An Insider’s View: How Private Equity Has Navigated the Global Pandemic
The COVID-19 pandemic turned 2020 into a lurching roller-coaster ride: The initial spread of the coronavirus prompted a nationwide lockdown in March, followed by a rapid federal monetary and fiscal response, which triggered a stock market rally. Retail businesses slowly began reopening, but social distancing limited in-person meetings and most travel. In the fall, the virus resurgence forced more businesses to close or restrict customers, while December saw the first inoculations of the most vulnerable.
One constant in the pandemic was strict guidance on social distancing. Navigating the severe mobility restrictions proved challenging for the private equity industry, like most relationship-based businesses. As 2020 wound down, First Republic Bank thought it was a good time to reflect on how the industry coped with the severe health and economic impact brought on by the pandemic, as well as peer into what might await the industry in the year ahead.
First Republic Managing Director Kelly Adelekan spoke with John Barber, the Managing Partner of Cohesive Capital Partners, a private equity co-investment firm that makes direct investments in mid- and lower-mid-market companies alongside of deal sponsors. John has had a ringside seat during the pandemic — his firm was busy buying and selling companies throughout the year, as well as keeping investors informed about how their investments were faring in what was a highly volatile and uncertain marketplace. What follows is an excerpt from a longer conversation held at the end of 2020.
Private equity has proven to be COVID-resistant:
- Mobility restrictions caused by the coronavirus affected a narrower set of businesses compared to the broader impact of the Global Financial Crisis (GFC).
- A growing investment focus on technology-related business lessened exposure to cyclical downturns.
- Two key lessons learned during the GFC benefited private equity general partners (GPs): Don’t overpay and don’t overleverage the companies you acquire.
- Private equity GPs today maintain a constant dialogue with their limited partner (LP) investors, which puts them in a strong position to manage the significant communication challenges created by changing business outlooks during the pandemic.
Kelly: How has the 2020 pandemic downturn compared with the global financial crisis of 2007–08?
John: The pandemic-induced downturn of 2020 is very different than the GFC. The pandemic is not a financial crisis as much as it is a health crisis that had some very specific negative effects to certain parts of the economy, industry and employment. On the other hand, the GFC was an overall meltdown of the financial system with much broader negative impact and that lasted longer (see Exhibit 1). During the pandemic, the public equity markets, the high-yield markets and the leverage loan markets all recovered relatively quickly, and private equity fundraising and the availability of capital, in general, didn’t dry up. Consequently, by June 2020, only a small amount of rescue capital was deployed and only a few bargains were to be had — again, which is very different from the GFC experience.
John: Unlike the last big downturn, deal activity this time followed a steep V-shaped recovery. While deals in Q2 2020 were almost nonexistent, by Q3 the asset class was open for business and much more aggressive. An important factor was that leverage came back and, to some extent, at lower rates than it’s almost ever been, with relatively loose covenants. Yet, mirroring the performance of the S&P 500, which has seen the large technology stocks significantly outperform much of the rest of the market, the private equity market has seen a K-shaped recovery of “haves” and “have-nots.”
COVID-resilient business — such as technology services, e-commerce and healthcare, which facilitated remote work and social distancing — received a boost in demand and thus were attractive sectors for private equity (see Exhibit 2). Less COVID-resilient businesses — such as retail, restaurants, travel and hotels — contracted and became less attractive to the asset class.
Two factors were critical in making private equity relatively COVID-resilient. One was the shift over time to technology-related deals, which turned out to be less vulnerable to the COVID-induced downturn. The second was the two key lessons learned during the GFC: Don’t overpay or overleverage the companies you acquire.
Kelly: What was your experience investing in, and exiting, companies through the pandemic?
John: A measure of Cohesive’s deal-making activity over the pandemic is indicated by our investment pace. By March 2020, when the pandemic hit, we had invested about 15% of our $385 million Fund III. Fast-forward nine months and we had announced or were close to completing deals worth almost another 20%. However, reflecting on my over 40 years of experience, it is important to recognize that there will be ripple effects from the pandemic that extend beyond what anyone can see. This has made us extra thoughtful about putting money to work in this environment.
During this time, Cohesive did not have to make any investments to stabilize any of our portfolio companies. This speaks to their strength and the relatively short period over which the economy froze in Q2 2020. Generally, the companies that we bought over the last five to 10 years have been much more resilient than many that we bought in the 2005 to 2007 period. Again, this can be attributed to putting in practice the lessons from the last downturn and the general shift in the businesses we target that are more asset-light, technology-oriented and thus less exposed to cyclical end markets.
The sustained rally in the U.S. stock markets helped to drive exits in 2020. We see continuing strong exit activity into the new year, particularly for GPs that are selling good companies that have done well during the pandemic. An improving economy and stable public markets should continue to drive this trend, as will the ability to travel to meet prospective companies and carry out due diligence in person.
Indeed, we think this is the biggest issue — when can we get back to traveling to visit companies, go to conferences and trade shows? Less restricted travel would also remove any advantage that the bigger firms with more resources have over smaller GPs to put their due diligence teams on private transportation.
Kelly: How did COVID-19 impact GP-LP relations?
John: Private equity investor relations (IR) has changed dramatically over the past 10 to 15 years. These changes put GPs and LPs in a better position to deal with the significant communication challenges created by the COVID-19 crisis. It used to be that a GP would raise money, have an annual meeting, and that would be the extent of its interaction with investors. There might be a person who dealt with the IR, but usually a senior person on the deal team would be responsible. Today, even small- and medium-size fund managers have IR teams and are always fundraising — always meeting and speaking with investors — to keep them informed on a much more regular basis.
GPs’ general response to the heightened uncertainty during the pandemic was to communicate more often and try to do so more effectively. Thus, there was an increase in the frequency of conference call updates to inform all LPs about short-term operational and financial changes in portfolio companies, as well as discussions with individual LPs to address specific questions. GPs adopted techniques like the “traffic light program” to quickly convey information — red: a portfolio company has deep financial problems, yellow: at risk, and green: financially strong and healthy. Finally, the pandemic and its acceleration of livestreaming technologies brought about an important and unexpected IR benefit: record annual meeting attendance with many people participating that might never have traveled to see us in person.
Kelly: What is your outlook for 2021 in terms of investing and exiting?
John: The obvious answer is that 2021 will be better than 2020, but we think it’s going to take a while for the world to go back to normal. Despite the great news about the vaccines, there is an enormous task ahead to make sure they are efficiently manufactured and distributed in scale. This extraordinary medical progress should translate into stronger economic activity. While in the short term, we see private equity continuing to focus on COVID-resilient investments, the opportunity set can be expected to grow as the coronavirus-affected sectors recede and the health of the broader economy improves. Thus, we are likely to return to the highly competitive pre-pandemic market associated with high purchase price multiples driven by high levels of dry powder and investors wanting to put even more money to work.
Going forward, today’s GPs — similar to the fund managers that weathered the GFC — will benefit by having more robust portfolio companies as well as even more comprehensive playbooks to manage their investments and generate value for their investors. After all, one of the pandemic’s more important silver linings is that it pressure-tested many companies’ ability to operate under the very constricting conditions of lockdown and working remote, in addition to the normal headwinds they face.
John Barber is the Managing Partner of Cohesive Capital Partners, a private equity co-investment firm that is exclusively focused on making direct investments in mid- and lower-mid-market deals alongside of sponsors. The sponsors, who lead the transactions, are high-quality private equity fund managers. John founded New York–based Cohesive in 2010 after spending nine years building the co-investment business at Citi Private Equity. Cohesive is currently investing in its third fund, Cohesive Capital Partners III, LP, a 2019 vintage fund with $385 million in committed capital.