The outbreak of the COVID-19 global pandemic is testing the economic environment of almost all branches of business. Already, a set of key market events have been cancelled or postponed due to the virus outbreak. And, the market turbulence has plunged the equity prices across sectors and large-cap businesses are somehow withstanding the economic shock.
Also, the travel and leisure industries have faced a plunge in demand. Even the retail foot traffic and service are witnessed by bar and restaurant operators as these are closed in many countries. And, manufacturers and retailers have been disruptions due to a slowdown in the international supply chains.
While these point at the negative revisions to the global corporate expectations and earnings, the cash flow profiles are likely to decline as revenues plunge. And, many businesses will look out for the capital to help mitigate the negative cash flow.
Various PE firms have asked their portfolio companies to tap their revolving credit lines. A Pitchbook report notes that the cash-burning venture-backed companies are expected to follow suit. PitchBook Data is a SaaS company from Seattle, US, that delivers data, research and technology covering the private capital markets, including venture capital, private equity and M&A transactions.
And, here is a series of questions and responses from lead analysts to help get a better understanding of the current situation. From the same, here are the major implications on PE and VC fundraising due to the COVID-19.
Genuine economic deterioration
While the market turbulence results in a slight impact, the major risk faced by the industries is the economic deterioration. The government-mandated policies are intended to curb the spread of the novel coronavirus, but massive shocks have been set to bump the global economy. PE tends to behave like a GDP-linked business. Due to a decline in the consumer spending and business investment, a slowdown in PE transaction volume is expected.
Tighter credit markets
High-yield bonds have skyrocketed as investors are seeking to sell risk assets with heavy velocity. And, leveraged loan volume witnessed a decline over the last month. Given the decline in demand for risk assets, it is expected that there will be continued lightening in the credit markets applicable to the upper end of private equity. The larger issuances will prove difficult to carry pout and private debt funds are sitting on record levels of capital to lend across the middle market.
With tighter lending, PE firms will be forced to enter transactions with more conservative capital structures that include a larger equity proportion. But, PE is well positioned to adapt with over $2.4 trillion in dry powder.
Return profiles to face pressure
The combination of tighter lending markets and depressed earnings and cash-flow profiles are said to pressure companies. In times of market distress, it is important to emphasis two components for valuing a business – free cash flow projections and weighted average cost of capital. As economic activity subsides, it is expected to see an enhanced risk premium in the types of leverage and debt solutions used by PE. As earnings fall and the cost of capital rises, asset prices will decline across the board, hurting exit multiples.
When it comes to the private market landscape, here are the responses from lead analysts to get a better understanding of the impact of COVID-19 on private asset class.
The research shows that returns in the private markets are not as volatile as the public markets. However, both peaks and valleys of performance are more extreme than before. If there is a prolonged economic downturn due to the virus outbreak, then PE and VC funds raised during this runup to the downturn wherein cost is rising and excess capital is secured could underperform. PE funds will exhibit a high degree of cyclicality and correlation to public markets will increase over time.
For allocators to private funds, selloffs in PE reduce the overall asset pool that is available for funding. The phenomenon called denominator effect wherein the private market allocation target falls drastically is said to outsize consequences with many institutional investors already overallocating to private markets. Overallocations have forced certain institutions to sell LP interests at steep discounts on secondaries markets.
New deal announcements are a trailing indicator of activity and ripple effects of fewer meetings, restricted travel, and heightened volatility. It is unlikely that these will be filly realised until the Q2 2020 numbers are out. For both PE and VC, dry powder levels are at record levels on an absolute basis but more reasonable when compared to recent investment activity. This capital is likely to be deployed, albeit more slowly and perhaps more prudently than in the last few years.
Stock photo from Lightspring/Shutterstock
Stay tuned to Silicon Canals for more European technology news.