In the wake of the COVID-19 crisis, private equity funds (General Partners, or GPs) have a lot on their minds from the health and wellbeing of their own employees and the employees of their portfolio companies to the urgency to deploy capital in a market where there won’t be many buying opportunities. But one of the most pressing topics on the agenda is the stability and health of their portfolio companies, especially those that are in sectors particularly hard hit by the crisis such as hospitality, travel and leisure.
Before COVID-19, growth and margin improvement initiatives had already increased in importance compared to other levers for PE value creation.
GPs following a “good to great” investment strategy have been investing in growth and margin improvement initiatives (“performance improvement”) to boost operating cashflow (or EBITDA, as a proxy) in their portfolio companies since the industry’s formation. Along with multiple uplift and deleveraging, performance improvement was one of the three main sources of value creation. In fact, recent studies, including one for the UK's Private Equity Reporting Group (PERG), have shown that performance improvement has become increasingly important in recent years. An INSEAD/Duff & Phelps study pointed out the particular importance of revenue growth, especially through underlying industry growth and buy-and-build strategies.
In the years leading up to the COVID-19 crisis, many GPs invested more in external advisers and inhouse teams to identify and deliver these performance improvements. Initially, these teams were small and focused where problems had arisen. However, in recent years, as challenging EBITDA improvements were baked into entry prices, the scope of activity expanded:
- From industry expertise to functional expertise. While industry expertise remains the primary focus, PE firms are investing selectively in areas such as procurement, finance, IT and pricing;
- From traditional functional areas to more contemporary domains such as big data/analytics, digital transformation and eCommerce;
- From focusing on underperforming companies to the systematic optimisation of most portfolio companies;
- From post-deal only to across the deal cycle (i.e. due diligence, value creation planning and realisation, buy-and-build integration and exit planning) and
- From senior/CXO only to mid-level (i.e. more “doing” as opposed to just directing and monitoring)
Before the pandemic crisis, the opportunity for multiple arbitrage was already more limited due to increased competition for deals or it was only available with significant execution risk (i.e. need for major restructuring). Post-crisis, valuations will be under even more pressure with GPs focused on evaluating targets’ liquidity needs, cash reserves and debt capital structures and insisting on heavy discounts. If they were not already, GPs may be preparing to sell at lower multiples than they bought, reinforcing the criticality of EBITDA improvement. Access to debt has already tightened and, at least in the short-term, there may be a power shift to lender-friendly structures, including lower leverage, an uptick in equity for deals and tighter covenants. As a result, performance improvement will continue to grow in importance as it provides a more sustainable approach to value creation and helps to underpin risks to the investment thesis.
COVID-19 will accelerate this shift towards portfolio company improvement with an emphasis on liquidity management in the short-term and operational improvement in the medium-term.
Today, GPs are prioritising portfolio company preservation and improvement over new deals. They are evaluating their portfolio to identify the companies which present the greatest risk to fund performance and developing tailored plans for each. In the short-term, GPs are focused on the safety and protection of workers, stabilising operations and managing liquidity risks. Proactive GPs are not letting a good crisis go to waste by taking a close look at operations and costs. At the same time, GPs are preparing for the recovery, knowing full well that those portfolio companies which are prepared to take advantage of the recovery will emerge stronger and hence more valuable.
While now may not the right time to sell, it seems to be a good time to invest selectively in portfolio improvement and to be on the lookout for well-priced assets. GPs will be looking at undervalued public companies and businesses exhibiting strong fundamentals but in need of a cash injection. To explore why a growing number of PLCs are in the cross hairs of both PE and activist investors, take a look at Between A Rock and a Hard Place.
In my next post, I’ll be talking about why, under the stress of COVID-19, a growing number of improvement projects and increasing project complexity, a less structured approach to portfolio company improvement may not deliver the desired results.