How does private equity navigate an unprecedented global human and economic catastrophe that goes far beyond the institutional memory of any organization? History books don’t offer a lot of insights, because this coronavirus pandemic is hitting in the midst of an information age that distinguishes it from past health crises. Companies will face numerous challenges in the coming months, but with the right strategies in place, these challenges can be managed and may even result in new opportunities.
At the end of the day, it comes down to focusing on the fundamentals and understanding how COVID-19-driven volatility will affect potential targets and transactions in today’s marketplace. These five areas deserve special attention.
1. SEPARATING OUT THE REAL OPPORTUNITIES
To understand the value of a business in the post-COVID-19 world, we need to understand where it was before the pandemic hit. Was it healthy or distressed? Next, assess whether its fundamentals were improved or damaged by the economic consequences of the pandemic. Finally, consider whether those changes are likely to be permanent or just temporary blips caused by shifts in consumer behavior that will revert to some norm when the crisis subsides.
The highest value will likely be found in businesses that were healthy pre-pandemic but are suddenly facing severe distress due to consequences of COVID-19 that will moderate when some solution to the virus is found. If you can obtain revenue data for periods pre-COVID-19 and compare to the months during lockdown, it will be easy to isolate the impact as extraordinary to operations and provide credit for it in the valuation calculation.
There may also be value in a business that was in dire straits before the emergency and seems unsavable now; look for assets like intellectual property, manufacturing facilities, or key relationships that might be available at below-market values. Be careful of overvaluation of businesses that have turned around or grown significantly because they provide products or services in high demand as a result of the pandemic; consider whether that demand is likely to hold over the long term, and whether the company and their supply chain can keep up with it.
2. DILIGENCE IN A TIME OF SOCIAL DISTANCE
It will be a long time before we shake hands again. We’d become accustomed to the use of technology like video meetings and data rooms as a supplement to in-person meetings and inspections of physical plants and financial documents, but suddenly we’re forced to rely on them as a substitute for those things. Instead of going on site for a day or two to meet a target company’s management, walk the floor, and see how they do their production and manage inventory, many dealmakers now must conduct that review over a series of calls.
Successful due diligence in the time of social distance will require creativity, patience, and a focus on utilizing new channels to develop a level of comfort with management teams. Background checks will play a much larger role in developing an understanding of the people in charge of a potential target, and dealmakers will need to be tenacious in their off-site research, making sure that all the necessary data is there and accurate and that findings are communicated. On-site physical inspections must be planned carefully so that social distancing conventions are met, or may even need to be written in as a post-closing condition.
3. FORECASTING THE MOST UNPREDICTABLE MONTHS IN A CENTURY
Effective valuations depend on accurate forecasts of upcoming revenue. COVID-19 has made it extremely difficult to predict anything in 2020 or 2021. If you’re analyzing a business that was thriving before the pandemic and is facing short-term distress, revenue data from pre-COVID-19 periods might offer relevant substitutes for periods during which the business was closed or its operations significantly hindered due to the pandemic. The challenge facing any private equity professional in this economy is how to determine EBITDA-C – earnings before interest, taxes, depreciation, amortization, and COVID-19. Those who can accurately quantify that last item will have a distinct advantage in the months and years ahead. It will be imperative to show a solid forecast for the balance of this year and next to demonstrate sustained recovery.
4. MANAGING WORKING CAPITAL AND MAINTAINING CASH FLOW
The stress that COVID-19 has put on every business leaves little room for error in a deal.
An investor group needs to make sure that all the cash that’s supposed to be on hand is actually there when the deal closes. Even in these extraordinary times, survival still comes down to successfully managing receivables plus inventory minus payables for a positive result. During the due diligence process, take steps to confirm that the cycle is still functioning. Is the supply chain that supports the business still reliable, and are its customers still buying the product and paying their invoices? Now more than ever, it is essential to monitor accounts receivable balances and ensure that payment terms are being met. Similarly, communication with suppliers is necessary to ensure that there will be no disruption to quality or quantity of materials needed to support production.
5. FINDING ALTERNATIVE FINANCING
Economic downturns typically drive traditional banks to tighten their lending criteria. Private debt funds may provide a significant source of financing in today’s market, but not without a price. They typically cost more than bank financing, and they often want some kind of warrant. Lenders are going to be choosey in this market because they can’t afford to be on the hook if a business goes south.
Perhaps more than ever in recent memory, no one has a good answer for that question. Businesses don’t know if the government is going to require that they shut down or whether any future relief efforts will help carry them through to more stable times. The risks may be higher than we’ve seen in our careers, but there are opportunities out there for those who can find creative ways to manage them.