Buyouts sat down with Hamilton Lane’s Erik Hirsch, vice chairman and head of strategic initiatives, to talk about the impact of the coronavirus-fueled downturn. Hirsch sees the PE industry following three phases back to normalcy, doesn’t expect a wave of PE-backed bankruptcies and believes PE dry powder could benefit the global economy.
How would you describe the environment right now?
To me it’s a question of what the investment activity looks like, and I think about it in three phases: we’re in phase one right now, which is, there certainly is corporate debt and distressed debt opportunities to buy today; that market has dislocated very quickly. You are beginning to see folks buying and that process is going to continue for quite some time.
Also in phase one, you are starting to see some activity around managers needing to put equity infusions into businesses that are already very troubled.
Phase two is more around structured equity infusions, think about these similar to what Warren Buffett was doing on a very big scale circa 2008, coming in with preferred equity, giving that to the bank, and getting equity returns with a lot of structure and downside protection. I think you’re going to certainly see private equity called upon to do a lot of that. We’re not there yet, but that process is what I’m thinking of as phase two.
Phase three is traditional buyout, and I think this phase is a ways away. I don’t think there are a lot of buyout deals to be done today, for a few reasons: one, getting financing put in place is not really feasible. What are you lending against? You don’t know what the revenue/EBITDA impact is so getting lenders to step up to go finance a brand new buyout deal is not really happening. Two, what are you paying for that business? The markets are still gyrating around so much that coming to a price and figuring out the comparable set I don’t think is practical today either.
The third piece is you need both buyer and seller to start to mentally agree as to where we are in the market. If you’re an owner of a business, a month ago that business likely was operating at record high levels and today, a month later, it’s not. That’s going to take some time for you to calibrate – is your business worth what it was worth a month ago because you believe it’s going to rocket right back, or is your business worth a fraction of what it was worth a month ago because we’re in this for the long haul?
What kind of funds are going to get raised in this environment?
I think what you’re going to see is people raising opportunistic credit-oriented types of funds to deal with what is happening in phase one, and then people beginning to raise vehicles around phase two for sort of rescue financing, DIP financing, structured equity – and playing that opportunity set.
Until we see that phase three is coming online and the world is in a much more normalized spot, I think traditional fundraising, basic buyout funds and the like, is going to be a little ways off. That’s not to say people won’t try and that’s not to say some LPs won’t sign up.
A word of caution for GPs: Be mindful of the gross/net spread. If I was a GP today I would be focused on how to do right by my customer base to make sure I don’t create a really unattractive gross/net spread.
GPs can get creative. Maybe that means moving into fees on invested capital, but with some ability to make up some of that on the back end of the fund. We’re in an unprecedented environment and managers need to put on their thinking caps and not operate as if it’s business as usual.
What are GPs going to do with their uncalled capital?
Every GP is going to have a tough choice to make. You would rather have more dry powder than less and if you go back and look at data, when the last downturn occurred, the 2008 vintage funds did fine. Where you saw the worst performance was in the 2006 vintage funds. You had folks that had basically fully invested that 2006 vintage fund, and were probably getting ready to raise in 2008, but ended up without the proper capital to spend. Maybe they had reserved the typical 10 percent of dry powder, but that didn’t leave them with enough ammunition to deal with the challenges they were having in their portfolio.
So to me, GPs all have this tricky choice to make: are you better off spending that dry powder to help one of your existing businesses, or are you better off trying to invest that in a brand new opportunity? Those choices will be made on a case-by-case basis, and some will have an easier decision to make because they have a lot more dry powder.
Are you expecting a flood of PE-backed bankruptcies?
There’s a couple pieces here. One benefit is that dry powder. Our calculation is that there is about $2 trillion of dry powder across all strategies and sub-asset classes, essentially equal to the first stimulus package. That money is an enormous weapon that’s poised to benefit the entire global economy. Once that gets unleashed, it will be doing things like keeping existing businesses around and allowing them to survive so they can eventually thrive, or going to businesses that, if private equity capital didn’t come around, they wouldn’t survive either.
The other benefit is on the lending side. Bankruptcies are caused by the lender forcing you into a process, and I don’t expect to see a lot of that – financing packages have generally been very flexible – covenant lite, covenant free, not a lot to trip.
Also, the lenders, I would posit, are not anxious to take the keys to these businesses. What we’re hearing is they’ll be willing to work with companies and fund managers to provide every flexibility they can to let them come out the other side. The person best suited for the business is the fund manager. Lenders will be calling fund managers and saying, “I get it, we’re in the middle of a war, what can I do to help you?”
Does that mean everyone makes it? Clearly not, and there will be some bankruptcies despite everyone’s best efforts. But I don’t think you’ll see a tidal wave of that.
What are LPs worried about?
The first thing they’re focused on is what they own. Those that have the technology tools to know what they own; those that don’t are having to make a lot of phone calls to go try to track all that stuff down.
The second thing LPs are focused on is the health of the portfolio. People are all having to make assumptions, so the good GPs are coming back with very granular analysis saying “Here’s my assumption, I think revenue is staying at zero in this restaurant business until the end of June. Based on that, here are my cash needs, here’s my cash burn, here’s the financing we have in place …” So, people are looking at capital structures and capital availability, and GPs are starting to go through today and make plans.
The sad reality of this is that there are some businesses that some GPs are going to be faced with the choice of, do they want to continue to support it, is it viable? And for some the answer will be no. It would just be good money after bad. GPs are starting to communicate some of those choices, or saying “Look, if this goes on for another X-number of months then I think we’ve reached the tipping point. But here’s the business that we think actually could benefit from this and so we are putting additional capital there.” Those are the tough choices that are having to be made now.
Are you worried about LP defaults?
No. While this downturn is different from ‘08, at least to date, the magnitude of the market drop is not different, and in fact is not even quite as steep in some cases. This is where we can go back and look at 2008 as a barometer because the drop there was quite significant and denominators shrunk and so what did people do? The answer is, we just didn’t see a bunch of defaults. Will we see examples? Sure. But that’s not going to be the overwhelming LP behavior.
Defaulting is an expensive thing to do and there are a lot of mechanisms the fund documents allow for to kind of cure that default so it’s a pretty punitive result for the LP that does that.
I’ve also been asked the question, “Do you expect GPs to call in a bunch of money just so they have the capital?” That’s career suicide. You know people are trying to manage cash very carefully and so for you as a GP to unnecessarily call in a bunch of money so you can sit on it is going to all but guarantee that you piss off your client base.
Secondarily, as soon as a GP calls that capital the IRR clock is ticking. So for a GP to sit on it and earn no return is going to completely erode the performance.
Any final thoughts as we look ahead?
From the LP side, the question is really what the opportunity-set ultimately looks like. People agree there will be opportunity – but the exact shape of that opportunity-set, and when and how you’ll be best positioned to take advantage of it – that’s what the industry is trying to figure out. And, of course, all of this comes back to the length and depth of this crisis.