COVID-19 FAQ: Private Equity

May 2020

The global pandemic is having a widespread impact on all aspects of the economy. In the private equity industry, many organizations are being affected by delays in fundraising, changes to valuations, a tightening credit market, an urgent need for liquidity, and challenges to deal making, as well as increasing risks prompting the need for more deal due diligence.

Here are some of the most frequently asked questions and resources to help PE firms, portfolio companies and PE funds in their immediate response and planning. We have also created a COVID-19 Response Resource Center for your overall reference.  
 

A. Cybersecurity is a vital concern in a largely digital economy and safeguarding against cyber threats is more important now than ever before. While private equity firms and their portfolio companies activate to respond to the COVID-19 outbreak, the rate of telecommuting has increased dramatically, potentially increasing the number of network entry points. Cyber-attackers have also become more aggressive, probing to exploit any vulnerability. Therefore, it is crucial to take the necessary steps to monitor and protect against cyber threats.
 
Strong access controls can ensure that only those who are authorized can access sensitive data, and audit controls can track access to systems. Intrusion detection systems can also monitor traffic across the network and trigger alerts due to suspicious activity, making it possible to stop cyber threats as they arise.
 
A cloud VPN for employees can provide secure access to the organization’s network and shared files with all data encrypted, and two-factor authentication can strengthen that security further. Internal threats are also a significant concern, but audit controls and intrusion detection can help protect against this. Staff should be trained to identify any suspicious activity as well, such as phishing emails, and promptly report these to the IT department.
 
Faced with a litany of potential threats and limited resources, organizations can benefit from threat-based cybersecurity. This identifies the most common attack vectors and focuses security efforts on protecting aspects of the network that are most likely to be targeted by threat actors. Businesses should also review their cyber insurance policy to understand coverage and the potential costs of filing a claim. Lastly, it’s important to develop, review and update the incident response plan and business continuity plan as necessary, in order to remain responsive to emerging threats and vulnerabilities during a changing business climate.
 
For more insights on data security and IT management during COVID-19, please see:

A. For many private equity firms, there will undoubtedly be short-, medium- and long-term impacts on the industry stemming from the novel coronavirus and the spread of COVID-19.

In the short term, we expect to see delays in fundraising, an impact on valuations, and a general fall in production. Medium-term considerations include taking steps to recession-proof portfolios and developing general business resilience at the portfolio company level. And, after a relative dearth of quality assets on the market in recent pre-COVID periods, we’ll likely see a huge uptick in quality, yet somewhat distressed assets at discounted prices, offering opportunities to some and challenges to others.

Private equity is uniquely complicated in times of crisis because you need to deal both with fund operations and portfolio company operations. It has to be a two-pronged effort, and both require an immediate response. It is important to actively engage all stakeholders to stabilize operations, build common ground and transparency, and problem-solve together. It’s a critical time for funds to manage a daily information and awareness briefing, direct the recovery effects, provide leadership with key information to inform executive decision-making, and, most importantly, show a willingness and ability to adapt to change.

In the immediate term, actions to undertake include facilitating crisis management (perhaps forming a designated team), driving situational awareness, establishing a command and control framework, while integrating efforts, in order to manage carefully through the COVID-19 crisis. This is at both the fund level and at the portfolio level.

Regarding thriving in the long-term, a crisis is a decisive moment for portcos in transforming the challenge into an opportunity. In most cases, a crisis is the only catalyst for long-needed change. Now is the time reimagine portcos’ business strategies and plans to work towards creating a secure future for each investment.

A. For many portfolio companies, supply chain disruption has already meant supply shortages and increased prices, fulfilment delays, and heightened transportation costs. While the initial COVID-19 impacts are disruptive, most are bracing for the aftershocks to be devastating. Looking longer term, the extent of these and other supply chain disruptions will be dictated by the speed at which the global economy—and the Chinese economy in particular—rebounds once the outbreak is contained.

If conversations and recommendations from fund managers around geographic diversification in supply chains aren’t already underway following the U.S.-China trade tensions of the past year, now is the time. By shifting supply sources to a variety of countries, and minimizing the dependence on a single location, companies have more flexibility when it comes to procurement and manufacturing. To address immediate risk, portfolio companies should identify which Tier 1 suppliers are experiencing production slowdowns, look for alternatives and then evaluate issues with Tier 2 and Tier 3 suppliers. When evaluating changes to supply chain operations, it is important to assess potential exit charges, permanent establishment status and the tax liabilities associated with the movement of functions and assets. Private equity firms understand the importance of exit strategies and transferring supply chain operations requires similar trains of thought to avoid obvious disruption.

In addition to diversification, a good supply chain resiliency and third-party risk initiative begins with ensuring your portfolio companies’ operational risk programs are strong, with particular focus in the areas of crisis management and communication, business continuity, and third-party risk. Portfolio companies may have different levels of control over the various sources of risk, and they need to quantify the expected effects of these risks defined by likelihood (probability) and effect on business (impact). Transparency and continuous visibility of risks and relationship is necessary so the organization is not caught off guard. The bottom line is you don’t want to let anyone know you are in trouble for fear of a ‘run on the bank’.

For more, read our insight on how companies can navigate the COVID-19 supply chain impacts here.

A. The two most important factors for success are care and communication. The crisis has a significant human toll, and managers must prioritize the physical and mental health of their workforce above all else. With workers losing the boundaries and the natural touchpoints of the office, staying connected is also critical. A VitalSmarts survey of more than 1,000 remote workers pre-crisis found that nearly half (46%) said the most successful managers checked in frequently and regularly with remote employees. Front-line managers can’t control the impacts of COVID-19 but they can leverage common collaboration tools to allow for streamlined communication and conferencing.
 
For more, read our insight on work from home options here.

A. Depending on the investment focus of each private equity firm, there are unique challenges and opportunities that have presented themselves, and will continue to evolve, over the foreseeable future. Some industries, such as restaurants, retail and travel, have been battered, while others like technology and healthcare have seen surges in demand.

On a macro level, the biggest issue COVID-19 is triggering, as businesses pivot towards planning for the future, is uncertainty. From a deal perspective, the associated disruption to revenue and earnings and, perhaps most importantly, the uncertainty regarding projected performance, has brought valuation into question. Reliable projections are now difficult to come by, let alone the appropriate discount rate use, so it can be fruitless to build valuation models right now.

Consequently, dealmakers have been largely sidelined. It is not surprising that recent data indicates that deal closings are down 50% since the pandemic was declared in the United States on March 11, 2020. This percentage will rise further before it returns to healthier levels.

New deals that are happening currently tend to involve targets with resistance to this particular brand of recession, such as remote working software or healthcare companies.

There will be opportunities in those sectors and with certain strategies, such as distressed investing, but it remains to be seen how deep or widespread the impact will be.

For more insights, consider watching our recent webinar, “2020 Private Capital Outlook: M&A, Shifting Strategies & Capital Deployment,” here.

A. The impact of COVID-19 is leading to more conservative valuations, a tightening credit market, and investors taking a more cautious approach. What’s more, fundraising is and will remain tougher in this new environment. Debt multiples will be more case-specific as well as factor in traditional considerations such as industry and markets served. With that said, some estimates have shown the average debt multiple being down by as much as two turns due to the effects of the novel coronavirus pandemic, while others predict a less severe change. Consequently, general and limited partner investors will have a break in the pre-COVID valuation frenzy but will also need to contend with less leverage for their companies. During this downturn, which is the worst since the Great Recession of 2008 and may end up surpassing even that, PE buyout distributions are expected to decline in size and frequency.

A. In the short term, private equity firms and PE-backed companies should consider leveraging any tax strategies that can help offset costs and increase cash flow. This includes provisions in the various stimulus bills, like payroll tax credits and delays, AMT credits, net operating loss carryovers/carrybacks, and tax-deductible charitable contributions.
 
Outside of the existing stimulus bills and other response measures, PE organizations should also consider tax-saving measures that were already available prior to the start of the pandemic, such as state and federal research and development (R&D) tax credits. Companies that operate internationally should be sure to also assess the tax relief options in the places they operate.
 
While there are many tax savings opportunities available, eligibility for some provisions is dependent on company size and other factors, and many benefits are mutually exclusive or have other tax implications that could affect an organization’s total tax liability. Given the level of complexity in tax planning during this time, it is critical organizations consult with tax professionals in order to maximize their savings and understand the long-term impacts of their tax strategies.
 
For more insights on tax strategies to consider in the current environment, please visit:

A. Fund managers with portfolios understand that each organization has a unique risk profile and its own set of operational challenges. One of the most proven ways to design an action plan to mitigate risk is to conduct a business continuity risk assessment. This should include an evaluation of any applicable third-party vulnerabilities with suppliers, vendors and customers. Based on its risk profile, a company should identify the possible disruptions and prepare a set of processes to reduce the probability of each one. Scenario planning for a range of circumstances can also help identify potential risks for the medium-term that may not yet be apparent.
 
Both at the fund level and at portfolio company level, changes in cash flow and deal activity present large risks to business, particularly due to uncertainty around the pandemic’s duration. Valuation has been upended by uncertainty about projected performance, as well as disruption to revenue and earnings. To combat this risk, businesses should prioritize short-term survival with the understanding that several decisions involve long-term costs. To ease concerns around liquidity and gain access to capital needed to make investments in infrastructure, talent, and R&D, PE can deploy the massive amount of dry powder once the economy begins to heal and demand for, as well as supply of, deals returns. One measure of resilience is the ability to create foresight: to anticipate the changing shape of risk, before failure and harm occurs. Fund managers should act as strategic advisors and work with their portcos to devise crisis strategies if they haven’t already, since not every issue can be resolved with extra capital.
 
For more organizational considerations and risk mitigation tactics, see here

A. Private capital-backed companies are generally ineligible for the CARES Act’s most publicized source of relief, the loans through the SBA, due to the maximum employee test. Small businesses that have received external growth capital from a private equity or venture capital firm will likely be required to include the employees of the private capital provider and its other portfolio companies when applying the 500-employee count though there are special rules for select industries. However, there are three potentially important exceptions. First, private equity-controlled hospitality and travel companies, those operating in food service industries (NAICS code 72) and franchises in the SBA’s Franchise Directory are not subject to the 500-employee test. Second, the SBA has published a list of maximum employees per industry, some of which include maximums in excess of 500 employees. The industry size standard set forth by the SBA can be found here. Third, there is an exception if a company is backed by a Small Business Investment Company (SBIC), in which case they might qualify for PPP loans. Given the complexities associated with the affiliation rules as well as the possible exceptions, care should be taken in evaluating individual companies’ potential eligibility. Further guidance can be found here. To find more information on access to funds from PPP loans, see the IRS FAQs on Employee Retention Credit under the CARES Act.
 
Employers who don’t take advantage of the Paycheck Protection Program (PPP) that either fully or partially suspend operation during any calendar quarter in 2020 due to orders from an appropriate governmental authority limiting commerce, travel, or group meetings (for commercial, social, religious, or other purposes) due to COVID-19 or experience a significant decline in gross receipts during the calendar quarter are eligible for a 50% credit on qualifying wages paid to employees on March 13 through December 31, 2020.

All employers are eligible to defer their social security tax liability due March 27 through the earlier of PPP loan forgiveness, if applicable, or December 31, 2020. The tax savings opportunities offered by the CARES Act, in addition to payroll tax credits and deferral, also extends to AMT credits, net operating loss carryovers/carrybacks, and tax-deductible charitable contributions.
 
Furthermore, all hope for portfolio companies is not lost as several incentives provided for in the CARES Act merit attention by private equity backed companies, including the Employee Retention Credit, Payroll Deferral and Main Street Lending Program. Most recently, the Fed unveiled a new $600 billion Main Street Lending Program available to small and midsized businesses with up to 15,000 employees or up to $5 billion in 2019 annual revenues.

Mid-sized and larger companies from a myriad of industry sectors may also be eligible for low-interest loans under the $500 billion economic stabilization plan included in the CARES Act. This includes $46 billion specifically allocated for air carriers and businesses deemed critical to national security—which is likely to include “critical manufacturers” as defined by the DHS. Unlike the SBA programs, these loans must be paid back and come with public disclosure requirements.

To learn more about the federal government’s economic stimulus package, please visit: Portfolio Companies’ COVID-19 Economic Stimulus Relief Incentives

A. The SEC has provided conditional relief for registrants that are impacted by COVID-19 and are unable to file on a timely basis. On March 25, 2020, the SEC issued a new order extending the due date by 45 days to file certain SEC disclosure reports, such as Forms 10-K or 10-Q. The exemptions granted relate to reporting and proxy delivery requirements for registrants and the new order modified exemptions to now cover filings due between March 1, 2020 and July 1, 2020. Registrants must disclose why they were unable to file on a timely basis. For more on how to take advantage of the extension, read our report on the accounting and reporting impacts of COVID-19 here.