The impact of Covid-19 on private equity, the law firms that accompany it and the future.

COVID-19 has disrupted all areas of commercial life and there is no exception within the private equity (PE) industry as it is one of the fundamental pillars of the financial sector. Nonetheless, the industry has managed to navigate its way through the pandemic in a relatively successful way, foreshadowing a promising future. The primary work of PE solicitors is concerned with the due diligence phase (a glossary of all underlined terms can be found at the end of the article) of corporate transactions; this role will have to evolve to meet the immense challenge of maintaining sustainability in the long-term for businesses. This article will examine and discuss these points and provide some clarity as to the future of PE and its interaction with corporate law. 

How has private equity fared in the pandemic?

Firstly, the inevitable challenges faced by the PE sector should be acknowledged. The industry has had to respond to a major decline in deal flow as well as the unprecedented restrictions that come with lockdown. Given there is an estimated $4 trillion worth of AUM in private equity alone, it is no surprise that PE firms immediately prioritised portfolio management and the protection of assets. A number of PE firms found themselves juggling with the issues their assets faced including trying to maintain revenue, ESG (Environment, Social and Corporate Governance) targets, employment levels and more. This is demonstrated through Pizza Express, a company predominantly owned by Hony Capital, where in order to maintain a revenue stream the company looks to close 73 restaurants which threatens over 1000 jobs. Adding insult to injury, acquisition levels have slowed with data indicating a decline of as much as 28% in merger and acquisition activity when comparing the first quarter of 2020 to the first quarter of 2019. This is due to the sharp fall in equity value in companies and a loss of confidence.

…mergers and acquisitions can begin to come back into fruition and the frequency of deals in some industries will increase by the end of the year.

However, the future doesn’t look too despairing as it is likely that with an easement in government restrictions and a better understanding of technology, mergers and acquisitions can begin to come back into fruition and the frequency of deals in some industries will increase by the end of the year. The larger firms with more money have already begun snatching up failing businesses at cheaper valuations in the hope that post COVID they will see a return for their investors.  Overall, despite relative success, the state of affairs in PE isn’t as robust as it should be for such an influential industry. This reinforces the significance of the work to be done in the coming months for the sector to recover. This has a knock-on effect whereby law firms are needed to aid industry recovery but are a large expense that firms may not want to pay. 

How has this impacted law firms?

If there was one word that has peppered discourse on the COVID-19 pandemic it would be: uncertainty. Many things that were once taken for granted have, since the beginning of the pandemic become unstable. The effect of COVID on law firms and specifically PE has been significant, as clients have held back on prospective deals and tried to preserve money where possible, some firms like KKR have even asked their advisors to offer a 15% discount on fees for this year. Therefore, a significant drop in deal value has been experienced by US Elite firms who derive most of their revenue from PE clients. 

As COVID took over the US and UK, PE buyers quickly cancelled on their investments and buyouts as the future was uncertain. However, sellers fought back and challenged PE firms in court in an attempt to force them to pay. This was the case when the Carlyle Group and Singaporean Sovereign Wealth fund attempted to cancel a proposed investment into American Express Global Business Travel of $1bn USD. The buyers relied principally on the MAC (Material Adverse Change) clause in its contract but also claimed American Express violated several terms in the purchase agreement. A Delaware judge refused to intervene in the case and therefore the Carlyle Group is guaranteed a legal victory. This case transcends the PE sector and demonstrates how solicitors are going to have to increase the detail of cancellation related clauses in acquisition and investment related contracts. This will be to try and prepare for unpredictable but foreseeable geopolitical issues that could easily create problems for corporate transactions.

Therefore, it is highly likely that due diligence is going to become more prevalent from both sides of the negotiating table. Buyers are now going to instruct their lawyers to assess the financial integrity of their target company and detail the contingency policies in place of the sellers to ensure stability in the short and long term of an investment. This means lawyers will have to not only assess the current financial situation in businesses but also stress test the company’s ability to perform in a situation similar to COVID or a major recession.

The likely future of PE?

In regards to deal flow and buyouts in the immediate aftermath of COVID and in the medium to long-term, there are no major prohibitions. An estimated $2.5 trillion USD of dry powder exists within PE firms with around $800 billion USD dedicated to buyouts alone. Due to the large absence in competition PE firms will likely take things slow in the initial post COVID phase and ensure they invest their dry powder where they can add significant value.

In the long-term, PE firms could begin to dominate the financial industry. During lockdown, we saw transactions like KKR purchasing Global Atlantic Financial Group with their own money rather than using buyout funds showcasing how PE is beginning to eat into the insurance industry. The new regulations in the United States giving PE funds access to $401k plans shows an easy way for PE firms to gain influence with pension funds and finally, it is becoming more popular for PE firms to lend their own money to businesses on similar terms to commercial banks, suggesting PE firms will render commercial banks obsolete over the next few decades. Considering the total amount of dry powder and the dynamic nature of the private equity industry, it’s fair to say that although COVID slowed things down the overarching financial and commercial ambitions still exist and PE firms have the resources to chase them.     

Glossary: 

AUM: Assets Under Management. It’s the portfolio of companies that private equity firms have invested in or own. 

Dry Powder: Money that has been guaranteed or pledged by investors but hasn’t yet been called upon by private equity companies to use. 

Due Diligence: Prior to a corporate transaction, an investigation or review of facts is conducted by lawyers and other advisory services to confirm and validate the deal. 

MAC: Material Adverse Change. This clause gives buyers the option to cancel a deal or ‘walk’ between the time of signing a deal and the point of completion if a qualifying adverse event injures the target company.

Private Equity: A financial term for when one uses capital (often from investors) to purchase a controlling ownership stake in a company that isn’t trading publicly on a stock exchange.