Private Equity and COVID-19

Paul A. Gompers is Eugene Holman Professor of Business Administration at Harvard Business School; Steven N. Kaplan is the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business; and Vladimir Mukharlyamov is Assistant Professor of Finance at the McDonough School of Business at Georgetown University. This post is based on their recent paper.

Private equity (PE) managers have significant incentives to maximize value. As such, their actions during the COVID-19 pandemic should indicate what they perceive as being important for both the preservation and creation of value.

In July–August 2020, we surveyed PE managers about their portfolio performance, decision-making, and activities during the global coronavirus outbreak. More than 200 PE managers from firms with total assets under management (AUM) of $1.9 trillion—about half of global AUM in PE—answered the survey. We report and elaborate on the findings in our new article, Private Equity and COVID-19.

This new paper is best described along with two other papers. First, What Do Private Equity Firms Say They Do? (by us) uses a 2012 survey similar in structure to the one deployed during the pandemic in 2020. The comparison between the two papers shows how the industry has adapted over time and from more “normal” times. Second, Venture Capitalists and COVID-19 (by Gompers, Gornall, Kaplan, and Strebulaev) is a similar contemporaneous survey of the venture capital industry.

COVID-19 has dramatically and unexpectedly shocked the global economy. In the short-run, financial performance, including revenue and cash flows, has been significantly affected. Additionally, uncertainty about the future of the pandemic potentially affects the ability to make new investment decisions.

The COVID-19 pandemic has had a meaningful impact on PE firms. On average, while 50% of PE firm portfolio companies are affected positively or unaffected by the pandemic, 40% are somewhat affected and 10% are severely affected. This heterogeneity allows us to explore differential activity across those categories. In particular, we look at how the actions that PE firms are undertaking in various categories of distress affect their importance for helping underperforming companies.

We consider three main types of PE managers’ actions. First, we look at how they are managing their portfolios and trying to mitigate the damage. In doing so, we look at operational and governance engineering, both of which are meant to improve operations and maximize cash flows of the business. We also look at financial engineering that is designed to improve firms’ liquidity and ensure that portfolio companies have the financial resources that they need to survive until the pandemic is over. Financial engineering in light of a reduction in current operating cash flows may be necessary to ensure portfolio companies do not default on their debt obligations.

For severely affected portfolio companies, we find, unsurprisingly, that the most common activities for PE managers are reducing head count and reducing costs. These activities are much less important for firms that are relatively unaffected. Similarly, replacing management is far more likely in severely affected companies than in unaffected companies. On the other hand, providing general operational and strategic guidance as well as recruiting new board members is similar across all three categories of companies.

The most consistent financial engineering strategy that PE managers employ to improve liquidity is drawing down company revolving lines of credit (revolvers). The more severely affected the portfolio company, the more likely the PE manager is to draw down the revolver. Larger and older PE organizations exhibit a significantly higher propensity to draw down revolvers. A second source of potential liquidity is equity investments. The vast majority of PE managers who indicate a desire to raise equity in existing portfolio companies indicate that the source of the equity would likely be the existing fund that had invested in the company, not a later fund or a third-party fund. Smaller PE firms, which likely have smaller portfolio companies, also are more likely to help their companies access the Paycheck Protection Program (PPP). Some PE managers indicate a desire to refinance the debt and to extend maturities.

Second, we explore the impact of the pandemic on investment decision-making. In the current crisis, PE managers still spend a significant portion of their time sourcing and evaluating new investments. Among the criteria that PE managers use to evaluate new investment opportunities, business model ranked as the most important followed closely by the management team. When asked where they expect value creation to come from, the PE investors overwhelmingly pointed to growth in revenue as the key driver with reduction in costs a distant second. The focus on increased revenue versus cost reduction is stronger than in our 2012 survey. In addition, the PE investors indicate they are giving a larger equity stake to management teams than in the previous survey. Finally, they also appear to target somewhat lower returns. For new investments, the PE managers target IRRs averaging 22.6%, lower than the 27.0% reported in 2012. These changes are consistent with the large increase in commitments to PE since 2012 increasing the competition (and cost) of management teams as well as leading to a modest decline in the returns targeted by PE investors.

Among industries, information technology (IT) and health care are the two most attractive industries. This is not surprising given the public market performance of these sectors. These preferences are similar to those of venture capitalists in the COVID-19 environment: Venture capital portfolio companies (which are heavily weighted in the IT and health care industries) have been relatively unaffected by the pandemic. North America and Western Europe remain the most attractive geographies (despite how severe the pandemic was in those geographies) while LBOs and growth equity remain the most attractive types of investments.

Third, our survey asks about the internal operations of the PE firms. We seek to understand whether the time allocation of investment and operating partners has changed given the external shock of COVID-19. We find that both investment and operating partners are spending the bulk of their time helping existing portfolio companies. At the same time, investment partners are still spending 17.7 hours per week finding and evaluating new deals. In total, investment partners are working nearly 60 hours per week while operating partners are working in excess of 50 hours per week. Investment partners also are meeting with limited partners 3.6 hours per week. Roughly 21% of limited partners have expressed a desire for reduced capital calls.

As a result of the pandemic, the PE investors expect the performance (both internal rate of return and the multiple on invested capital) of their existing funds to decline. They are more pessimistic about that decline than the venture capitalists surveyed contemporaneously (who reported almost no change). Given the positive performance of the public market, particularly the tech-driven S&P 500 over this period, this is likely to make comparisons with public markets more difficult for existing PE funds.

Long-term, however, optimism remains. 76.8% of managers believe that their investments will (somewhat or substantially) outperform the public markets over the next ten years, while 53.1% predict that the entire PE industry will (somewhat or substantially) outperform.

The full paper is available for download here.

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