A related opinion article was originally published on March 12, 2020
One large and powerful group of investors, with plenty of money to put to work, need not panic quite so much at the precipitous falls stock markets have suffered due to the spread of the coronavirus Covid-19 and the lockdowns that have followed. Instead, its members are already looking for bargains amid the carnage, sometimes hunting alone, sometimes coming together in packs.
In that wonderful, bygone, sunlit age – back at the start of February – data from Preqin, Dealogic and other sources suggested that across funds dedicated to buyouts of established companies; venture capital to support growth; dedicated infrastructure, real estate, special opportunities and distressed funds, managers of private equity had more than $2 trillion of dry powder – money that had been raised in large rounds of fund raising but not yet invested.
In the first phase of any financial market panic, correlations go to one. Investors sell anything they can see a bid for, irrespective of quality. The only surprise about government bonds, credit and stocks all crashing at the same time is that anyone should be surprised. Cash is king.
The guardians of these large pools of private capital are sitting on a lot of it. If governments can hold societies and economies together for now, central banks protect financial systems and their portfolio companies survive, then these private cash buyers will be big drivers of whatever happens next.
“This is different from what happened during the financial crisis in 2007/08 and the dotcom bubble in 2000,” Klaus Hessberger, co-head of the strategic investors group EMEA at JPMorgan, tells Euromoney.
Klaus Hessberger, JPMorgan
In the last crisis, Hessberger worked in equity capital markets, seeking various pools of capital that overleveraged corporates might tap for rescue equity raisings and rights issues. Private equity had already done its work.
“In those days, there was less dry powder available,” Hessberger recalls. “Private equity had previously amassed large funds but then invested most of it in big leveraged buyout acquisitions in 2006 and 2007.
“This time, most funds have a lot more capacity to invest, having just finished their fundraisings.”
Much of that uninvested cash comes from long-term investors such as sovereign wealth funds, pension plans, wealthy family offices and some public funds allocating to alternatives.
It has also been boosted by some of those limited partners in private equity funds, led by Canadian pension plans and some of the Middle Eastern and Asian sovereign wealth funds, opening further pockets to co-invest directly in targets alongside the private equity sponsors or even on their own.
This February, consultants at Bain calculated that, looking across all fund types for general partners and limited partners, uncalled capital, which has been rising since 2012, had hit $2.5 trillion by the end of 2019.
Those cash piles, which up until February this year were a drag on sponsors’ returns, are now an immensely valuable source of future performance.
Private equity has never been so cash rich. Assets have rarely been so cheap. Vast fortunes are going to be made by those who best take advantage of this extraordinary combination.
Pier Luigi Colizzi,
“What we are seeing right now is that these large private pools of capital, which, as well as sponsors, also include family offices, sovereign wealth funds and even activists, are now presenting themselves to companies as potential providers of investment right across the capital structure,” says Pier Luigi Colizzi, head of M&A for Europe and Middle East at Barclays.
“They are able to evaluate changing situations quickly. They do not just buy companies outright. They can also take minority equity stakes, buy hybrid instruments, provide straight debt and even credit lines. They can present themselves as a potential solution for companies under stress and uncertainty.”
There are a lot of Warren Buffet wannabes out there looking for the next $5 billion investment in preferred stock of Goldman Sachs in 2008.
And, perhaps surprising to hear, there is also still appetite to lend.
“As part of our fiduciary duty we are providing liquidity on debt and equity trading on a daily basis and we are still providing underwriting for bond and loan deals in buyouts,” says Hessberger. “If a client sees an opportunity, we can tailor a solution and finance it.”
What we are seeing right now is that these large private pools of capital... are now presenting themselves to companies as potential providers of investment right across the capital structure- Pier Luigi Colizzi, Barclays
Cash-rich investors know that corporate owners that were already intending to dispose of large divisions and focus on core operations, family founders of businesses and public shareholders will not be looking for outright sales for some time yet.
The gap between sellers’ valuations and those of buyers widen to unbridgeable extremes in times of stress. And the financing markets are difficult to access.
Even in late March, investment-grade companies were still coming to the primary bond markets in size on the good days. But high-yield funds were seeing heavy outflows, and spreads had widened quickly to crisis-era highs.
Any private equity buyer descending on a company it has not previously approached and hoping for a quick acquisition may struggle to win support from lending banks and the broader financing community. They need some leverage to make deals worthwhile. But as M&A falls quiet, there are other ways to put cash to work.
Hessberger says: “Sponsors will be looking at shares and debt trading levels of portfolio companies they have IPO’d – even ones they have sold outright but still know well – and may buy back stock that they think has fallen too far.
“As well as special situations funds for taking minority stakes via straight equity or PIPE-style [private investment in public equity] investments, they might support companies with liquidity lines. Some of the sponsors also have credit funds and may be willing to buy debt trading on the secondary market at 60% to 80% of face value if they think irrational market moves have pushed prices far out of line with credit fundamentals.”
There is no shortage of candidates for beaten down secondary market bond and stock valuations. But even the smartest and most cold-blooded investors need to think carefully about providing new money.
“There is a massive dislocation now underway,” says Eamon Brabazon, co-head of EMEA M&A at Bank of America. “However, we have seen its like before. Remember that the great financial crisis also felt like Armageddon, with a different bank collapsing every week. So, while the duration of this episode remains to be seen – and we all hope it may wash through the system in just a few months – it does feel time limited.”
The first thing to do is select potential winners among the many more obvious losers. Panic-stricken sell-offs tend not to discriminate finely between the two.
“Some of the losing sectors are obvious – transport, tourism, restaurants,” says Brabazon. “You can see distress in their share prices and with potential future liquidity concerns. These are the obvious first-order impacts. And while the more nuanced second- and third-order effects yet remain unclear, it is inevitable that a number of companies in these sectors will have a requirement for capital injections.”
Private capital will be available, at a price.
Only when the bear market we are living through eventually falls into depressed acceptance of lower valuations will private capital fully go to work in takeovers. When it does, it will likely move fast.
“The speed at which equity valuations are changing right now is unprecedented,” Simona Maellare, global co-head of alternative capital at UBS, tells Euromoney.
Speaking in the second week of March, Maellare points out that: “Every price that seemed to have been reset last week was overturned again this week.”
And this pattern has carried on since.
“But private equity clients understand this,” Maellare says. “They are out looking now at what there might be to buy. They may prefer resilient assets with conservative business plans at first. And vendors will not be so quick now to dispose of assets they had previously earmarked for sale, unless they are forced sellers. Also, there will be less leverage available. But this will be a huge opportunity for private equity, and there will be some very large deals.”
Private equity buyers are focusing on what other targets they have been doing work on, and as soon as credit markets normalize, they will strike very quickly- Klaus Hessberger, JPMorgan
These investors have already demonstrated that they can hold their nerve amid heightened public stock market volatility. Likely to be the first big buyers back into the M&A market when valuations eventually stabilize, they were also among the last to step out.
On March 18, 2020, KKR Infrastructure agreed to pay £3.7 billion to Pennon Group, owner of South West Water and other regulated UK water companies, for Viridor, its waste management and recycling subsidiary. Briefing analysts on the day the sale was announced, Chris Loughlin, chief executive of Pennon, sounded surprised that a transaction could somehow be completed amid such extraordinary market turmoil.
It gives the UK company cash to pay down debt, potentially to invest in additional water assets (if further consolidation now comes to the provision of this essential service) and to return to shareholders. And while the sale was the result of a classic restructuring process, with the company deciding last year to narrow its focus on water and realize value from a recycling operation it had nurtured for many years, this is an opportune moment to show creditors and investors substantial cash resources.
The proposed sale values Viridor, which recycles waste into energy among other activities, at 18.5 times ebitda.
“That is a significant uplift from the current implied trading value,” Loughlin pointed out, and even from the implied value when negotiations first began following the board’s strategic review of the group business portfolio in September 2019.
If certain contingent payments to Viridor are received in the years ahead, KKR may yet pay an additional £200 million in consideration.
This is not a sudden deal. It was in the works for months and just managed to get across the finish line, even while other private equity bidding processes were being put on hold as the primary leveraged loan and high-yield bond markets slammed shut.
A banker away from the Viridor transaction tells Euromoney: “That one got financed and done thanks to the quality of the underlying asset and the quality of the sponsor.”
The deal is still subject to shareholder and regulatory approvals. There’s a potential break fee of £42 million, payable to KKR if the Pennon board were to amend or withdraw the recommendation to shareholders to accept the offer.
It would, of course, be mad to do so.
And this is not an isolated example of private equity holding its nerve through market turmoil to complete big acquisitions.
At the end of February, a consortium of private investors led by Advent International, Cinven and German foundation RAG and including a couple of sovereign wealth funds, agreed to pay €17.2 billion for the German conglomerate thyssenkrupp’s elevator business. The deal should complete later this year.
By the time it was signed, European stock markets were already selling off sharply on the realization of just how serious the economic impact of the Covid-19 pandemic was going to be.
On February 19, the Europe Stoxx600 index had hit a 2020 high of 434. By the time the private equity consortium signed this purchase, it had already fallen over 13% to 375.
By March 18 – the day Pennon sold Viridor to KKR – it had hit 280, down 35% in just four weeks: an extraordinarily rapid crash that no investor or analyst was then calling the end of. Over the same period, the FTSE100 had fallen 32%.
As Euromoney goes to press it is still not yet clear when and how the thyssenkrupp Elevator purchase will be refinanced or quite how much equity the consortium members will each provide.
This is a big-ticket transaction. The Abu Dhabi Investment Authority had long been interested in the asset and is thought to have joined the consortium early on in a competitive bidding process against other sponsor-led groups.
One source away from the deal suggests that one of the Asian wealth funds also came in much later.
“There was a consortium here simply because the purchase price was so high,” this person says, adding: “We can only assume that it will be refinanced in multiple markets.”
What is remarkable is that the deal – one of the largest LBOs ever in Germany – was agreed at all with the crisis already unfolding. That shows a willingness to look through volatility in public market valuations in order to seize highly desirable assets and a determination to ride out further falls in valuation that could yet be quite sharp.
There won’t be any more deals of this size until equity markets settle and prices stabilize.
Withstanding the storm
Private equity sponsors have other things on their minds right now than bargain hunting: namely, looking after the companies they already hold in their investment portfolios.
“Every conversation with private equity clients begins with their portfolio companies’ liquidity positions,” says Colizzi, “whether they have already drawn their revolving credit facilities; what planned expenses may now be saved or investments delayed and what additional capital they might need to withstand this storm.”
This is the top priority ahead of the search for other companies that may suddenly be offering very generous terms for new debt or equity.
It also gives the large banks insight, through their sponsor coverage groups, into a rolling wave of drawdowns on backup credit lines that are increasingly likely to be heavily used.
These are meant to be saved for an emergency when other sources of funding – commercial paper for better-rated companies, flexible short-term working capital and overdraft facilities from banks, and trade credit – might suddenly dry up.
This is an emergency. And the heavy use of revolving credit facilities – war-gamed in every regulatory stress test – will now limit banks’ ability to lend. The big private equity groups will be rigorously imposing liquidity discipline on every company they fully own or majority control.
“What we saw in the first couple of weeks among sponsors and other private market investors,” says Hessberger, “was an almost 100% focus on this bottom-up review of their portfolio companies, pressing management teams for updated business plans and reruns of their numbers, taking account of the virus, and stress testing for a U-shaped rather than a V-shaped recovery, along with projections for liquidity and capital needs.”
Private equity fund managers learned their own lessons from the great financial crisis. They now employ large operations teams – the kind of people you never see on CNBC or at industry awards dinners – and these have been coordinating management of financial and operating issues across portfolio companies in different industry sectors and geographies.
As the first shock at the speed of spread of the virus and at the depth of the economic shutdown starts to pass, these operating teams can spend a portion of their time sharing insights with investment managers on potential credit and equity buying opportunities; both for minority stakes and for assets they might eventually want to own outright.
Flight to quality
What is private equity looking for right now?
“There will be a flight to quality,” says Jonathan Arrowsmith, head of advisory at Investec corporate and investment banking. “Managers of these private pools of capital are looking for underlying assets in resilient sectors that either have no or only limited exposure to coronavirus – for example, technology, business services, software.
“Only once they understand the likely magnitude and duration of the impact can cash-rich investors start to think about a valuation.”
Those judgements are very hard to make right now on any business. That’s why public equity market valuations continue to jag downwards.
One source tells Euromoney they have just been in a pitch with a technology company where coronavirus didn’t even rate a mention: remarkable for any business meeting in mid March.
There will be a premium for stability over growth in the months ahead. It will be some time yet before the bargain hunters are searching for opportunities in manufacturing industries with complex international supply chains.
Even investors with bags of cash can only focus on acquisitions they can take a calculated gamble on. And even if they are prepared to stretch, the credit investors they depend on won’t accept uncertainty. They will only finance resilient assets in the first phase of any stabilization and recovery.
M&A bankers say it will only be much later that equity-based consideration becomes acceptable in consolidation within industry sectors that survive.
If maximizing value is your overriding objective as a vendor, then the months ahead will not be the right time to sell, because even the best assets will not achieve that- Simona Maellare, UBS
At the end of some of the meetings for this story, Euromoney was amazed at conversations that have so quickly become matter of fact.
“There is still going to be an airline industry,” one source reassures us, “but it will have a very different structure than it does today, and we can’t tell yet what that is going to be.”
“There’s a lot of talk about private equity buying biotech companies at the cutting edge of the search for a vaccine,” another points out. “I’m not so sure. You don’t need to buy a healthcare company at 25 times earnings in the hope of eventually selling it for 35 times, when you could probably do better buying an airline at one times ebitda and hope to sell it at 2 times.”
Arrowsmith agrees: “There has to be a period of stabilization first. But when that comes, motivated sellers with assets that are both coronavirus- and recession-resistant – that had perhaps already been thinking for some time of disposing of assets before this pandemic broke out – will be keen to sell as soon as the window opens.” Maellare at UBS says: “If maximizing value is your overriding objective as a vendor, then the months ahead will not be the right time to sell, because even the best assets will not achieve that.”
And while private equity can move fast to make acquisitions, it can also be patient once it has secured them.
“This is definitely an opportunity,” says Maellare. “We saw one of the biggest LBOs of the past 10 years agreed while Covid-19 was already materializing, even though its impact was not as clear as it is now. There will be a re-rating. But private equity can afford to buy businesses and take the risk of short-term underperformance. If valuations fall for the next six months, private equity will be fine over the next three, four or five years.”
Seizing the chance
Sellers keen to raise cash might seize the chance to get out even at far lower valuations than prevailed at the start of 2020. The attraction of selling to private equity is that deals are much less likely to be held up on competition grounds than sales to corporate buyers.
thyssenkrupp Elevator sums this up nicely. It is a business that combines manufacturing, still subject to uncertainty about plant closures, but also long-term servicing contracts that its customers must stick to, even if servicing visits are delayed. It is therefore quite defensive, hence perhaps why the private consortium was so keen to seal the deal even as the big sell-off was just gathering steam.
The vendor had its own strong motivation to proceed. thyssenkrupp is a renowned German conglomerate fallen on hard times, with management under pressure from activists to deliver a radical restructuring. It is selling one of its best performing businesses and will reinvest €1.25 billion of sale proceeds in a minority stake to retain some upside.
A portion of rest of the cash will be used to pay down debt and partially fund pension liabilities to strengthen the balance sheet and hopefully secure an investment-grade credit rating.
The company will have to invest the remainder in improving retained portfolio businesses.
Martina Merz, chief executive of thyssenkrupp, said when the sale was announced: “Not only have we obtained a very good selling price, we will also be able to complete the transaction quickly.”
A strategic sale to an industry competitor in the elevator business might have required lengthy consideration from competition authorities. In negotiations with employee representatives and the IG Metall union, the buyers also committed to far-reaching site and employment guarantees.
In addition, it was agreed that the buyers will continue to manage thyssenkrupp Elevator as a global company.
Bank of America
One reason that the bidding consortium succeeded was no doubt the inclusion of RAG-Stiftung, a German foundation set up to fund from its investments a perpetual obligation to contain the environmental damage from hard coal mining in Germany, particularly pit water management and groundwater purification.
Bernd Tönjes, chairman of RAG-Stiftung, said when the sale was announced: “We value thyssenkrupp Elevator’s long heritage. The consortium is committed to maintaining its headquarters and its strong roots in Germany.”
“I suspect that RAG-Stiftung gave the consortium a local flavour that helped win over the German establishment,” suggests one banker away from the deal.
Tönjes also alluded to the defensive characteristics of the investment, which also no doubt attracted Cinven and Advent as the financial world trembled: “This asset fits into the foundation´s portfolio extremely well because we expect it to provide stable returns.”
When M&A resumes, there will be three groups of sellers to watch out for.
Family owned companies will likely be most reluctant to abandon the valuations they might have enjoyed before the crash.
The playbook for corporate executives right now is that they are still internalizing the shock... They have to assess the impact on their businesses and try and figure out if they are winners or losers- Larry Slaughter, Bank of America
Executives of large corporations considering disposals of big divisions will likely feel the same but be more pragmatic, as were the leaders of thyssenkrupp.
“There could even be bilateral deals negotiated with sponsors and other funds including family offices, infrastructure, sovereign wealth and pension funds,” suggests Hessberger, “if corporate vendors worry about failed auctions further depressing pricing or need a speedy equity injection.”
That’s a few months away yet.
“The playbook for corporate executives right now is that they are still internalizing the shock,” says Larry Slaughter, executive vice-chairman of global corporate and investment banking at Bank of America. “They have to assess the impact on their businesses, and try and figure out if they are winners or losers. We are spending much more time with corporates right now than with private equity funds, which tend to be quicker in their thinking and more able to stop and start processes. Corporations are focusing on capital and funding needs. They’re not even thinking about M&A right now.
“However, the time will come when they lift their heads up and look for opportunities. And if we are through this in six, nine or 12 months, that resumption in activity might come much sooner than it did after 2008.”
Portfolio managers of institutional shareholders in public companies will be the most interesting. They too will hate selling out at lower valuations, but monitoring prices every day and thinking about comparative performance may incline them to listen to offers with a more receptive ear.
“There had not been a lot of public-to-private transactions for almost a decade until 2019, which was a record year for them in the last 10 years,” says Arrowsmith at Investec. “Private equity sponsors have worked out how to take companies from the stock markets, how to incentivize management teams and make those deals work. Public investors will need to see a rationale for a sale that works for them, but they are no longer opposed on principle to selling to private equity.”
And recent experience shows that when private equity bidders do come forward, public company management teams, boards, advisers and investors are usually good at flushing out whoever else might be interested and encouraging price tension.
“I think we will see more public-to-private deals, when we get through this, albeit at much bigger premia in partial recompense for much lower valuations,” says Colizzi.
Private equity bidders were close to a number of assets that they have analyzed for a long time but whose disposals are now on hold. As soon as M&A activity resumes, those deals will be straight back.
“Private equity buyers are focusing on what other targets they have been doing work on, and as soon as credit markets normalize, they will strike very quickly,” says Hessberger.
So much is so uncertain right now. But this is becoming clear: human society, the world around us, the financial and business worlds will be changed by this pandemic, possibly quite radically.
Private capital will end up owning an even greater share of world GDP and of the corporations that employ us.
Critics have called them mere financial engineers or worse, locusts. For their part they proclaim their patience and long-term vision.
Let’s hope they show that.