By Dana Pawlicki
Without fail, the question front and center of our client’s minds is “What does the covid-19 pandemic mean for fundraising?” This question is often followed by; “Will anyone really invest?” or “Should we pause and wait this out?”
I thought I would use the extra time afforded to me by the unusual lack of client travel to share our current impressions.
First, we have all seen recent record-breaking fundraising numbers announced by the largest industry players, as they continue to ride their final closings of massive fundraises, but that is not what this article is about. I intend to address what the pandemic means for fundraises of sub-$1 billion Funds I, II and III.
There is both bad and good news on the fundraising front: LPs have certainly been distracted, as we have witnessed increased efforts to closely monitor both GP fund relationships and direct co-investments. This has clearly been with good reason, as covid-19 has proven so many opportunities previously thought to be recession proof – transactions in education and a wide range of critical services businesses – to be more vulnerable than imagined. These efforts seem primarily focused on determining:
- 1.) Do businesses have enough liquidity to weather the storm?
- 2.) Which businesses will likely “snap-back” to some degree once the economy opens back up?
- 3.) Which businesses may have suffered too much damage, and will be permanently impaired or lost?
In addition to this analysis, many LPs also are being asked to put additional capital into deals they are already invested in for “rescue financing” as companies suddenly hit lender covenants thought highly unlikely just two months ago. Many LPs also are opportunistically seeking out these types of opportunities within other investors’ portfolios.
The second piece of bad news is the denominator effort. Recently a college endowment shared that they had just increased their private equity allocation from 15 percent to 20 percent. Two weeks of March went by, and they were suddenly there without making a single new investment. This of course brings up internal portfolio management questions of whether to seek to increase the allocation or stay the course with the planned strategy. Of course the roller-coaster of the public equity markets has very recently brought many investors to approximately “half-way back,” but many investors are still fearing (or even anticipating) another downward ride, as the collateral effects of various quarantines and quickly dwindling public funding dries up.
That all said, ALL IS NOT LOST for lower middle market fundraising. First, funds-of-funds have always been a very import part of capital raising for Funds I, II and III, particularly those focused on the lower part of the middle market. The best news is that many of these groups also just completed record fundraises before the pandemic struck. These investors have no denominator effect, no pressure to deploy capital into any other asset classes and most see this as another historic opportunity to put capital to work at more reasonable valuations. It is very hard to believe that 2020 and 2021 will not be excellent vintage years for the asset class.
Secondly, at least anecdotally, I have heard of very few LP defaults to funds-of-funds, mainly only some delays for vehicles not yet having reached their final close.
Family offices are each unique and not surprisingly have been more diverse in their approach to the current state of the market. We have seen many taking an opportunistic approach with respect to favoring funds with a “blank canvas” and cherry-picking specific deals through co-investments.
It is ironic that just three months ago, investors were clamoring for “seeded” fund portfolios with appreciated assets. Now we are seeing these same investors approach those funds with caution, or even favoring new funds that are not yet raised to have exposure to only “Post Covid” transactions.
So what does these mean for lower middle-market managers on the fundraising trail? Our advice has been to stay the course and stay in the market. While there have been fewer meetings, and they are on Zoom, there are meetings, and they have been productive towards advancing raises forward. It is an opportunity to not only meet new LPs, but also to update existing relationships on how covid is affecting your portfolio and what steps you are taking to set up your portfolio companies for success. Sharing where you see new opportunities in the post-covid world is also of great interest. Finally, LPs continue to actively look at co-investment opportunities, although there are clearly less of them right now.
We know this is a tough time for buyers and sellers of businesses to agree on price, and credit providers have also pulled back. It is hard to imagine that as the economy opens back up, and travel bans are lifted, that this log-jam will not break. As an aside, valuation professionals’ recent discussions of EBITDA”C” (representing an add-back for losses related to Corona virus) may become an interesting tool to help bridge buyers and sellers on temporarily depressed performance numbers. We also believe the more widespread use of Zoom and other video conferencing tools will make company sale processes and fundraising more efficient. In fact, we had a client attend a management presentation via Zoom as recently as two weeks ago.
In summary, GPs are still best served to stay in the market and be in the best position and top of mind when travel restrictions lift and capitalized investors look to complete their 2020 allocations. Otherwise, read about them in the press after it happens, which will likely come silently and without forewarning.
Dana Pawlicki is managing partner at placement agent Stonington Capital Advisors.