A Light at the End of the Tunnel?

Amid Uncertainty, PE Sees a Way Back to Normalcy

By: Scott Aleali & Jeff Maier

It truly has been as tumultuous a year as any of us have experienced in our working lifetimes. As we look to a fourth quarter that includes both a high-stakes presidential election and a possible resurgence of COVID-19 cases, we decided to take the temperature of private equity investors.

We wanted to know… more than six months into the pandemic and the accompanying economic uncertainty, where do PE professionals see long-term change—and how long do they think it will take to return to the market conditions that were the norm for nearly all of the 2010s?

Our survey received responses from 141 different private equity firms. Respondents manage funds that range in size from under $500 million to more than $3 billion, and they invest in everything from growth-stage businesses to distressed assets, real estate and secondaries. While primarily concentrated in New York and California, we also surveyed investors from Texas, Florida, Chicago, Boston, and other states across the country.

In a nutshell, while our respondents see permanent COVID-driven changes to how those of us in the PE industry perform our work, they are notably bullish on the industry’s ability to bounce back from the slowdown experienced in the second and third quarters of 2020.

High-Level Observations

A Slow Return to Offices

Like much of corporate America, our PE respondents anticipate a slow return to the office setting. The majority do not expect to fully re-open offices until sometime in the first half of 2021. Even then, most expect to move forward with greater work-from-home flexibility for their employees.

Business as Usual?

A majority of respondents expect capital calls to return to the levels that prevailed through most of the 2010s in Q4 of 2020 and Q1 of 2021, with investors expecting to deploy more than 80% of that capital in new investments or platform add-ons.

Even more surprisingly, given the prevailing uncertainty, a vast majority of respondents say their LPs are planning to keep their PE allocations steady or even increase them over the next 6–12 months.

The 2020 Slowdown

Of the more than 4 in 10 respondents who have experienced a slowdown in capital deployment in 2020, most said that was due to an overall drop in marketplace opportunities along with misalignment between buyers and sellers on price. Not surprisingly, few pointed to a lack of available capital as a reason for slowed activity.

Other COVID Impacts & Trends

Putting our fund finance hats on, we of course had to dig a little deeper on the credit side of the house. A substantial majority of the people we surveyed said their firms’ use of subscription/capital call lines of credit was unchanged during the pandemic, while just over 45% said they had found leverage to be less available for their portfolio companies since the start of the COVID crisis.

We also had to ask about all the headlines we were seeing about SPAC formation done at the bulge-bracket level—can we expect to see a trickle down to the middle market where we (and most of our clients) are active? A little over 1 in 10 respondents expect to use SPAC vehicles in the coming years and another nearly 30% say they are exploring options in that area, so this may be something to keep an eye on.

So, what to make of this information? We took a shot at a “lightning round” of our reactions to the responses below.

Working from home continues for your firm:

a)   Through the end of 2020

b)   Through Q1 2021

c)   We do not expect employees to come back to the office until 2H 2021

d)   We are already back in the office

We were surprised that over 20.5% of respondents said they were already back in the office. Of the remainder, just over 56% expect to be back in the office sometime in Q1 of 2021, another 15% expect a return to the office in Q2 and the remaining 8.5% don’t expect to be back in the office until the second half of ’21.

Scott: I’m willing to bet that the majority of that 21% that’s already back in the office are the firms that are investing in “real assets,” primarily REITs and other real estate-focused funds.  It’s impressive to see the leadership role that real estate asset managers are taking to create safe and efficient ways to return to the office.

Jeff: When you add up all the folks that aren’t going back until at least early 2021, it’s almost 80%, which is aligned with what other industries are saying about their office returns. The real estate firms are leading the way and setting an example for others! We can learn from their experience.

What adjustments are your firm making for the long-term return to office plans?

a)   None, returning to pre-COVID full-time office ASAP

b)   Full flexibility to work from home

c)   A hybrid of a) and b)

 Just 22.7% of respondents expect a full-time return to offices as soon as possible post-COVID. Of the remaining respondents, just under a third believe that we’re headed for full work-from-flexibility, while more than two-thirds expect the future of work to be a hybrid of office and home work.

Scott: COVID is clearly leading to some long-term office changes for the PE sector with 56% planning to go into some kind of hybrid work model. What does this mean for Commercial Real Estate? I’d love to be a fly on the virtual wall during a conversation between Microsoft or other large tech company execs already messaging to the market that flexible work schedules will be long term or permanent, and GPs of real estate managers that are leading the charge to return to office.

Jeff: This seems like a permanent change, not a temporary one. With 77% not working in the office as they did pre-COVID, this could have massive long-term implications to work, life and urban planning as we know it.

Capital calls as a percentage of unfunded commitments have averaged 9% since 2010. On average, over the next two quarters (Q420/Q121), what percentage of your total commitments do you estimate will be called per quarter?

a)   < 6%

b)   6.1 – 9%

c)   9.1 – 11%

d)   > 11%

Nearly 54% of respondents’ answers were clustered in the two choices that bracket that 9% figure (32.6% expect to draw down between 6.1% and 9% per quarter; 21.3% expect to draw down between 9.1% and 11%). A substantial minority (28.4%) anticipate drawing less than 6% of unfunded commitments as capital calls in the next two quarters, while 17.8% predict making up for lost time with hefty 11%+ drawdowns.

Scott: We’re already seeing deal flow volume pick back up through the first several weeks of Q4. We’re going to get to a later question that indicates buyers have plenty of access to capital but are having a hard time finding the right opportunities and getting to “yes” on price. To the extent we’ve been seeing a game of chicken between buyers and sellers, it looks like that may be about to end.

Jeff: This is the strongest indication I’ve seen to date that buyers are ready and eager to get back in the market. You see 18% of respondents saying they expect to call in excess of 11% over the next two quarters, which tells me to batten down the hatches and prepare for a busy year-end going into Q1. It is also a solid leading indicator of a productive 2021.

How will the majority of your capital call proceeds over the next two quarters be used?

a)   Pay down subscription lines

b)   New investments

c)   Follow-on investments in existing portfolio + fees/expenses

A full 60.3% expect to use the majority of their capital calls to fund new investments, with another 22% anticipating the money will go to follow-on investments in existing portcos or fees and expenses—and 17.7% are planning to use the proceeds to pay down subscription lines.

Jeff: Sixty percent are expecting to put money to work in new investments—this is huge!

Scott: I agree, this is great. The markets are expected to open up again! We remain in “unprecedented times,” so have managers found the right balance of waiting it out versus their instinct to find and close new investments?

What sense do you have from your LPs about how they plan to adjust their allocation to PE funds over the next 6-12 months, given the current environment?

a)   Increase

b)   Decrease

c)   No changes

Very few respondents—just over 24%—anticipate LPs deviating from current PE allocations over the next year. Even among that group, more than three in four anticipate LPs increasing PE allocations vs. decreasing them.

Jeff: This is a little surprising for me, to see that private capital views things as “Business as Usual” even in the face of the outperformance of the public markets during COVID. I wonder if GPs are overly optimistic by nature, or if this is a case of the chickens just not coming home to roost quite yet. The upside argument is that LPs are going to watch PE come through another down cycle as a proven and safe (read “conservative”) investment strategy with outsized returns in a low yield environment over a long-term horizon.

Scott: It’s clear the GPs view their industry as just as attractive as it was a year ago, if not more so in light of COVID. Having access to capital to invest in deals at post-COVID price points is huge, and managers with long-standing LP relationships and track records seem to have no shortage of demand.

Has your firm experienced a slowdown in the deployment of capital?

a)   Yes

b)   No

Of the 141 respondents who answered this question, just 42.6% said they’d seen a slowdown in deploying capital during the pandemic—a perception that flies in the face of our experience.

Jeff: I was surprised this number wasn’t higher. Almost 60% say they saw no slowdown? This seems counter to the data and what we saw across our portfolio. That said, it seems temporary and muted. While we definitely saw a slowdown in the deployment of capital, it was on the margins, down roughly 10 to 15% across the board. Deployment for new deals was down even further.

Scott: This is one of the more head-scratching results in the survey. I’d love to hear from people in the comments if this tracks with their reality.

Please rate the reasons for the slowdown on a scale of 1 to 4 (1 being the least impactful and 4 being the most impactful).

a)   Increased buyer/seller misalignment on price (2.63 weighted average)

b)   Reduction in opportunities (2.61)

c)   Inability to conduct on-site diligence (2.12)

d)   Lack of access to capital (deployment contingent on current fundraising) (1.56)

Just 59 respondents (of the 60 who said they experienced a slowdown in the question above) answered this question, and their responses were averaged and weighted. They gave roughly equal weight to the impact of misalignment of price discovery between buyers and sellers and a reduction in opportunities. Less impactful, in their opinion, was the inability to conduct on-site diligence, with a lack of access to capital rated as the least impactful factor.

Scott: The claim that lack of access to capital wasn’t the cause for any slowdown absolutely tracks with all the reports we’ve seen about the massive mountain of “dry powder” PE firms are sitting on. I’m a bit surprised that the inability to complete appropriate on-site diligence wasn’t more of a factor.

Jeff: That’s the mountain that investors are eager to start shoveling out the door when they talk about 9%+ capital calls in Q4 and Q1. Fasten your seatbelts, everybody, especially with continued low interest rates for the foreseeable future.

Post-COVID, how have you modified your use of subscription/capital call lines of credit relative to prior years?

a)   More actively using

b)   About the same

c)   We are utilizing less

85.6% of the 132 respondents said they were using their credit lines at about the same levels as they did pre-COVID. Another 9.1% said they’d reduced use of the lines and 5.3% said they had boosted their usage.

Jeff: This was another surprising result, given what we’re been hearing elsewhere—that sub line usage is down roughly 10%. However, you could easily argue that 10% slippage is not material, and as such, folks feel that line usage is about the same. It is also worth pointing out that repayment terms on sub lines have been extended over the last half-decade, and as such, pay downs have not been required over the last several months, keeping usage/outstandings artificially high. I think if the question was about how many firms have pulled down a sub line for a brand-new deal since COVID, we’d be looking at very different answers.

Scott: No surprise here. With the asset class performing and LPs continuing to honor their capital commitments, even in funds with the most distress at the asset level, I’d expect even more banks entering the market…as if it wasn’t crowded enough at the last Fund Finance Symposium!

How has COVID impacted access to capital markets? Has there been a change in the availability of leverage for your portfolio companies post-COVID?

a)   More available

b)   Less available

c)   We do not use leverage on investments

Responses here were roughly split between leverage being less available (45.5%) and stating that they don’t use leverage on their investments (45.1%). The remaining 12.9% said they were finding leverage more available post-COVID.

Jeff:  Again, these answers make me wonder about the impact of sub lines. Banks have definitely tightened requirements—I would be really interested to correlate the respondents who said they weren’t using leverage or who said they had more leverage available with those who are drawing on subscription lines, perhaps even as fund guaranteed portfolio company or holding company notes.

Scott: I’d be interested in hearing from our NAV lender friends if the increase in conversations around NAV facilities has translated to more NAV facilities being originated.

Do you anticipate your firm using SPACs as part of your strategy in the coming years?

a)   Yes

b)   No

c)   We are contemplating, but no decision yet

Just 11.4% are definitely including SPACs in their strategy, but there’s a “silent minority” (29.6%) that seems to be keeping an eye on developments in the space—which spurred divergent reactions from your #PEFinance friends…

Scott: This was one where I feel like we’re hearing a ton in the media about SPACs becoming more popular, yet a relatively small percentage of survey respondents expect to use them. I feel like the potential trickle-down of SPACs to the middle market is maybe being overblown. Perhaps just as a means to create liquidity events faster and before we enter 2021, where tax implications could be much different with a potential new administration?

Jeff: I’d argue that the jury is still out to lunch. When I factor in that altogether 40% of respondents say they will use a SPAC or are considering it, I see that as a huge market move. In the past, SPACs were not even a considered option for the distinguished private equity arena. I think there’s also an interesting view for SPACs as a democratized solution to the exclusivity of private capital. SPACs make it possible (perhaps easier) for the general investing public to access private equity style deals—I think this is something a lot of folks in the PE industry are watching closely. Especially as a potential liquidity/exit source.

We thought there were a ton of interesting results in these responses, but we’re really interested in hearing your thoughts. What resonated with you? Are we missing the point on any of these takeaways? Where do you think the PE market is headed in 2021? Let us know in the comments.