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COVID-19 Checklist of Considerations for Private Equity Funds and Portfolio Companies

May 11, 2020

Private equity funds and their portfolio companies are facing a crisis of unprecedented proportion. To help you navigate this crisis, EisnerAmper has prepared a high-level checklist of key considerations.

  1. Valuation Considerations- Q1 2020 and Beyond
  2. High-level Due Dilgence Considerations in a Virtual Environment
  3. Information Management and Security in a Work from Home Environment 
  4. Fund-Level Tax Issues
  5. Portfolio Company Tax Issues
  6. Paycheck Protection Program Loans

I. Valuation Considerations - Q1 2020 and Beyond

With the onset of COVID-19, the long period of soaring private equity valuations appears to be coming to an end. Public markets have dropped dramatically since early March, and expectations for the global economy in the near term are not positive. In light of the new turbulent landscape, private equity firms have very little time to evaluate recent market conditions and develop reasonable fair value estimates for their portfolio company investments, as Q1 2020 reporting deadlines are fast approaching. What should private equity firms be thinking about when marking their investments in such an environment? In many respects, the issues which merit consideration are relevant in any market environment.

Portfolio Company Information Flow

  • When markets are dislocated, the typical routine of receiving portfolio company information on a monthly basis that supports valuations no longer applies; private equity firms should now be in constant contact with and receive timely updates from their portfolio companies.
  • Firms will need more than the usual balance sheet, P&L and 12-month forecasts to develop their valuations; sales backlogs, stability and availability of the workforce, and business continuity plan updates are part of a host of topics that need to be communicated and understood.
  • Private equity firms will need to have a direct dialogue with company lenders to assess companies’ short-term liquidity needs, as such matters may have a large impact on the value of a company’s equity.

Valuation Methodologies

  • It is highly likely that the mix and weighting of market-based and income-based valuation approaches applied in 2019 will need to be revisited in 2020 quarterly valuations.
  • The valuation methodologies used for each investment will likely vary depending on facts and circumstances; for example, methodologies used for investments in industries such as hospitality will need to change, as historical company performance and multiples may be much less relevant than in the past.
  • Investments that in the past were valued using an income-based or discounted cash flow (DCF) technique may be the most challenging as predicting the future has never been more difficult.
  • Valuations derived from recent (e.g., Q4 2019) financing events may be less relevant then they might otherwise be when marking such investments in 2020.

Comparable Companies and Transactions

  • Now more than ever, firms should scrutinize the comparable company sets used when valuing their investments.
  • Turmoil in the public markets will likely cause current comp sets to have outliers (good and bad) that may need to be considered for removal or inclusion.
  • Valuation multiples derived from recent 2019 transactions may not be nearly as relevant as they otherwise would have been.

Qualitative Considerations

  • As is often said, valuations are an art form, not a science; qualitative considerations are often highly relevant when forming valuation conclusions, especially in times of market turmoil; therefore, now more so than ever, it is critically important to thoroughly explain why and how you concluded on your fair value estimates.
  • Broad-based correlation to the public markets may be too simplistic when valuing investments in private companies; a private company’s unique characteristics and issues will drive the ultimate valuation conclusion.

Document the Analysis

  • The importance of a well-documented valuation analysis that comprehensively presents the quantitative and qualitative considerations cannot be overemphasized.
  • Telling “the story behind the valuations” will be very important for Q1 2020; investors, auditors and others that use or assess the valuation analysis will be less likely to play Monday morning quarterback if the analysis is thoughtful and well-documented.

Going Forward

  • Q2 2020 valuations may be even more challenging and important than estimates made at the end of Q1 2020.
  • With Q2 2020 valuations, a full quarter of company performance and market activity in the COVID-19 environment will be behind us, and users of valuations will likely expect more precision regarding the effects of COVID-19 on the investment portfolio.

II. High-level Due Diligence Considerations in a Virtual Environment

M&A professionals are nimble and accustomed to quick changes. With federal and state stay at home orders under COVID-19, M&A professionals are adjusting how they perform due diligence in a virtual environment. Most companies spent the initial period of the shutdown assessing liquidity and cash flow. Private equity firms with dry powder and strategic acquirers with strong balance sheets have a definitive advantage assessing new opportunities in this environment. Businesses and markets will eventually open and deal-making will resume.

Stabilizing the business

  • Strong management teams have always helped support a premium valuation. This environment is their time to shine. How quickly management assessed the impact on liquidity and cash flow, and reacted appropriately, will help determine how successfully business will resume.
  • Frequent communications with customers and suppliers is of paramount importance and enables companies to get ahead of issues before they become crises.

Moving forward

  • Virtual management meetings are a good first step, but for most people, they cannot replace the efficacy of in-person meetings. The CEO level connection is necessary to get deals completed.  Besides, we have yet to see a virtual plant tour. 
  • Companies that have already completed sell-side due diligence will be better equipped to manage the current economic challenges on the business and the sale process.
  • Online datarooms are already the norm. Management should consider soliciting input from its professional advisors with sufficient lead time to begin accumulating and populating commonly requested items.
  • Timeline to complete a deal will be longer.
  • Do what you can to enhance leverage. Alternative lenders are looking to fill the gap left behind by many banks that are still assessing outstanding loans prior to making new commitments.  We are observing that companies with stronger banking relationships have an advantage. 

Transaction considerations

  • Buyer and seller expectations will likely not align in the near term. Sellers looking for pre-COVID 19 valuations will be disappointed and likely to reassess the timing of a transaction. The second quarter of 2020 is generally being viewed as a period of minimal transaction activity.  This assumes that the country begins returning to some degree of normalcy by the end of June. 
  • Additional due diligence will be necessary to assess the revenue pipeline and backlog. Buyers will be performing in-depth analysis of the quality of backlog and the likelihood that the orders received will be delivered at the same profit margins.
  • It is unclear how buyers will assess the pro forma effect of a shutdown on the business. Aside from lost revenue, correctly assessing the effect of furloughed or terminated employees, rent abatements and other potential one-time costs will be critical. Management teams need to compile sufficient historical data in order to provide context for pro forma adjustments. 
  • Assessing how soon the business will return to a normal level of net working capital and whether historical trends will even be useful to project future needs.
  • Assessing the effect of the shut down on the historical repair and replacement cycle of equipment is also critical. The shutdown may likely extend the useful lives of some vehicles and equipment if they were idle.  Management may also decide repair is a better short-term use of cash than replacement. 

III. Information Management and Security in a Work from Home (WFH) Environment 

Private equity firms need to critically review, assess, and improve protection protocols for their portfolio company investments. During a time like this, extra scrutiny is needed to help companies protect data, follow policies and procedures, and hold onto their competitive advantages. PE firms should mandate that the companies they have invested in are taking the right approach to continue to be diligent with data privacy and data security. Key areas of consideration include:

  1. Digital Resilience
    Quickly assess your technology (data/apps) to keep your operation processes and protocols efficient and effective (….”how am I using/utilizing the technology that I have?” and “do I need more?”):
    • Data management/backups/recovery
    • Productivity/collaboration
    • Help desk
    • Accounting – billing/collections/AP
    • Mobile device management
  2. Cybersecurity
    Work to increase the security of your environment:
    • Are we conducting security awareness training and ongoing phishing tests on at least an annual basis?
    • Is multifactor authentication in place for all applications and devices?
    • Is patch management being monitored to ensure home devices, routers, and firewalls are all up to date?
    • Do we have mobile device management technology in place to ensure devices and endpoints are secure?
    • Is password management software deployed to help reduce risky password saving and sharing practices?
    • Are we using a VPN solution to create an encrypted connection to the company network and applications?
    • Are only authorized company applications and devices permitted for completing company-related work?
    • Is security and incident monitoring (end point, data loss prevention while WFH) in place?
    • Are offboarding procedures in place to ensure former employees no longer have access to company data and/or the network?
  3. Policies and Procedures
    Maintain compliance in a remote work environment to avoid regulatory issues and associated risks:
    • Are we compliant with our current information security policies? 
      • Document and get approval for any exceptions to corporate policies, if normal policies are not being followed due to a temporary remote work environment.
    • Do we need to update policies and procedures to reflect any new or changes to controls?

IV.  Fund-Level Tax Issues

The CARES Act includes tax relief provisions that provide businesses with a greater ability to use interest deductions, excess business losses, NOLs and depreciation deductions to offset their taxable income. This will provide liquidity and a reduced cost of capital given the economic effects of the pandemic. Private equity funds should consider these provisions and evaluate their potential benefit and tax consequences.

Business Interest Expense Limitation

  • Under the CARES Act, the limitation on business interest expense under IRC Sec. 163(j) has been changed for tax years 2019 and 2020. The Act allows for a deduction of interest expense equal to 50% of adjusted taxable income (ATI) plus business interest income (BII) plus floor plan financing interest. This was an increase from 30% to 50%. The application of this change applies differently depending on whether your entity is a partnership or a non-partnership.
  • For partnerships, with tax years beginning in 2019, the business interest expense deduction remains at 30% of ATI plus BII and then floor plan financing interest.
    • Partnership will allocate to its partners excess business interest expense (EBIE), excess business interest income (EBII) and excess taxable income (ETI).
    • Any EBIE will be shown on line 13K of the Schedule K-1 and be tracked by the partners of the partnership.
  • For partnerships, with tax years beginning in 2020, the business interest expense deduction is limited to 50% of ATI plus BII and then floor plan financing interest
    • Partners of the partnership are allowed to deduct 50% of the 2019 excess business interest expense (the amount reported to the partner on Line 13K of the 2019 Schedule K-1) without regard to the IRC Sec. 163(j) ATI limitation. This rule is in place because non-partnerships have the 50% benefit in 2019. This rule is automatic unless a partner elects out.
    • The next 50% of the 2019 excess business interest expense will be subjected to the IRC Sec. 163(j) limitation as it applies to carryover amounts of excess business interest expense.
    • In 2020, the 50% is automatic unless the partnership elects out.
    • In 2020, a partnership can elect to utilize 2019 ATI if it is larger than 2020 ATI, thereby allowing a greater deduction. A partnership can utilize 2019 ATI in 2020 only if it elects to do so.
    • 2020 quarterly estimated taxable income will be affected by this change.
  • For corporations, the increase to 50% of ATI applies to tax years beginning in 2019 or 2020.
    • A taxpayer may elect not to have the 50% of ATI rule apply.
    • An increase in business interest expense can also increase or trigger an NOL. Please see new carry back provisions for NOL in Section V.
    • If the corporation already filed its 2019 tax return it can amend that return.
  • Useful considerations:
    • Real estate private equity funds that have made a real property trade or business election with regard to IRC Sec. 163(j) and are rethinking that decision due to the change to the depreciation rules (discussed in Section V) can only make such change by filing an amended tax return (2018 or 2019 depending on when the election was made).
    • Model out the business interest expense limitation in your PE structure to take full advantage of the 50% increase in ATI.
    • Consider restructuring to maximize results.
    • Assess potential savings for your corporate structure by maximizing interest expense deductions and create larger NOLs to carry back to those years with income.
    • Many states will automatically follow these changes; however, some states might decouple from this provision.

Impact of IRC Sec. 461(l) – Loss Limitation Rules for Taxpayers Other than Corporations

  • The CARES Act suspends the excess business loss rules under IRC Sec. 461(l) retroactively for tax years 2018, 2019 and 2020. Prior to the CARES Act, non-corporate taxpayers were only allowed to utilize net business losses of up to $250,000 for single filers, $500,000 in the case of joint filers, to offset investment income and any excess business losses carried over as an NOL.
  • This change will allow partners in private equity fund of funds and management companies with flow-through business losses to utilize more of their excess business losses, which can potentially generate an immediate tax saving and/or refund opportunities.
  • If business losses were limited in 2018, taxpayers may amend their 2018 tax return to take advantage of this provision.
  • Useful Considerations:
    • Deductions for losses in the sale or exchange of a capital asset are not taken into account in increasing an IRC Sec. 461(I) limitation.
    • January 1, 2021 and thereafter, the calculation excludes items that are attributable to the trade or business of performing services as an employee.

Qualified Improvement Property

* This topic is addressed in Section V.

V. Portfolio Company Tax Issues

Private equity fund portfolio companies can reap substantial tax benefits from the net operating loss (“NOL”) and other related tax provisions in the CARES Act. The most significant provisions in the CARES Act are as follows:

  • NOLs
    • Five-year carryback provision
      • The CARES Act provides portfolio companies with a five-year carryback period for NOLs arising in tax years beginning after December 31, 2017 and before January 1, 2021. The CARES Act amends the provisions of the Tax Cuts and Jobs Act (‘TCJA”) that formerly provided for an indefinite NOL carryforward but no carryback.
    • Temporary suspension of 80% of taxable income limitation on use of NOLs
      • Corporate taxpayers can use NOLs to fully offset taxable income for tax years beginning before January 1, 2021. Under the TCJA passed in 2017, NOLs arising in tax years beginning after December 31, 2017 could be used to offset 80% of taxable income in any given tax year. Pursuant to the CARES Act, corporate taxpayers can now use NOLs to fully offset taxable income in tax years beginning before January 1, 2021.
  • IRC Sec. 163(j) – Limitation on deductibility of interest expense
    • 50% limitation
      • The CARES Act increases the limitation on the deductibility of interest expense to 50% of ATI from 30% pursuant to the TCJA for tax years beginning in 2019 and 2020.
      • Corporate taxpayers may base their limitation for tax years beginning in 2020 on ATI for 2019 on the notion that 2019 ATI amounts will be significantly higher than 2020 ATI amounts due to the economic impact of COVID-19 in 2020.
  • Alternative Minimum Tax Credits (“AMTCs”) – Accelerated Refundability
    • 100% refundability
      • The CARES Act provides that any remaining AMTCs held by corporate taxpayers will become 100% refundable in tax years beginning in 2019.
      • Corporate taxpayers can also elect to obtain refunds of their remaining AMTCs reflected on their 2018 tax return by filing an application for tentative refund by December 31, 2020.
  • Qualified Improvement Property (“QIP”)
    • Technical correction of a drafting error in the TCJA
      • The CARES Act corrected a technical error by the TCJA that assigned a 39-year life for depreciation purposes to QIP. The CARES Act corrected this error by changing the life for QIP for depreciation purposes to 15 years. Property with a class life of 20 years or less can elect to take bonus depreciation.
      • The definition of QIP now includes:
        • Interior improvements to nonresidential buildings
        • Qualified leasehold improvements
        • Qualified retail improvements, and
        • Qualified restaurant improvements
      • Property with a class life of 20 years or less (now including QIP) can elect to take 100% bonus depreciation on the acquisition of such assets.
      • For taxpayers who placed QIP in service in 2018, there are several alternatives:
        • Amend 2018 returns to claim bonus depreciation or shorter life (39 to 15 or 20) if not claiming bonus depreciation;
        • Adjust the depreciation of the remaining basis in the asset over its new life; or
        • File a Form 3115 to deduct the difference in depreciation the taxpayer would have been entitled to take in 2018 and 2019, if the return was filed, as if the assets had the shorter life from day one and continue to depreciate over the assets remaining life.
    • Useful considerations:
      • Bonus depreciation is not available for taxpayers having made a “Real Property Business” election under the interest limitation rules of IRC Sec. 163(j). In addition, the Real Property Business election requires taxpayers making the election to use the alternative depreciation system for QIP, which depreciates QIP over 20 years.
      • Many states have decoupled from the federal bonus depreciation deduction rules. This can result in a state addback of the bonus depreciation amount in a year that the bonus depreciation may not be currently deductible under federal law (passive loss limitations, at risk limitations, excess losses carrying forward, etc.). This may result in current state income tax liability.
      • For management companies, this provision interplays with IRC Sec. 461(l) business loss limitation.
  • Employee Retention Credit and Payroll Tax Delays
    • Employee retention credit (“ERC”)
      • The CARES Act provides for a payroll tax credit against the 6.2% employer social security tax. The ERC is a refundable credit for up to 50% of qualified wages paid by an eligible employer between March 12, 2020 and December 31, 2020. Qualified wages cannot exceed $10,000 per employee.
      • An eligible employer is defined as follows:
        • Operations fully or partially suspended due to a COVID-19 governmental shutdown order, or
        • Had a decline in gross receipts of more than 50% compared to the same calendar quarter in the prior year.
      • Qualified wages are defined as follows:
        • Employer with 100 or more full-time employees
          • Wages paid to employees not working due to COVID-19 shutdown
        • Employer with less than 100 full-time employees
          • All wages paid to employees whether working or not.
      • If an employer receives a loan under the Paycheck Protection Program, the employer is not eligible for the Employee Retention Credit. In addition, consider the aggregation rules for eligibility of the ERC where one entity in the aggregated group received a PPP loan
    • Employer payroll tax deferral
      • The CARES Act allows for deferral of employer 6.2% payroll taxes incurred between the date of enactment (March 27, 2020) and December 31, 2020 according to the following methodology:
        • 50% due by each of December 31, 2021 and December 31, 2022

VI. Paycheck Protection Program Loans

  • The CARES Act provides for loans to small businesses and entities in operation on or before February 15, 2020. These loans apply to certain businesses that employ 500 or less employees with certain exceptions for companies that have under a certain amount of tangible net worth and net income as well as other exceptions. Eligible businesses and entities include sole proprietorships, independent contractors, eligible self-employed individuals, and 501(c)(3) nonprofit organizations.
  • This provision has been stealing all the headlines because of the potential for forgiveness. The maximum loan forgiveness will be reduced if there is a reduction in the number of employees or a wage reduction of greater than 25% on an employee by employee basis. The maximum loan amount is 2.5 times the average monthly payroll costs incurred in the previous year ending on the date of the loan or $10 million. However…
  • Per Notice 2020-32, PPP loan recipients that have expenses (payroll, etc.) that are forgiven will not be able to deduct those expenses to the extent they result in forgiveness. At the same time, the income associated with the forgiveness is excluded from gross income. The open question is why the code would say the loan forgiveness is not includible in income, if the government will just take away deductions in the same amount? Lawmakers are attempting to maintain the deduction. Stay tuned.
  • To be eligible for this program, the borrower must certify that due to current economic conditions, the loan proceeds are being used to support ongoing operations and the proceeds will be used for eligible costs.  No personal guarantees are required.
  • Proceeds from loans should be used for the payment of payroll costs, group health care benefits and premiums, employee salaries and commissions, mortgage interest payments, rent, utilities and interest on debt obligations incurred before February 15, 2020, and certain refinancing.
  • Payments of principal and interest will not be required for six months following the date of disbursement of the loan. The length of the loan is two years, with an interest rate of 1%. Interest will still accrue during the six-month deferral.
  • Useful considerations:
    • Hedge funds and private equity firms are primarily engaged in investment or speculation, and such businesses are therefore ineligible to receive a PPP loan.
    • Although this program provides a great source of capital at a very low interest rate with a possibility of forgiveness (although expenses may not be deductible), some PE portfolio companies might not be able to participate due to the affiliation rules where the portfolio company may be treated as an employer of more than 500 employees.
    • The affiliation rules may apply to portfolio companies due to common ownership by the same private equity fund or common control by the same general partner or management company. These rules are highly complex.
    • Before submitting a PPP application, borrowers must certify that “current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant.” Borrowers must make this certification in good faith, taking into account their current business activity and their ability to access other sources of liquidity sufficient to support their ongoing operations in a manner that is not significantly detrimental to the business. For example, it is unlikely that a public company or a private company with substantial market value and access to capital markets will be able to make the required certification in good faith, and such a company should be prepared to demonstrate to SBA, upon request, the basis for its certification.
    • PPP loans are designed to help small businesses. Some critics say that the revenue for the alternative asset managers might not be affected by the crisis; making it hard to prove the need of the funds.
    • Any borrower that applied for a PPP loan prior to April 24, 2020 and repays the loan in full by May 14, 2020 will be deemed by SBA to have made the required certification in good faith.
    • There are other alternatives for businesses that don’t qualify for PPP loans:
      • Federal Loans for Larger Businesses/Main Street Loan Facility (501-10,000 Employees)
      • Economic Injury Disaster Loans (“EIDL”) for Small Businesses
      • Some states have localized programs to assist struggling businesses.
      • Employee retention credit and FICA payroll tax deferral (see Section V)

We are here to provide guidance and additional information on the considerations. Please reach out to any of the below contributors or your EisnerAmper contact if you have any questions.

Visit our Coronavirus Knowledge Center for additional resources and helpful information for you and your business.


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