering the underlying qualitative drivers at a level of detail that supports the impact of COVID-19. Companies may not be able to go back to lost customers six months from now to ask them why they left.
- Items to consider tomorrow – While much of the impact of COVID-19 will be supportable after the fact, it is important to begin tracking and gathering the support as soon as possible. Doing so will allow companies to better manage cash flow, reassess lender expectations, communicate with limited partners and prepare for an exit.
Tracking the working capital impact of COVID-19: Given many deals use a trailing 12-month target mechanism, working capital will be affected and normalizing adjustments will be prevalent for the coming year or two. Refer to the “Managing active deals” section above for more info on closing working capital for active deals.
M&A outlook
While overall sentiment varies across industries, there is consensus that the current environment is different from 2008, which was exacerbated by systemic issues in the banking industry.
- Timeout: In the short-term, our clients are pausing or slowing deal activity while they focus on stabilizing portfolio company operations. Deals that are further progressed are proceeding cautiously.
- Lenders sitting on the sidelines: Like private equity, lenders have shifted their focus to the liquidity of their portfolios. Deals with committed capital are proceeding cautiously, but new deals are having trouble finding leverage.
- Displacement of value between buyers and sellers: Buyers are reevaluating future forecasts and cash flows, which is driving a displacement of value between buyers and sellers. While buyers are communicating reduced enterprise values, sellers are scratching their heads wondering why the values of their businesses—which may be fundamentally unchanged—are not the same as they were three weeks ago.
- Potential shifting toward buyers’ market: Sentiment is that COVID-19 could result in a reduction of historically high multiples, depending on industry. In particular, some firms are expecting a heavy emphasis on add-ons, as many small businesses will need a liquidity event.
- Dry powder and available lending will fuel private equity: As alluded to above, there remains an abundance of funds for private equity activity. Many private equity firms are looking forward to getting back in the game and deploying capital at lower multiples. After a new normal is established in the form of revised pricing, there is an expectation that private equity will flourish.
- Potential increase in minority investments: Some businesses may not be ready to sell, but they may still need cash infusion to weather the storm. That could mean minority investments by some private equity firms that typically make majority acquisitions. Those that pivot will need the operational and legal playbooks to be strong minority partners.
- Subordinate debt investments: Some private equity firms have considered dabbling in subordinate debt investments in order to continue to deploy capital.
RSM understands that these are uncertain times for individuals, communities and businesses as the COVID-19 outbreak continues to spread around the world. We want to help however we can by providing information and resources for businesses. Please reach out to RSM if you would like to discuss the impact COVID-19 has had on your business and how to support related EBITDA adjustments.
