New Approaches to Private Equity
December 01, 2020
In 2020, private equity firms and their portfolio companies experienced the same pandemic-fueled economic shocks as every other business. But because of specific eligibility criteria, many PE firms did not qualify for forgivable loans from the Paycheck Protection Program instituted by the CARES Act. Now PE firms are looking for growth opportunities in a low-asset-value environment. They’re also taking on an expanded role in shepherding their portfolio companies through an uncertain economic future that may include future lockdowns in response to a resurgence of COVID-19 infections.
To learn how the pandemic and its aftermath has changed private equity firms’ approach to mergers and acquisitions, due diligence and other decisions as well as how they’re preparing for a “new normal,” Crain’s Content Studio turned to three experts in the private equity field:
- Elena Newman, partner in financial services at EisnerAmper
- Matthew John McNally, managing director of True Partners Consulting
- Anthony Tomaro, partner and consulting services leader at Grassi Advisors & Accountants.
Following, they share insights into the opportunities and challenges shaping firms’ decision-making processes.
Crain’s: How has the pandemic changed private equity firms’ and their portfolio companies’ approach to deal making, risk assessment and other strategies?
Elena Newman: The effects of the pandemic have driven private equity firms to place greater focus on a company’s technological capabilities and its ability to rise above another disruption. Restrictions have led the shift to a virtual platform for due diligence, fundraising and other key deal-making processes, and this method appears to have the potential of paving the way for a new reality. Although the pandemic has led to deal slowdowns in some sectors, firms can find success in their abilities to quickly adapt to the new environment and identify opportunities to create value for their investors. The changing landscape is expected to lead to interest in mergers and acquisitions, distressed transactions and creatively structured exit vehicles that may not have been as attractive before the pandemic. Firms will look for exit strategies that will attempt to mitigate the uncertainty of the current environment.
Matthew John McNally: The private equity industry has been significantly altered by the pandemic and is just now starting to see signs of recovery. With uncertainty now the new normal, deal strategy and risk assessment has been momentarily altered and heavily concentrated in the distressed, opportunistic and strategic-alliance areas.
Anthony Tomaro: As private equity firms deploy their cash in the second half of 2020, they are taking a much closer look at the prospects of target businesses and portfolio companies. The pandemic has created a unique situation: corporate problems and considerations that go far beyond liquidity stress. Amid another potential COVID-19 wave and altered consumer spending, some PE firms are adopting a wait-and-see approach for new investments, but with this approach comes the risk of missing some opportunities for cash deployment.
Crain’s: What are portfolio companies expecting from private equity firms in terms of assistance during the pandemic? How can PE firms help portfolio companies with cost containment?
Tomaro: Since the pandemic hit in early 2020, many PE firms have stepped up to support their portfolio companies in several ways. Portfolio companies, especially smaller ones, seem to appreciate the private equity firms’ management input and industry connections as much as the capital they provide. PE firms can help their portfolio companies with managing inventory and cash flows through agile executions — with technology playing a large role. They can pass on best practices for building digital capabilities, rightsizing and reviewing operating models and support functions.
Newman: During volatile times, portfolio companies need the support of their private equity firms. Firms can provide guidance by refocusing on ways to create value for their existing portfolio companies by assisting them with adopting new strategies to preserve capital and reduce costs. Although this has always been a focus, the challenge now is the demand for quicker, decisive action plans to address these changes. More frequent forecasting, planning for support during continued disruption, outsourcing functions to allow for the seamless adoption of a remote environment and guidance about where companies can best deploy their capital to provide for that necessary support will be of great value to the economics of the portfolio company.
McNally: Since the pandemic, many private equity firms have been compelled and in most cases obligated to increase support for their portfolio companies. PE firms should seize this opportunity to build more robust relationships. As portfolio companies look to the PE firms for guidance, the firm has a platform to showcase their industry expertise and build rapport. PE firms that can develop strong relationships with their portfolio companies are better positioned to build growth and have a smoother transition upon exit.
Cost containment can be achieved in a multitude of different ways depending on how the private equity firms are structured and how the legal agreements are written. Here a few examples: A typical PE firm should look to reduce expenses by consolidating any redundant administrative and back-office work throughout its portfolio of funds. Build a portfolio committee that brings together the heads of each of the portfolio companies to share experiences and find solutions to problems as a team. Speak to your professional-service providers and see if they are willing to negotiate on fees. Engage a cost-reduction service provider to work with the portfolio companies to reduce indirect procurement costs and increase productivity.
Crain’s: How has the CARES Act affected the private equity industry?
McNally: The CARES Act provided financial relief to support businesses during the COVID-19 pandemic. The Act permitted a majority of private-equity-owned portfolio companies to participate and provided critically needed liquidity to stem the downturn. The liquidity provisions of the CARES Act gave portfolio companies the ability to borrow funds through the expanded Small Business Administration loan program with deferred payroll tax liability and credits against particular employee taxes.
Tomaro: The CARES Act helped most businesses in the U.S. by providing funds to keep employees employed and to pay other crucial expenses such as utilities and rent. But it did have major limitations that affected the eligibility of private equity firms and their portfolio companies. Generally, the eligibility requirement for a Paycheck Protection Program (PPP) loan was 500 or fewer employees, unless the company’s NAICS code threshold, annual receipts or net income otherwise deemed it a small business. This ruled out many portfolio companies. It appeared that many private equity firms would be left out of PPP relief based on the SBA affiliation rules. One of the simplest ways that SBA defines control (and hence, affiliation) is whether an individual or another business owns more than 50% of the voting equity of another business. Control can also arise through contractual or other economic dependence.
The bottom line is that PE firms — even though they met the employee threshold — still had to jump through hoops and prepare an analysis of their portfolio companies to demonstrate eligibility for relief under the CARES Act.
On the bright side, the CARES Act allowed portfolio companies that incurred net operating losses in 2018, 2019 and 2020 to recover federal income taxes paid in 2013, 2014, 2015, 2016 and 2017. This is a great federal income tax strategy and cash-flow generator. A company can carry back a net operating loss incurred in a year in which the federal income tax rate was 21% to a year when the maximum corporate income tax rate was 38%.
Crain’s: What kind of due diligence is required as PE firms use a low-asset-value environment to grow their portfolios?
Newman: Firms need to maintain more frequent communication with their portfolio companies as well as provide valuable insight on cost efficiencies and business sustainability plans. Volatile times can lead to the exploration of diversification in their portfolios and strategic alternatives to boost value creation, while paying careful attention to maintaining the right balance. Private equity firms are well-positioned to take advantage of a downturn in the market through their expertise in deal structuring and are equipped with the appropriate skill set to maximize value in an underperforming environment.
McNally: Private equity firms should integrate due diligence procedures and reviews from the date of purchase until the date of exit. This will give the PE firm a true macro and micro view of the company’s competitive realities, as well as its regulatory and legal reporting requirements, taxation and management bandwidth. True insight can be achieved through unified due diligence procedures and periodic testing.
Tomaro: Due diligence is due diligence. It is not necessarily specific to asset value. Due diligence activities certainly need to be adjusted based on the risk level of the target. The most important thing to consider in the current environment is what type of industry the firm wants to invest in based on the market needs resulting from the pandemic.
Crain’s: How can PE firms sell assets at an optimal price in a distressed economy?
Tomaro: I believe that the challenge here is for private equity firms to find the right buyer. When I say the right buyer, I mean a strategic buyer and not necessarily another financial buyer. The key here is to identify where your asset can be a solution to a problem or, better yet, the missing piece of another business’s puzzle. This takes good industry-research skills, which most private equity groups have. The hardest part is to monetize the piece of the puzzle to the new venture.
Newman: A key fallout of the current crisis is a change in the traditional buyer pool. Firms will need to engage in the selling process with flexibility and be open to creative strategies that might include joint ventures or credit alternatives. Private equity firms will benefit from the appropriate accounting, tax and legal expertise to guide them on structuring the deal in the most effective manner while mitigating risk. Firms that can illustrate a clear prospective plan, explain their cash situation and show how performance and cash will be impacted by their plan will gain investor confidence. Firms may want to decrease or establish caps on their post-closing obligations and consider engaging outside valuation experts to ensure they maximize value. Their ability to provide the purchaser with quick and satisfactory responses could make the difference in optimizing a deal.
McNally: The COVID-19 pandemic has had a devastating impact on the economy and an increasing number of companies are under extreme pressure. A healthy and well-capitalized portfolio company before COVID-19, today could be a company on the brink of bankruptcy. The private equity firm must devote itself to building up its weaker portfolio companies’ balance sheets and operations, accelerate transformation and most importantly create value. PE firms need to build a systematic approach to value creation, for the time being placing less emphasis on operational performance. Healthier portfolio companies can focus on reinforcement of their positions and growth.
Crain’s: What should investors know about the increasing popularity of SPACs in the PE space?
McNally: Special purpose acquisition companies (SPACs) are essentially blank-check funds that are designed exclusively for the purpose of acquiring and/or merging companies. It was estimated by the year 2025 that SPAC IPOs’ value will be approximately $80 billion in the United States, with 2020 on track to be another record-breaking year. However, SPACs come with a tremendous amount of uncertainty. On Sept. 21, 2020, the Securities and Exchange Commission issued new guidance requiring SPACs to satisfy the eligibility requirements for registering securities on Form S-3, the short-form registration statements. This of course comes with additional administrative requirements and increased cost.
Newman: There are several areas of the industry that have gained traction as a result of COVID-19. One example is the growing interest in SPACs, also known as “blank-check companies.” The increase in popularity is curious as the concept of a SPAC is not a new one. Some feel the restrictions and uncertainty of the pandemic have made them attractive because they typically allow for seller flexibility, more certain pricing and an easier journey into the public markets, which are particularly attractive in a volatile market. They allow for a lower upfront investment with a significant potential upside and structuring economics for increased liquidity after an IPO. However, SPACs do come with risks and rewards that an investor should evaluate to determine if this vehicle is right for them.
Tomaro: As many traditional investment opportunities tighten up or become less valuable in this distressed economy, investors are looking for creative and effective new strategies to pursue. This has caused a spike in interest in SPACs, which are shell corporations designed to take companies public without an IPO.
Investors should understand the unique set of risks involved in this investment vehicle. Unlike most investments in tangible assets or specific companies, a SPAC is an investment in the management team, their decision making and their ability to execute on ideas. You are betting on the jockey instead of the horse, so to speak. Investors will want to be strategic about the industries in which they invest in SPACs. The cannabis industry, for example, is ripe for acquisitions.
Crain’s: How should PE firms approach tax planning in 2020?
Tomaro: Prior to the presidential election, there was speculation that a change in administration would drastically affect tax-deferral strategies and tax planning for partnerships and C corporations under then-candidate Joe Biden’s proposed tax plan. Those changes do not appear to be as imminent if Republicans maintain control of the Senate, but it reminds us just how valuable the benefits of the Tax Cuts and Jobs Act are, especially to flow-through entities. Private equity firms should also be discussing the proposed carried-interest regulations that are set to affect partnerships and funds as early as 2021.
Crain’s: What can firms do now to prepare for future surges of COVID-19?
Newman: The rapid impact of COVID-19 and its effects have proven the need to prepare for the unthinkable. This virus has reshaped the mindset and functional landscape across multiple sectors of the industry, and planning and preparation are key to surviving the next disruption. The need for enhancing technological capabilities and defenses against cybersecurity has increased significantly. Firms must continue to assess their business continuity plans and implement plans for phased cost reductions, identification of solutions and plans for supporting the work-from-home workforce. Aside from the operational aspect, firms should also reassess the forward-looking valuation metrics for their portfolio companies. Firms that can withstand the effects of COVID-19 will most likely have a competitive advantage with future investors, as this will contribute to an increased level of investor security.
McNally: Firms should make technology an integral part of the business and a world-class data capability should be developed. They should make sure employees are equipped with all the necessary tools and equipment to be able to work both efficiently and effectively remotely. They should implement additional cybersecurity, as remote workers are more susceptible to hackers and phishing attacks. They should make communication simple, build and save cash reserves and cut extraneous expenses. Firms should apply for available relief funds and try to develop new revenue streams.
Tomaro: In the present, firms should make sure their portfolio companies are not relenting in stringent screening, hygiene and environmental safeguards. To prepare for the long-term future, businesses should look into enhanced environmental controls, such as upgraded air filtration systems, to invest in more permanent workplace safety measures.
Even as businesses bring their workforces back to the office, sick leave and work-life-balance policies need to remain flexible. Virtual meetings are the reality for the foreseeable future, and firms should continue to find new ways to effectively engage with clients, employees and new business prospects.
Crain’s: What can we expect of private-equity performance over the next two years?
Tomaro: From what we have seen in the market, commencing with June of this year, private equity firms are definitely back in the market seeking opportunities to buy assets. The biggest challenge that private equity firms face right now is sector expertise. The pandemic is reshaping industries and, unless you have a deep knowledge in the sector, getting to the right answer can be difficult.
Determining equity performance over the next two years will be difficult. One would have to look at the specific sectors the private equity firms are investing in. For example, the life science and healthcare market, specifically information technology, will have positive and robust M&A and equity-financing activity. Perhaps the best example of this trend is medical practices’ rapid adoption of telemedicine.
Newman: Private equity professionals predict that the industry will thrive and the road to recovery will continue to lead to opportunities and creativity in deal structuring and vehicle popularity. However, as the recovery continues, industries will experience change and be challenged with hardships that they will need to navigate; business strategies will need to evolve.
Meeting new demands in a cost-effective manner as a result of changes in consumer behavior will be one of the main focus areas for portfolio companies. Although business segments like technology and innovation have been an industry focus prior to the pandemic, as the population continues to adapt, their changing lifestyles will likely result in attractive M&A opportunities for these markets, as well as in health care/life sciences and e-commerce, to name a few. However, one thing is clear from this and past experience: The industry has thrived through significant transformation. And many believe these events have better positioned it to sustain future disruption.
Crain’s: What do new consumer habits mean for the future of private equity?
McNally: Covid-19 has shifted consumer spending towards health and wellness and is reinforcing the trend toward healthier foods and lifestyle. Consumers are reluctant to spend on luxury goods and have increased savings given the uncertainty of future lockdowns. Some private equity firms will see this as an opportunity to identify a role for M&A in their portfolio companies, undertaking acquisitions in the consumer goods market to pursue inorganic growth or divestitures to fuel growth elsewhere.
Newman: Changes in consumer behavior as a result of the pandemic have forced certain business sectors to quickly shift their delivery-of-service strategies. New habits are most likely going to lead to ways of life that will remain with us after the pandemic. These changes will impact the operations of private equity portfolio companies, as well as which types of businesses will be attractive to investors. The concepts of working from home, contactless shopping for groceries and services, and virtual healthcare have the strong potential to become part of the new normal. This will lead to an increased attraction to business sectors such as technology and innovation, telehealth, gaming, well-being and e-commerce. These changes have forced portfolio companies to revisit growth and success strategies along with the means of satisfying new client demands.
Tomaro: I believe that consumer habits, more than ever, mean everything to private equity groups. Every individual is determining what his or her “new normal” is. As a result of the pandemic, most individuals have altered their spending habits. Most individuals are shifting their spending to essentials while cutting back on most discretionary categories. Private equity firms need to assess and study consumer demands going forward before making investments.