Private Equity – Year in Review and 2021 Outlook

Andrew J. Nussbaum and Steven A. Cohen are partners, and Katherine L. Chasmar is an associate at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell memorandum by Mr. Nussbaum, Mr. Cohen, Ms. Chasmar, Jodi J. Schwartz, Nicholas G. Demmo, and Igor Kirman.

2020 was a tale of two halves: during the first half of the year, global private equity deal volume fell precipitously, declining more than 20% relative to the same period in 2019; in the second half of the year, private equity dealmaking roared back to life, ending the year at approximately $582 billion, its highest level since 2007, as private equity firms acquired and invested in companies and businesses in record numbers even as the global Covid-19 pandemic continued to wreak havoc on the broader economy.

We review below some of the key themes that drove private equity deal activity in 2020 and our expectations for 2021.

Pandemic Takes a Toll. As we describe in our recent memo, Mergers and Acquisitions—2021, the Covid-19 pandemic took a toll on pending M&A transactions in the first half of 2020. Private equity was no exception to this trend, with private equity buyers alleging violations of interim operating covenants and pointing to “material adverse effect” clauses in transaction agreements as justification to call off deals or renegotiate. In May 2020, Sycamore Partners and L Brands announced that they had mutually agreed to terminate a deal signed earlier in the year in which Sycamore would pay $525 million for a majority stake in Victoria’s Secret, after Sycamore had sued alleging breaches of interim operating covenants, among other things. That same month, Carlyle and Singapore sovereign wealth fund GIC announced that they would abandon their deal, entered into in December 2019, to acquire a 20% stake in American Express Global Business Travel. In other cases, deals survived, but the terms were recut. For example, after Advent International signaled that it wanted out of its agreement to acquire Forescout Technologies for $1.9 billion struck in February 2020, the parties ultimately agreed to proceed with the transaction at a reduced price of $1.6 billion.

However, private equity sponsors still remained some of the most active dealmakers during this period, with private equity backed buyouts accounting for approximately 17% of overall M&A activity—the highest percentage since the first half of 2007—as private equity investors seized opportunities created by the unprecedented volatility and dislocation in markets. At the same time, private equity sponsors focused their efforts on strengthening existing portfolio companies, particularly those in industries such as hospitality, retail, travel and energy that have been hardest hit by the pandemic, and reassessing eventual exit strategies and timelines. During this period of acute uncertainty and volatility, private equity sponsors deserve credit for being creative, flexible and nimble, and for providing an important source of liquidity to companies facing challenging circumstances.

Rebound in Second Half. After a slowdown in the early months of the pandemic, private equity dealmaking activity surged in the second half of 2020, ending the year with the highest aggregate dollar volume of deals since 2007 and the highest number of deals struck since records began in 1980.

Sponsors have always demonstrated an aptitude for adapting quickly to new circumstances, eschewing a one-size-fits-all approach and structuring deals of different shapes and sizes to fit the times. This penchant for innovation was on full display in 2020: private equity investors deployed capital in a variety of ways, going beyond traditional buyouts to pursue other value-creating opportunities, such as finding exits through SPAC transactions, making strategic investments in public companies, executing add-on acquisitions as part of “buy and build” or “roll up” strategies, acquiring businesses from companies seeking to divest non-core assets in carveout transactions, providing rescue financing and making minority and growth investments. We discuss some of these trends in greater detail below.

Embracing SPACs. This past year saw the spectacular rise of the next generation of the special purpose acquisition company (“SPAC”), with private equity playing a leading role. (See our prior memo on SPACs here.) Last year, SPACs raised a total of $83.4 billion of capital in 248 IPOs, surpassing the previous record, set in 2019, of $13.6 billion raised in 59 IPOs. SPACs also dominated the IPO market, accounting for approximately 50% of IPO volume in 2020, as compared with 14% in 2007, the prior peak. A number of large, well-regarded private equity firms have sponsored SPACs, including Apollo and TPG, as a means to diversify their investment strategies beyond traditional buyout funds and acquire attractive assets that may not fit within the requirements of existing vehicles. Private equity funds have also looked to SPACs as a means to monetize their investments in portfolio companies. For example, in September 2020, Advantage Solutions—a company backed by CVC Capital, Bain Capital and Leonard Green & Partners— withdrew its plans for an IPO, more than three years after its initial registration statement filing, in favor of a transaction with a SPAC formed by Centerview Capital that valued the company at approximately $5.2 billion, including debt. Other notable SPAC transactions in 2020 involved MultiPlan, a company sponsored by Hellman & Friedman, merging with a SPAC backed by Churchill Capital in a deal worth $11 billion, and the announced combination between United Wholesale Mortgage and a SPAC backed by Gores Group in a deal worth $16 billion, the largest SPAC transaction to date. We expect that private equity funds will remain important players in the SPAC landscape, both in their capacity as sponsors of SPAC vehicles and as sellers looking for an alternate path to liquidity.

This is not to say that traditional IPOs have fallen out of favor—private equity sponsors logged more than $74.5 billion in exit value, measured in terms of a company’s pre-money valuation at the time of the IPO, across 22 IPOs of portfolio companies acquired via buyout as of December 10, 2020, the highest annual value in at least a decade. As long as the capital markets continue their unabated rise, IPOs will remain an attractive exit route.

PIPEs Are Back. Just as there was a notable uptick in private investment in public equity (“PIPE”) transactions during the financial crisis of 2007-2009, the market turbulence and economic disruption caused by the pandemic brought PIPE transactions prominently back into the picture. There were approximately 120 PIPE transactions involving NYSE- and Nasdaq-listed companies announced in 2020, with an aggregate value of $36 billion, including Silver Lake’s $1 billion investment in Twitter, Apollo and Silver Lake’s $1.2 billion investment in Expedia and KKR’s

$500 million investment in US Foods. PIPEs have also played a role in the SPAC boom, with SPACs commonly seeking committed financing for a business combination in the form of a PIPE announced simultaneously with the announcement of the business combination. For example, the recently announced merger agreement between fintech startup Social Finance (SoFi) and a SPAC sponsored by investment firm Social Capital, pursuant to which SoFi will become publicly listed on the NYSE, was supported by a $1.2 billion PIPE led by Chamath Palihapitiya, Social Capital’s founder and CEO. We anticipate that PIPEs will remain a feature of the dealmaking landscape in 2021, as private equity sponsors, among others, offer companies looking to shore up their balance sheets an important source of liquidity as an alternative to more traditional sources of funding.

The Effects of Near-Zero Interest Rates (Present, Future…and Past). To many observers, the early months of the Covid-19 pandemic signaled a time of reckoning for highly leveraged portfolio companies facing the worst economic downturn since the Great Depression. Instead, the Federal Reserve’s zero-interest- rate policy and direct purchases of corporate debt gave private equity funds and (many of) their portfolio companies a lifeline by facilitating continued access to cheap credit. A second-half surge in high-yield bond issuances and buyouts at historically high multiples (albeit off Covid-impacted numbers) was another byproduct of the Fed’s largesse, and, given the central bank’s stay-the-course guidance through 2023, 2021 bodes more of the same.

But perhaps the most interesting financing “development” in 2020 was the harvesting of the fruits of the last decade of yield-chasing by lenders and bondholders. Lack of financial covenants, flexibility in earnings measures, expanded debt accordions and large investment baskets (including for separately financeable unrestricted subsidiaries) permitted many sponsored entities to weather (hopefully) short-term revenue and earnings declines without needing to seek accommodations from existing creditors. More spectacularly, the institutionalization of some of the tools pioneered in 2009 to address the illiquidity of the Great Financial Crisis—notably, non-ratable loan purchases by borrowers and less-than-unanimous vote requirements for issuance of priming debt—permitted private equity sponsors to engineer financing transactions with requisite lender majorities where such consent was necessary to address Covid-19  hits  to  liquidity. While litigation continues with respect to a number of these transactions, the leading case, regarding Serta Simmons Bedding, suggests that a decade of loose money has left sponsors well positioned relative to their creditors, even in the most challenging of times.

Rise of Tech. Private equity firms continue to make significant inroads into the technology sector, which comprised its highest ever percentage of overall U.S. private equity deal activity in 2020. This trend is not new, but the pandemic has bolstered the appeal of tech (and software in particular), with digital transformation accelerating across industries and consumers relying, more than ever before, on tech- enabled platforms and services to shop, work, learn and be entertained from home. Of particular note is the pending $10.2 billion acquisition of real estate software company RealPage by Thoma Bravo, a transaction involving an approximately $7.4 billion equity commitment from a single private equity firm, among the largest in recent financial sponsor history. The interest in tech is also evident in the success of tech-focused private equity fundraising—certain well-known managers that specialize in tech buyout deals closed large funds around the year-end mark, including Thoma Bravo, which raised $22.8 billion across three vehicles focused on technology and software investments, and Silver Lake, which raised $20 billion for its sixth flagship fund, the largest-ever tech-focused vehicle by a private equity firm.

Spotlight on Growth and Venture. Over the past decade, the private equity industry’s involvement in late-stage venture and growth equity deals—once the province of venture capital firms—has increased considerably. This trend was on display in 2020, with private equity firms participating in more than 800 venture capital transactions with an aggregate value around $48 billion in the first three quarters of 2020. Notable transactions included Silver Lake’s $3 billion investment in autonomous driving technology company Waymo and KKR’s participation in the latest funding round in Epic Games, the creator of video game sensation Fortnite, valuing the company at $17.3 billion. While venture and growth deals lack some of the important characteristics of traditional private equity deals—for example, investors in emerging companies are generally unable to exert the level of control seen in buyouts—we expect that private equity funds will continue to pursue these opportunities on a selective basis.

ESG Continues to Gain Ground. Consistent with the growing trend among investors and asset managers to incorporate environmental, social and governance (“ESG”) factors into their investment programs, private equity firms have continued to make inroads into ESG through the formation of dedicated “impact” funds, participation in global responsible investing standards and use of new metrics and methods in managing portfolio companies. Sponsors face many of the same challenges as public companies emanating from the lack of standardization and clearly adopted definitions of the goals of, and appropriate metrics to measure, ESG or “sustainable investment,” as well as pressure from investors to prioritize ESG. As the broader market becomes more sophisticated in operationalizing ESG, so too will the private equity industry.

Fundraising Drops, but Significant Dry Powder Remains. Global private equity fundraising in 2020 dropped approximately 19% relative to 2019, due in part to the challenges of securing new commitments from investors amid travel and other restrictions. But with private equity funds sitting on an estimated $1.7 trillion of dry powder, capital supply is robust. As private equity funds put money to work for their investors in 2021, we expect to continue to see fierce competition for assets, high valuation multiples and a wide range of deal structures.

Portfolio Company Incentive Compensation Plans and the Pandemic. The early months of the pandemic saw the potential for portfolio company management teams, like public company management teams, to fail to achieve short- and long- term incentive compensation plan performance targets. Although that prediction has come true for many portfolio company 2020 annual bonus plans—for instance, those based on achieving certain EBITDA targets—the most likely impact of the pandemic will be felt through the postponement of a liquidation event, and should not require wholesale reductions in multiple on invested capital targets or resets of option exercise prices. We also do not expect material changes to the standard private equity “liquidation event” formula for portfolio company long-term incentive compensation plans.

A Cautionary Tale for Public Company Directors in Leveraged Buyouts. A recent decision in the Southern District of New York, In re Nine West LBO Securities Litigation, is worth noting with respect to leveraged transactions. In Nine West, the court declined to grant a motion to dismiss, finding that the business judgment rule would not shield directors who allegedly acted recklessly in failing to conduct a reasonable investigation into the company’s post-sale solvency, taking into account plans for a post-closing carve-out and additional debt incurrence. The court also found that the target’s directors could, if the facts alleged are ultimately proven, be held liable for aiding and abetting breaches of fiduciary duties by the company’s new directors, as they could be charged with actual or constructive knowledge that the new board members would carry out post-sale transactions that would leave the company insolvent. The decision suggests that, in the leveraged buyout context, when exercising the board’s traditional duty to obtain the highest value reasonably available in a sale of the company, directors should be mindful of the post-sale solvency of the company, to the extent contemplated post-closing transactions that may jeopardize the ongoing viability of the corporation are known to the target board.

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Private equity dealmaking bounced back and finished strong in 2020. And yet, as we enter 2021, there is considerable uncertainty regarding the Covid-19 recovery, the future performance of the equity markets and broader economy, and the tax and regulatory environment applicable to private equity. While we expect private equity deal volume to remain strong in 2021, as private equity investors look to put their hefty capital stockpile to work, we believe that the landscape will reward financial sponsors that exhibit both caution and creativity, taking care to manage their existing portfolio companies in the context of the ongoing market disruption stemming from the pandemic and its resulting business impacts, while at the same time seizing on value-creating opportunities using creative deal structures.

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