A year and more on from the UK’s first lockdown, business continues to adapt to the impact of the COVID-19 pandemic.

Whilst the early stages of the pandemic saw private equity investors focus on stabilising their portfolios, investors adapted quickly and the second half of 2020 saw a resurgence in activity as many deals previously placed on hold were completed.

As we move into the second half of 2021 this update reviews briefly the prospects and challenges for the sector.

Opportunities

With a vast amount of uninvested capital at investors' disposal there a number of opportunities for PE backed deals.

• Portfolio bolt-ons
  PE will continue to encourage and finance growth by acquisition among their portfolio companies - particularly having completed any necessary repairs and identified those companies best-placed to grow.

• Disruption
  Private equity is renowned for its ability to prosper during economic disruption. The on-going business turbulence caused by the crisis represents an obvious investment opportunity - particularly as government support is withdrawn in the second half of the year.

• Carve-outs
  As public companies and large private groups review their structures and redirect resource to their core businesses, transaction opportunities will arise whether in form of carve-outs or public-to-private sales both of which private equity is well-placed to execute and support.

• Demand
  Pent-up demand and robust credit markets should mean a plethora of opportunities for private equity in the coming months.
  
  

Challenges

As the impact of the pandemic plays out some of the more immediate issues confronting private equity include:

• Virtual world
  Private equity firms and their advisers adapted quickly to the challenges posed by the shift to the online world successfully navigating remote presentations, management meetings, due diligence and deal execution. While some innovations may become permanent and have helped investors improve the efficiency of their processes, elements of due diligence and portfolio management inevitably benefit from old-style face-to-face meetings.

• Hybrid working
  Businesses continue to adapt working practices to the changes brought about by the various lockdowns. Portfolio companies will have an opportunity both to downsize and save costs while simultaneously being able to offer staff flexible working arrangements. Effective consultation together with finding the optimum balance between individuals’ preferences and the organisation’s needs, technological constraints and effective supervision will be key. Monitoring the well-being of employees working remotely is also essential.

• Future proofing
  Whilst investors will have spent a large part of their time during the pandemic working with their portfolio companies, the need to improve businesses’ resilience to future economic shocks is an evolving theme and will continue to require the time and attention of management and investors. All this being said, inevitably some changes and innovations to business practices and models will prove to be less useful and not survive long-term. Businesses will benefit from identifying those sooner rather than later.

• Prudence
  Private equity investors will need to be discerning given the likely surge in transaction opportunities with a premium on sector expertise and sound due diligence.

Management incentives

A significant consequence of the pandemic for PE backed companies is the impact of its economic turmoil on management incentive arrangements e.g.:

• performance conditions and targets – set in very different times – have become unrealistic strike prices of options may be higher than market value

• exits may have been pushed back

The consequence is that management may have become disincentivized or incentivized to make business decisions not necessarily consistent with strategy – or both. It also creates a challenge for the investor to recruit. Solutions are various and broadly fall between refining existing arrangements and implement new versions. Examples include:

• restructuring of investor debt or ratchets

• exit cash bonuses

• modifications of performance conditions e.g. reset of hurdles or adjusting profit calculations or targets

• adjusting strike prices to reflect the impact on performance of the pandemic

• new ordinary share issues whose value is linked to the performance of specific parts of the business

• deferring bonus payments coupled with shareholder loans to finance bridging funds to management

• cash retention incentives.

Whilst the investor’s attitude to the dilutive impact of any changes will of course be key, the tax implications – particularly where EMI or CSOPs are involved – will need careful scrutiny to ensure that the tax status of those arrangements is not jeopardised. It is vital to all stakeholders that management have a clear understanding of the return expected by the investor and at what point management equity becomes valuable.

IR35

The government recently introduced new IR35 legislation changes. Amongst other things these rules mean that certain businesses which previously engaged workers via an intermediary (e.g. a personal service company) will now need to check whether those workers are disguised employees or office holders. These new rules may have significant implications for PE investors who typically with a large number of consultants and contractors – from appointees to portfolio boards to industry specialist sitting on PE advisory boards. There are potentially significant implications for the portfolio companies too. The consequences of these changes may impact the proceeds of a future exit and will force PE investors to look closely at their arrangements.

Investment Trends

• Businesses whose models which were immune to the worst effects of the pandemic will inevitably attract attention. Alternatively, those sectors which were harder-hit such as retail and leisure are likely to present opportunities of a different sort for investors experienced in turning around distressed assets.

• Similarly, businesses with models which are perceived as resilient to, or anticipated to benefit from, the socioeconomic changes being wrought by the pandemic will be a target for investment.

• The broader technology sectors – from financial services to gaming software - have been the focus of attention for several years before COVID-19 and that trend is likely to accelerate.

• Environmental social and corporate governance (ESG) continues to play a significant part in the investment strategies of many private equity investors. Leaving aside the connection between ESG investing and financial returns, there is little question that ESG has become essential to not merely fundraising but also engaging potential investees.

Closing thoughts

These are interesting times for private equity. Whilst the economic outlook has improved significantly it remains difficult to predict. There are likely to be significant opportunities for PE backed transactions in the short term and so too for incumbent management teams.

We have significant experience of advising management teams of PE backed companies at various stages of the investment lifecycle and of working with investors and management teams to devise solutions to restructuring management incentive schemes. If you would like to discuss any of the above we have specialists who can help.

Please contact Johnathan Rees, Head of our Corporate & Commercial Team to arrange a conversation.

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