Q1 2020 - (released May 2020)
SA's quarterly Private Equity & Venture Capital magazine
Adapt or die
by Michael Avery
For many Private Equity Houses, this will be the second major global crisis they have had to steer their portfolio companies through, following so soon after the 2008 global financial crisis (GFC). And considering that events of the magnitude of a global pandemic like COVID-19, an oil price collapse or freezing of global credit markets tend to happen only once in a generation, the experience will stand them in good stead.
Will this shock sustainably change the way that CEOs and investors look at leverage?
John Bellew, Head of the Private Equity Sector Practice at Bowmans, doesn’t think so.
“PE depends in part for its returns on the benefits of deleveraging,” says Bellew, “and without leveraging, many funds would not be able to purchase the companies they buy – their internal prudential limits would prevent them from making the investments. Post the financial crisis, a lot of PE houses re-looked the extent of leverage (some deals were being done at debt levels of up to 8 x earnings before interest, taxes, depreciation, and amortisation (EBITDA)), and levels of 3.5 to 3 x EBITDA are now more normal. These are sustainable in a normal market. The industry cannot run on the basis of a worst case scenario outcome.”
JP Fourie, Head of Investor Relations at Metier, believes there will be a more conservative approach in the immediate aftermath, but that it will be short lived.
“We have seen this before,” says Fourie, “After the GFC, there was a similar reaction and by mid-2014/15 you had seen the “come back” of higher leverage and covenant light deals, so there will be a re-look but I don’t think it will be permanent.”
Genevieve Alberts, executive at RMB Corvest, agrees with Fourie that the crisis will lead to a possible short-term reaction.
“Long term, I’ve no doubt we will mean-revert back to old habits,” says Alberts.
“Whilst historical financial and economic crashes have followed different triggers, most have had excessive leverage at their core. There is no doubt that heavily leveraged businesses are hurting disproportionately right now. Unfortunately, in the very near term, most businesses will have to leverage themselves further just to trade out of the current distress, or they will fail. The benefits of not having a heavy debt-service burden going into this global crisis won’t be lost on CEOs or their investors, but as the markets recover and grow again, so too will debt appetite.”
But, to Bellew’s point, Alberts says Corvest has never embraced aggressive gearing in its acquisition structures.
“We apply a modest level of gearing, cognisant that our market is more volatile than most. We tend to invest for the longer term than some of our peers, meaning ours is not simply a deleverage and exit strategy. Investing for the longer term means leaving some debt capacity available to fund future growth and acquisitions.”
On the issue of dealmaking once the COVID-19 lockdown dust settles, Bellew believes that private equity firms with dry powder are ideally placed to deploy, a theme that is echoed around the world and is not dissimilar to past crises, where companies that over-geared were bought out at the sort of multiples that end up making vintage years for acquisitive GPs.
“I think that multiples on disposal for assets bought post-crisis may be very favourable, as good companies starved of cash may be available at attractive prices,” says Bellew. “However, I still think banks will be prepared to lend. Each case must be looked at on its own merits. Also, I think a number of deals post-crisis will see PE funds injecting equity in order to strengthen existing balance sheets, and either repay bank debt or remedy covenant breaches.”
The challenge for investors right now, according to Alberts, is that the immediate future is somewhat opaque and acquisition prices are likely to reflect that heightened risk.
“Good organic growth is a lot less risky than acquisitive growth and is usually rewarded in the offer price,” says Alberts. “In the current South African context, organic growth is increasingly hard to find and therefore high growth businesses do justify higher multiples, particularly if the cash conversion supports it.
And that means, in Alberts’ opinion, given low organic growth, GPs cannot afford to shun acquisitive growth models and still deliver attractive returns to shareholders.
“We manage the risk by matching acquisitive growth strategies with high-calibre management teams and partners and, as mentioned previously, by applying modest gearing principles.”
Alberts believes that while all of this is being added to any due diligence, the hurdle rates should not change materially, given that the market adapts pretty quickly with prices, valuation multiples and debt reduction to compensate for the higher risk taken.
In the end, the lower growth and higher risk is compensated by paying reduced valuation, but the result is that net IRRs remain similar for PE houses.
Another important factor to consider is the South African Reserve Bank’s response so far, slashing interest rates by 200 basis points, which Alberts believes will also help to improve the equity IRR, given that the cost of the gearing has reduced.
Bellew points to the South African model being driven by fundamentals, rather than leverage, as key to the sector’s resilience against these types of economic shocks.
“Unlike in the international market, PE returns in South Africa have historically been driven more by business growth and multiple growth (for example buying at a 3 PE and selling at a 5 PE) and I think that this will continue to be the case,” says Bellew. “At this time, a PE house will want to buy a good asset cheaply and grow it vigorously against its competitors, or in a space where many competitors have been wiped out, I can also still see a lot of ‘bolt on’ deals where a portfolio company snaps up complementary businesses that are cheap, using follow-on investments from their PE owners. These so-called platform plays are a common feature of African PE generally.”
That’s not to say there won’t be any pain.
Alberts says there is little doubt that private equity investors will suffer along with the underlying portfolio investments through this crisis.
“How much and for how long will depend on the extent of Government lockdowns, the stimulus measures introduced to mitigate the pain, and the quality of the investee management teams who will need to find creative solutions to a low growth environment,” explains Alberts.
“Portfolios that are well diversified, do not have heavy debt burdens, have access to rand funding, and where investors do not have exit timing pressures, will fare far better,” says Alberts. “RMB Corvest possesses these characteristics; being an on-balance sheet funder means that we can exit opportunistically from a well-diversified portfolio (of over 55 investments) which is moderately geared, and being part of the FirstRand group gives us access to funding and a banking network.”
Although it is still early days, Alberts reveals that only a handful of Corvest’s portfolio companies are requiring bridging finance from shareholders.
“In most instances, their gearing levels going into the pandemic were modest enough that their primary banks are able to bridge the gap, assuming a temporary financial position. To the extent that the lockdown and market continue to be challenging, far more support from shareholders would be required.”
Very little has been researched or published about private equity performance through this shock (it’s probably too soon), but common sense would dictate that many businesses carried too much debt into this crisis and now need bailouts.
“I think, unfortunately, that for a number of these businesses that have been unable to trade, any debt is too much debt,” laments Bellew. “I think we are going to see a lot of restructurings (better businesses are likely to do this privately; weaker businesses may have to resort to business rescue) but I also think that banks are going to be pragmatic and come to the party to save those businesses that are worth saving. For a bank, it is often better to support a basically healthy company through a crisis than to pull the plug and have to realise security in a fire sale. In some cases, banks will even convert some debt to equity in order to maximise overall.”
So what happens next, after the worst pandemic since the 1918 Spanish Flu, and the worst oil shock since the 1973 oil crisis?
“The next step for us and our clients, coming out of this pandemic, is to get back to basics,” says Alberts. “Businesses will need to find ways to systematically trade out of the lockdown, preserve jobs and build earnings again. Our role is to support our management teams in this unprecedented climate, and be patient – the returns will return.
The one thing that Alberts says is certain is that there will be business fatalities, and some industry models that will be affected permanently. These businesses will need to adapt to the new normal very quickly – “adapt or die”.