Tech support: How the next unicorns could save PE from the Covid crisis

The combination of the potential for major upheaval in markets, the economy and politics is almost sure to take a toll on dealmaking and on PE-owned companies too.

Already, PE dealmaking has fallen by half in Europe in the past six months, and a raft of PE portfolio businesses have been hit by economic turmoil.

Now the European Commission is forecasting the region’s economy could contract by more than 8% in 2020, and several governments are rolling out new lockdown measures and restrictions.

While this could increase buying opportunities and a sense of optimism, the possibility of a major mishap is heightened too.

As the third quarter of a tumultuous 2020 closed, Private Equity News spoke to investors, analysts and market insiders about their expectations for the months ahead.

Uncertainty is certain

Private equity firms in Europe closed 801 transactions valued at $37.7bn between March and September, 52% down year-on-year, Preqin data reveals.

New deal activity could fall even further in the near term, says Joana Rocha Scaff, head of Europe private equity at Neuberger Berman, which has $64bn of PE assets in its portfolio around the world.

It’s harder to settle on deals when future earnings are so unclear, with investors nervous about paying prices that reflect high valuations and vendors reluctant to crystallise lower valuations at the bottom of the cycle.

With little prospect of calmer times ahead, three out of four senior executives in Europe said the pandemic has lessened their dealmaking appetite, according to a survey by law firm CMS of executives from 170 companies and 60 PE firms.

The research found that 65% of those surveyed were not considering making new deals at all – compared to 45% at the same time last year.

Stefan Brunnschweiler, head of the corporate group at CMS, says that decision-making among investors could be complicated by the multiple challenges of Covid, the US election, Brexit and deteriorating relations between China and the West.

Tech is the bright spot

Tech is bucking the trend for a downturn in dealmaking with activity in Europe’s tech sector largely unchanged from last year, according to data from Preqin.

Since the pandemic hit, buyout firms have concluded 233 tech deals valued at $12.3bn in Europe, compared with 238 transactions worth $12.8bn in the same period a year ago.

Tech accounted for a third of all deals from March through September, up from the 16% stake it had in the same period last year, and three out of the five largest buyouts in the region since the pandemic hit were in the software and technology sectors.

Dominick Mondesir, research company PitchBook’s Emea private capital analyst, says a long-term trend toward tech investing has essentially accelerated during the pandemic.

Meanwhile, Carlyle’s head of global research, Jason Thomas, believes the appeal of tech assets is broad as [over the past decade] “companies with tech-enabled digital platforms have outperformed the broader market whether their primary business lies in retail, auto, healthcare, or beverage manufacturing”.

But, he adds, some sectors are particularly appealing, such as communications equipment, B2B software, and related services providers. “Companies seek out the technology needed to advance their digitisation and business transformation agendas in the aftermath of the coronavirus recession,” he notes.

In July, Carlyle’s fourth technology-focused fund, which closed last year at €1.3bn, acquired a majority stake in Czech language translation software provider Memsource, and also invested in the French environmental data processing company Envea, in a deal valuing the business at €186m.

The increasing adoption of cloud-based technology drove a group led by private equity firm Silver Lake, for example, to pour $650m into Klarna, a Swedish payments company focused on e-commerce, last month.

A recent McKinsey & Company consumer survey found that 82% of those who have tried a new digital shopping method intend to continue using it even after the crisis ends.

Joe Zidle, chief investment strategist at Blackstone, says investors turned to technology as an area of high growth in the Covid era. Recently, he argued in a research note that even as high-flying as tech has been, and despite its massive growth potential, investors should always take into account hurdles.

“In a more challenging economic environment, policymakers must keep interest rates at record lows and balance sheets supportive of elusive growth and inflation targets. The result is that higher valuations and tighter credit spreads don’t reflect the fundamental challenges facing companies in a low-growth, high-debt environment,” Zidle says.

While a number of private equity firms are starting to put more focus on tech now, the pandemic did not bring much of a change for Hg, the London-based software and tech specialist, the firm’s head of research, David Toms, told PEN.

The firm, which has led more than 100 investments in the software and services sector during the past 25 years, has been backing “strong global trends” and being rewarded with strong returns, he says. Some of these assets are in the regulatory visibility space (how tech can help businesses stay compliant to regulation and tax, for example), automation and cloud computing.

“In our experience it does make it all the more important to identify the ‘A grade’ assets that will deliver attractive returns despite optically high entry prices, and to focus on specific end-market applications and subsectors where we can leverage prior experience to deliver incrementally better returns each time,” Toms adds.

Carve-outs and delistings

Christophe De Vusser, head of Emea private equity at Bain & Co, says companies under more strain from a prolonged economic downturn will represent a big opportunity for PE buyers.

First, companies that are looking to save their business will be increasingly willing to sell specific assets in a carve-out deal.

Following a pandemic-driven demand uptick for hand sanitisers, EQT acquired the producer Schülke from French industrials group Air Liquide in a €1bn deal, in April. Two months later, mid-market firm Inflexion acquired New York-listed pharmaceuticals company Perrigo’s British drug manufacturing subsidiary Rosemont Pharmaceuticals in another significant carve-out.

De Vusser also expects more public-to-private deals as PE buyers look to take distressed companies out of the public view.
And, again, the tech sector is set to lead the way, according to a recent research by PitchBook. The data company points to security-focused companies as the most attractive at the moment.

Since March, notable deals have already surfaced, such as Thoma Bravo’s $3.9bn take-private acquisition of listed cybersecurity software provider Sophos.

Another example from May, saw Paris-based private equity firm Jolt Capital sell a stake in Verimatrix, a publicly-listed cybersecurity company, to US-based One Equity Partners.

Who dares wins

Despite the uncertain environment, there are plenty of cheerleaders for those brave enough to make investments during the downturn.
“It is a moment to acquire assets at lower valuations, but you will have to live with the insecurity that is still around it. As always, the bigger the upside, the bigger the risk,” says CMS’s Brunnschweiler.

De Vusser cautions that “only time will tell” about the wisdom of deals made during the pandemic, but also said “data shows that deals invested during and immediately after a downturn tend to perform particularly well, and we expect to see a similar pattern here”.

Data by investment analytics company Cepres shows that investments made before the global financial crisis, in 2007, generated, on average, an internal rate of return (IRR) of 9%.

But deals made after the downturn, in 2008 and 2009 generated an IRR of 11% and 29%, respectively.

Time to heal?

A September CMS survey of 230 senior Europe-based executives found 53% expect activity levels to decrease significantly during the next 12 months, while almost two-thirds (64%) don’t expect the M&A market to return to pre-pandemic levels before 2023 at the earliest.

However, there are reasons for optimism.

European economic growth is widely expected to rebound in 2021. Also, government lockdowns are becoming more targeted, allowing some businesses to adapt, and meaning that vendors, investors and advisers are more likely to agree on deals.

Neuberger Berman’s Scaff says LPs are more likely to put more cash into a handful of big funds. “I expect to see a continued ‘flight to quality’ trend, with more capital concentrated in fewer larger, more experienced managers with deeper resources, and a more challenging environment for emerging managers,” she says.

Fundraising is subdued, but it hasn’t stopped.

Just two weeks ago, Nordic Capital reached a final close of its €6.1bn fund, raised entirely remotely, without any face-to-face meetings. In July, CVC

Capital Partners wrapped up its eighth fund with around €21.3bn in commitments: Europe’s largest buyout fund to date.
And Paris-based Ardian raised $19bn for a secondaries-focused vehicle closed in June, while British buyout firms IK Investment Partners and EMK collected €2.85 and €1.5bn, respectively.

“We have to be optimistic. The reality is that we are going through a tough period, but that’s not the end of the world,” Brunnschweiler adds.

Source: Private Equity News