The early guesses on how COVID might affect our industry were pretty dramatic but things have actually played out quite differently so far. Looking back at the first 3 quarters of COVID-19 in PE – what have we learned?
The first instinct of almost all GPs was to rush to their portfolio and check what was happening. Inevitably firms with heavy exposure to the sectors most affected (travel, consumer…) had bigger issues to deal with, but from our perspective the majority of funds came through this first phase relatively quickly, in perhaps 4-6 weeks. Not everything was fixed in this period but in the main, partners worked out where they stood and what they needed to do about it. Plans were put in place, changes made, and applications submitted to emergency government funding schemes.
Phase 2 combined implementing those portfolio plans with rebuilding deal pipelines, and as the year comes to a close we are now seeing the results of these efforts with a trickle of signings turning to a more significant flow, and if rumours are to be believed, a veritable deluge to come in the new year. The industry seems to be in rude health.
Valuations have fluctuated accordingly. Depending on market segments, Q1 write downs were written straight back up again in Q2 and by Q3 many portfolios were showing material uplifts, with the anticipation of more to come shortly. Tech and healthcare assets have driven much of this rebound and investor appetite for new deals in these areas is making those prescient enough to have invested early and now be selling into this look smart.
Meanwhile, out there in the real economy, there is real pain, so how can the PE industry, which after all feeds off the wider economy, be so insulated? A business model where your income is locked in several years in advance does tend to help avoid panic, for starters.
The traditional view is that a downturn offers a golden buying opportunity with reduced entry pricing and a slingshot effect from monetary policies to reboot the market, but as we have noted, valuations have not just held up, they have largely risen through H2. And yet deployment rises.
It’s counterintuitive but reflects a shift that has been going on for some years, that of a maturing asset class. There is far more competition, processes are quicker and more aggressive, prices are in nose bleed territory that would not have been contemplated a cycle ago. But LPs want more, because the stats show this asset class works, so the pressure builds and margins will naturally compress.
How are the best responding to these challenges? Well, these conditions are a great time to be selling, so congratulations if you have been building to that successfully. And if you can’t wind the clock back, what other approaches are we seeing?
Many may deny it, but there is a drift from carry towards management fees as a key incentive, as deployment trumps capital gains, or is that too cynical? Maybe, maybe not, but for those still driven by carry it’s clear they are having to run a lot faster to hit that hurdle rate, meaning finding more angles in origination, ever-bolder structures and a more intensive period of active ownership. This all needs more manpower, so fixed costs continue to rise.
As a sector recruiter we are seeing demand for talent build solidly. Existing firms need more people just to stand still, but AUM is increasing and so hiring accelerates. Added to this are the new platforms entering the market, whether first time funds (and many of these are now substantial with several targeting debut funds at €1bn or more), or international players coming into new markets, as well as heritage strategies through which growing firms launch a ‘baby brother’ vehicle to go back to their roots for smaller deals. All need fresh personnel.
The supply side is tight by historical levels with many experienced investors locked in and at the junior end the flow into the industry from investment banking hemmed in by reduced graduate class sizes. How to navigate this imbalance? Employers are having to sell before they buy in recruitment, pitching themselves to candidates and if you are using a headhunter, you need them to be your advocate from first contact, stressing what is special about a career with your firm.
In our experience, the key to differentiation is culture, what it is like to live and breathe with you, from the way people are treated and developed, to cornerstone values and identify. After all, this is really the only level on which you can separate one group from another. And so in our hierarchy of priorities when we advise candidates on their choices culture comes before strategy and definitely before money.
And from the firm’s side, when selecting candidates soft skills come before hard; the latter can be bolted on where necessary but basic brainpower, motivation, values and EQ are either aligned or they are not. The most successful careers in this industry are where this alignment works best.
So, 9 months in, the industry is busy doing what it does best, taking opportunities to invest in and grow businesses. We may yet see greater operational defaults as recessionary impacts hit in 2021, and in any event many exit timelines have been pushed out a year or more by the disruption, taking carry distribution dates with them.
But the hunger to deploy ever more capital in the asset class continues for LPs and GPs alike. The pressure to perform is making the top performers step up even more with distinctive ways to win deals and to create value. We expect to see increased bifurcation between the best and the rest, with the latter showing returns trending to, or behind, public markets, whilst the stars continue to earn their risk premium. Fund selection will be more important than ever.
Meanwhile, the reputation of the industry seems largely rehabilitated. The players have adopted a more humble, partnership style to engage owners up front more intelligently and perhaps a new generation of entrepreneurs is less threatened by a financial buyer, even beginning to see this as a hallmark of success, as has been the case for years in the US.
Maybe too, though, those steep valuations play a part as well, and perhaps the sceptics were right in earlier cycles, PE was buying too cheaply after all? As ever, we will need to wait several years to find out what happens.