Addendum: Covid-19 Crisis

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To help write this addendum I asked Jim Strang, Chair and Managing Director of EMEA for
Hamilton Lane, to collaborate. I should make clear that Jim is not responsible for any of the
main text that precedes this addendum.

Introduction

Mike Wright and I finished writing the fourth edition of Private Equity Demystified shortly
before Mike’s untimely death in November 2019. His death and the academic publishing
cycle meant that the final drafts were submitted to OUP in February 2020, weeks before
the world changed due to the Covid-19 global pandemic.
In this edition we have been at pains to stress both the mechanics of private equity and,
much more importantly, why those mechanisms exist and what problems they seek to
solve. We looked through the market at each level of analysis and briefly highlighted con-
cerns, tactics, and potential future strategies.
Our conclusions were based on a sense that we were at the top of the economic cycle
and that the real test of the evolving private equity model would come in the next down-
turn. We had no inkling that the test was on the horizon and that it would be borne by
a virus.
Jim Strang and I are writing this addendum in mid-April 2020 without being able to
meet, and that, in and of itself, is data that points to the enormous disruption the market
faces. One of the key new risks that none of us has ever encountered before is the inability
to meet face to face. No investor or lender in private equity has ever done deals without
meeting any of the other parties to that deal in person. It remains to be seen how this
entirely novel feature affects the ability to react to the crisis.

The Level of the Individual Investment

To state the obvious, an unexpected exogenous shock of the type brought by Covid-19 is a
severe test for any business. Private equity uses leverage and leverage amplifies outcomes.
Capital structures are tailored to each investment and are designed with some degree of
tolerance to unexpected outcomes, but none will have anticipated this.
Businesses fail due to acute cash shortages (often preceded by chronic lack of profitabil-
ity). The response of any business in a crisis is therefore to focus on the preservation of
cash flow. As we have said, cash can only come from three sources: profits after tax, capital
reduction, or external parties.
296 Private Equity Demystified

Profitability

In the first instance companies do all that they can to optimize profitability. Clearly
that means seeking to drive revenues as far as practicable. This is something private
equity is increasingly good at, having developed a set of muscles for this topic since the
last global financial crisis. Obviously, businesses will also require to optimize their
costs as best they can. The external perspective brought by private equity helps here,

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with the aim being to trim the fat—but not the muscle and certainly not the bone. In
the Covid world, governments have provided an unprecedented level of support to
businesses, and the people that work within them, to support companies through the
worst of the storm. Governments have already indicated that taxation will be deferred
to ease cash flows for many businesses. This includes both the effect on cash of not col-
lecting corporation taxes, as well as the working capital effect of delaying collection of
sales taxes and employment taxes.

Capital Reduction

This requires either the sale of fixed assets or a reduction in working capital.
Selling fixed assets in a falling market is difficult and time-consuming for many asset
classes and causes fire sale losses. Also, stating the obvious, selling fixed assets reduces the
productive capacity of the business permanently—which is no-one’s goal.
Reducing working capital is a zero-sum game in the overall economy (unless there
are material supply chain inefficiencies). We expect there to be an immediate and severe
increase in pressure on the terms of trade. Accelerating payments owed by debtors will
be difficult for most businesses. All businesses, whether PE-backed or otherwise, will
look at delaying or avoiding payments to their creditors, including governments via the
tax system. In addition to supplies needed for the business’s normal trade, creditors
typically include property (either through leases or rents) and services. These are
already under severe pressure. Many companies use credit insurance to help them
manage what would otherwise be the onerous requirement to fully fund their debtor
balances. Thus the current crisis will require those relatively few firms that provide
credit insurance be given sufficient support to allow them to maintain the terms so
badly needed by their clients.
Where services are provided via a subscription, it is more difficult to defer payment and
still be confident that the services will be available. We therefore expect property and
physical asset leasing to bear the brunt of delayed payments. This will necessarily impact
private equity real estate funds. The least affected may be mission-critical subscription
­services, such as software.

Management and the Equity Illusion

The one certainty of the crisis is that the timescales assumed in designing the incentive
structures of management will turn out to have been wrong. The implications are subtle.
Private equity investments involve both third-party leverage and leverage in the equity.
 addendum: covid-19 crisis 297

As we discussed in the section on the equity illusion, the longer it takes to achieve an exit,
the more preferred interest on PE loanstock (or preferred dividends on preferred equity)
will eat into the value of the ordinary shares or common stock. Therefore, to the extent
that the crisis extends the hold period for investments, the management teams running
the businesses are losing out. It is especially problematic because the fixed yields that
are rolling up come against a backdrop of a looming deep recession. It will be very hard
for managers to find ways to grow more rapidly than the yield is rolling up, so equity val-

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ues for man­agers may fall, even if enterprise values do not. In such cases the alignment
between the management team and the equity sponsor breaks down, exposing the equity
sponsor to considerable downside risk that the management simply looks out for its own
self-interest.

External Funders

Once the investee company has implemented all cash savings from within its operations,
new cash can only come from the existing shareholders, new shareholders, lenders, or
government. This can come from new capital inflows or stopping capital outflows.
The delay in repayments of financial capital provided by lenders and investors has
implications for them that we discuss below.
Businesses with undrawn facilities have often drawn them down to maximize the avail-
ability of cash and eliminate the risk that facilities are cancelled. This reflects the lessons
learned in the last crisis when banks started to fail and undrawn facilities were cancelled at
the earliest opportunity to reduce lenders’ exposures. In this crisis there is no sense yet of a
‘banking’ crisis, but companies and their private equity owners have erred on the side of
caution and drawn down the facilities.
Leveraged businesses have additional costs in interest payments that can be stopped.
The shareholders of a business must weigh up the likelihood that a lender who stops
receiving payments will seek to recover their debts via a formal insolvency.
Governments around the world are tweaking the insolvency process to attempt to
en­able lenders and borrowers to work through the crisis. They are also providing guar-
antees and loan facilities to try to increase the available liquidity to all companies.
There is much debate about whether this ought to be available to private equity backed
companies.
Those arguing against the availability of loans to PE-backed businesses argue that the
shareholders, the private equity funds, have access to liquidity through their undrawn
committed capital or ‘dry powder’. It is argued that investee companies are in some sense
part of a group with the PE fund as the parent company and that the businesses should
look to the parent to fund them. This repeats two errors of analysis. First, PE funds
are investment vehicles to allow collective investment, not conglomerates. The owners of
the businesses are not the fund, they are the LPs. The fund is just a wrapper to allow
­collective investment. Secondly, the line of arguing implicitly assumes that one particular
type of ownership structure, private equity, can be separately identified and excluded from
the general support of all other businesses: it cannot.
In summary, at the level of the investment, as for any company in a crisis, cash
is king.
298 Private Equity Demystified

Moral Hazard and Rescue Funding

An argument that has reappeared since the start of the crisis is the effect of so-called moral
hazard on long-term incentives. Essentially the argument is that if highly leveraged
­businesses (of any kind, not just PE-backed) can expect to be rescued by the state in a cri-
sis, they benefit from an implicit guarantee. This will substantially weaken or remove the
market constraint on lenders to avoid over-lending, because they can ignore the risk of

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ma­ter­ial market-wide shocks. This is by implication important to private equity because,
as we saw in the chapter on debt, PE firms are takers of debt when it is loosely available.
This is a somewhat philosophical argument about incentives. At the firm or fund level
such philosophic thoughts are rarely discussed. Funds and businesses will take tactical
advantage of any port in a storm, but it is big stretch to make that a general argument
about an industry.
More prosaically, if we look at the various schemes that have been created we see
there are practical limitations on their use to try to limit abuse. In the US there is a limit
on the total leverage of 6x EBITDA, in the UK the business must demonstrate viability to
the satisfaction of a third party bank, and there are other carefully, if quickly, designed
criteria to attempt to stop abuse.
At a social level, the question seems somewhat more straightforward: if there is a social
benefit to rescuing businesses in a crisis, why wouldn’t that social purpose exist for
PE-backed companies that have been shown in numerous academic studies to be more
efficient and productive than the overall business community? Whatever the reason for
this productivity, excluding these businesses from the rescue schemes needs a strong
rationale. We have not to date heard a compelling one.

The Lenders

In the main text we described how the debt market had changed, particularly in Europe,
since the global financial crisis. Not wishing to become repetitive, the key difference is the
emergence of debt funds to replace banks and the growth in unitranche to replace amort­
iz­ing loans. We have also seen the return of cov-lite lending both in the bond markets and
from funds and banks.
These changes combine to reduce the immediate threat to businesses unless they are
approaching the redemption date on a unitranche facility. Debt has become slightly
shorter in duration since the crisis, but nevertheless, it is not likely that the need to repay
debt will cause a general increase in failures in the short term.
The evidence from the last crisis was independently examined in the US and UK and
those studies showed that failures were lower in PE-backed companies, even adjusting for
various other factors. The evidence suggested that PE-backed businesses were more robust
than others. A second harsh test is upon us.
The wall of debt in leveraged finance (Figure Add.1) is larger than at the time of the last
crisis, but similar in duration. Again, that wall was efficiently repaid, refinanced, and
traded away.
 addendum: covid-19 crisis 299

56,641 56,683

53,031

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22,591

17,391

11,518

2,543
357

2020 2021 2022 2023 2024 2025 2026 2027

Figure Add.1. Leveraged Finance Maturity Wall at May 2020

Source: S&P

The level of arrears in loan books of lenders is not yet being reported but we expect it to
rise sharply as companies choose to stop paying lenders through the shutdown. To the
lender a build-up of arrears of capital and interest creates two decision points:

(1) The lender must decide whether to impair the value of the asset in its own books.
To a regulated bank, this increases the amount of tier one capital required in the
lender’s balance sheet and therefore reduces the return on capital of the lenders by
both the numerator (reduced interests received) and the denominator (increased
amount of capital used).
(2) The lender must decide if and how to use its powers to recover its capital. As shown
in the main body of this book, most debt funds are less than ten years old. Few
have built work-out or so-called ‘special situations’ teams. They therefore must
choose to build workout teams, use external advisers, or sell the loans in the
­secondary markets. Debt advisers will be busy.

Large funds and banks have the resources and reputational requirement to manage
non-performing loans in-house.
Facing this environment, on the one hand a lender may choose to try to sell loans in the
secondary market at a discount rather than working through the problems. On the other
300 Private Equity Demystified

hand, this crystallizes the loss and, in a fund, reduces fund fees (which are calculated on
the value of assets under management).
We expect there will be an uptick in secondary loan transactions, but the incentives are
not such that this will happen sharply in any but the most acute cases. Nevertheless, we do
expect that a lack of new deal flow, coupled with impaired portfolios of loans, will prob­
ably result in consolidation in the small debt fund market.
An unknown is the effect that non-standard terms will have on the secondary markets

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and bond markets. As loans have become bespoke—that is, having their own unique
terms—the amount of information asymmetry in the secondary markets has increased.
Pricing those variations can be slow and costly, or in the limit, impossible. If there is a
wholesale move to reduce the holdings of leveraged loans, this lack of standardization may
cause issues with the liquidity of that market. Governments have moved quickly to act as
purchasers in these markets, thereby maintaining liquidity. We may see pressure to return
to more standardized terms like those developed by the LMA and LSTA.
One thing that seems highly likely is a return of private equity funds buying back non-
performing debt in their investments. This is the equivalent of investing new equity with a
preferred return equal to the discount paid. GPs will be scanning their portfolios for
opportunities to buy.

PE Funds

Historically crises have had two effects on private equity: deals done before the crisis
tended to have lower returns; deals done in, and after, the crisis did better. A counter-
cyclical narrative has grown up around private equity. We look at this shortly.
Traditionally PE funds have been bankrupt remote. They had no creditors that were not
matched to their debtors, so could not become insolvent. Failing ones just withered away.
Today there is debt in funds from both subscription lines and NAV loans.
Subscription lines are matched to a guarantee from an LP, so do not create significant
bankruptcy risk. A defaulting LP would be highly unlikely, as we discuss later.
NAV loans are more nuanced. They rely on the value of the underlying, unrealized
assets for security, and this brings us to the issue of valuations.

Valuation

In simple terms, values are usually calculated by multiplying an appropriate profit metric
by a factor that reflects some combination of traded comparables and relevant M&A
transactions. Such a process lends itself to a highly subjective outcome. New investments
in the same company can be thought of as comparable transactions for these purposes.
This is of course only a proxy for the real value of an asset, which is solely determined by
the expected value of its future cash flows and the cost of capital to the potential purchaser.
Thus, valuations are uniquely challenging at this time. What is the most appropriate
period to consider as regards profitability? Historic, LTM, something else? Also, how
should the large and ever growing number of adjustments to profitability be accounted for
from a valuation perspective? Then what multiple to use? What is the relevant peer set?
 addendum: covid-19 crisis 301

What should be in the basket, and what not? There is no one correct answer. Best in class
GPs rely on transparency and consistency of approach to help validate these inherently
uncertain values. GPs thus must be thoughtful in how they derive valuations in times of
such extreme uncertainty, and LPs must understand that valuations are as much art as
science.
This brings us to the effects on LPs.

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LPs

Existing Investments

Of course, if the LPs all intend to hold the fund to maturity this valuation issue is of no
great importance. The ultimate returns will be what they are, and this was very largely the
position in 2008. However, since then the secondary market in LP positions has grown
dramatically. Many investors’ strategies are based on being able to dip in and out of posi-
tions depending on their individual needs. All these trades have traditionally been articu-
lated based on discounts and premia to net assets.
Just as EBITDA multiples are not causes of value, but measures, so NAV discounts do
not cause portfolio values, they just express them. However, the valuation challenges
alluded to above will certainly disrupt ‘normal operations’ in the secondary market
until some semblance of normality returns to markets. The large established participants
will probably prosper as they have the resources and processes to evaluate these potential
trades. Either way, LPs should expect secondary trades to be much more protracted and
discounts to NAV to be less reliable guides to fundamental value. In the limit the secondary
market could sharply contract or even temporarily freeze.

New Investments

The market for new funds raising will of course be disrupted by the crisis. LPs will be
examining their programmes trying to understand valuations, liquidity needs, and any
changes to investment strategy that the crisis will determine. Furthermore, as the deal
markets slow, so will fundraising. There’s no need to raise a new fund if you are still invest-
ing the old one! Most likely the market sees a short-term hiatus where the most proven
and experienced GPs are able to raise funds, while those not so fortunate find conditions
harder, at least until markets stabilize.
There are potential knotty issues for funds that were fund raising before the crisis broke
but had not reached a final close. First the timetable will have lengthened. Second, there
are scenarios where a fund has reached a first close, started investing, and must perform a
valuation of the new investments before the final close. There could be a material write-
down of the assets. Traditionally private equity has been viewed as a long-term investment
and the true-up mechanism would have ignored temporary valuation movements
(in either direction). Potential new investors in funds that have not reached final close
may not be as keen to buy into losses as they might have been in the past.
302 Private Equity Demystified

Returns

There are many ways of examining returns. The most popular, IRR, is not a perfect metric
and is distorted by the effects of time and compounding. TVPI mixes cash and valuation,
and DPI, while cash based, ignores residual values and timing. The effects of the crisis will
be to slow the emergence and realization of most winners and eliminate some. It may cre-
ate some new successes, but we have no particular insights to know where they are.

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The delay will reduce IRRs. Revaluations will reduce TVPI in the short term. The end of
dividend recaps will delay DPI, but overall we cannot be sure whether investments will
recover lost value. Historically, new deals that emerge from a crisis have been priced at
levels that resulted in strong returns, but each crisis has hit an increasingly mature private
equity industry, so the past is not a solid guide to the future.

LP Defaults

There has already been an increase in the discussion of potential LP defaults. As we saw in
the main body of the text, this is both poorly documented and vanishingly rare because
the consequences are financially and reputationally disastrous.
In the last crisis LPs and GPs cooperated to avoid defaults, and this will happen again.
The methods included suspending new investments, extending the fund life, allowing
greater recycling of funds received by the fund, and some wholesale restructuring of funds
with new economic terms, usually resulting in lower fees if the GP initiated the process.
The availability of NAV loans and preferred equity adds a new alternative that was not
available in the GFC. For new investments, funds also have the cushion of subscription
lines for short- to medium-term needs, and LPs could use their private equity interests to
secure debt in an ‘NAV loan type’ arrangement outside the fund.
The secondary market provides an avenue to exit private equity, but as we have said,
this market is unlikely to be as liquid in the short term as it has been.
Overall, it seems very unlikely that there will be LP defaults on any material scale.

Closing Remarks

Uncertainty is a theme throughout this book. This addendum was written against a back-
ground of great uncertainty. In a crisis it is tempting to see only the storm. During the
dot-com crisis a partner at a fund remarked that ‘the thing about mass hysteria is that
we’ve probably all got it to some extent’. Nevertheless, each crisis has tested the private
equity model and each one to date has ended with the industry stronger and larger than it
was before the storm broke. We expect the new debt market participants to feel the brunt
of the storm, but the overall industry to emerge intact.