The Pandemic’s Effect on Private Equity Transactions and Valuations
The COVID-19 pandemic has injected a significant amount of uncertainty into the public and private markets, presenting private equity firms with both a potential buying opportunity as well as a conundrum on how to value their portfolio companies. The pandemic has changed the investment landscape in ways that would have been inconceivable six months ago. In March, just four months ago, the world stock markets were down more than 30% from their February highs. Since then, the markets have rebounded significantly. Despite this rebound, the S&P 500 is essentially flat and the NASDAQ up almost 20% year to date. The path to get there, however, has been anything but flat.
Early in the crisis, there was daily discussion among analysts and experts on the anticipated pace of recovery. Would it be shaped like a “V,” a “U,”a “W,” or an “L”? It appears that the answer to that question currently is “it depends.” For example, technology companies are doing better than most experts could have predicted, with a “checkmark”-shaped recovery. On the other extreme, most airlines and energy companies are still near their March lows. Outside of the technology industry and for well-capitalized Fortune 500 companies, the situation is not nearly as rosy. For many private, non-technology companies, the situation is still quite grim. Around the nation, many businesses deemed “non-essential” during the coronavirus lockdowns are still shutdown or operating at a capacity level that makes profitability near impossible.
PE Transactions: The New Normal
Normally, recessions and other challenging times make terrific buying opportunities for private equity funds. In fact, heading into 2020, the private equity industry was holding a record amount of cash. Unfortunately, this situation is been anything but normal. Transaction volume is actually down significantly year-over-year as new previously not thought of barriers to transactions have arisen.
Thorough due diligence is challenging in ordinary times. Current conditions have made it far more difficult. While services such has Zoom, Microsoft’s Teams and Cisco’s WebEx have helped take meetings virtual, many potential buyers and sellers still are not comfortable making such a big decision without meeting the other party in person. Even if the parties can get comfortable with having never met, certain components, such as effective, thorough tours of the office or the plant, cannot be done virtually. New uncertainties have also slowed the transaction market. Will the target company be able to not just survive but thrive in a post COVID-19 world? How do we adjust the company’s metrics to account for the future effects of COVID-19, and what multiple should we apply to the adjust metrics? Finally, there’s a human aspect. During these times, in many industries, owners are spending a tremendous amount of time keeping their businesses running. From finding ways to improve employee safety, understanding and applying for new governmental programs, and trying to meet payroll, finding time to market and sell your business might not be possible.
Post pandemic Challenges to PE Portfolio Valuations
In the private equity space, firms analyze their current investments in private portfolio companies at regular intervals, and the value of these portfolio companies are “marked to market.” As someone who appraises companies for a living, the current situation has me intrigued. Does the portfolio company have the cash/wherewithal to survive an unspecified time period of decreased/negative cash flow? Is an increased reliance on discounted cash flow analyses more prudent given the current market dynamics? Has the pandemic increased marketability issues and corresponding discounts for private companies? Do public company market multiples need an additional adjustment for the potential, incremental incomparability between the public and private markets? With second quarter marks coming out shortly, it will be interesting to see how these issues are addressed.
Compounding the aforementioned issues, with stock prices rapidly rebounding, but revenue and earnings down significantly, multiples are going to be significantly higher in many industries. This situation occurred during the Great Recession, when the S&P 500 reached its all-time high multiple of 123 times trailing 12-month earnings. Private equity firms will have a difficult choice to make in how they utilize these multiples in valuing their portfolio companies or how they glean meaning from them.
All of these factors should make for a very interesting next few quarters in the private equity industry.
Coronavirus Resource Center
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