The economic repercussions of the global pandemic continue to be felt across businesses and industries worldwide. The stock market continues to rise, but the path is rocky, and not all sectors are outperforming. Amid historically low rates, government bond yields are at multi-year lows. How are alternative investments, such as private equity and private debt, fielding the crisis?
Private debt is a general term used to describe loans to private companies, consisting mainly of lending strategies to small and mid-sized businesses. In the United States, small and mid-sized firms make up almost 99% of all businesses.
Private debt offerings include a broad array of credit strategies with varying levels of risk and targeted return offered, and can be categorized by level of seniority, or by type of lending transaction. They include direct lend, distressed debt, mezzanine (subordinated) level, real estate, infrastructure, venture debt, and special situations.
The Great Financial Crisis accelerated the growth of the private credit market. As commercial banks cut back lending due to solvency issues and regulatory changes, companies looked to non-bank lenders for funding. Guidelines required by regulators limited the amount of leveraged loans that traditional banks could issue but did not impose the same restrictions on private lenders. The private debt market expanded substantially after the passage of the Dodd-Frank Act and Basel III, growing from $205 bn in 2007 to $812 bn in 2019.
The economic consequences of COVID-19 have far-reaching implications for many small-to-mid-sized firms. Traditional bank lenders have increased scrutiny over loans, and companies are finding it difficult to project costs, forecast sales, and allocate resources accurately.
Central bank stimulus has all but evaporated yields in the traditional lending markets. In an effort to assist in the economic recovery, interest rates are at or near zero following the pandemic. As companies look for funding and inventors search for higher yields, both may look to private debt.
As companies try to cover gaps in cash flow to deal with COVID-related fallout, private debt may be an alternative funding source. Nishank Khanna, Chief Marketing Officer, Clarify Capital, stated “As the economy becomes more and more volatile…businesses become increasingly more leveraged as they try to weather the unpredictable and deal with the unexpected.”
The current economic environment has made it nearly impossible for firms to project costs accurately, forecast sales, and allocate resources. “The majority of private debt fund managers are focusing on their existing investors and investments that were established pre-pandemic. As the market regains traction, and direct lenders are slow to respond, the need for private debt will become increasingly important as both the private debt funds and the businesses they serve strive to maintain liquidity”, stated Trish Tetrault, Financial Analyst, FitSmallBusiness.
But with higher yields come higher risks. Many borrowers are already overleveraged, and many non-bank lenders could default in the current economic environment. According to Dirk Hackbarth, Professor of Finance at Boston University’s Questrom School of Business, “The private debt market has seen increases in concentration towards larger players due to smaller ones struggling with the impact of COVID-19 on debt prices and risks.”
Private equity investors retain ownership in the companies, with returns correlated to the company’s value. Private equity is considered capital that is not listed on a public exchange, and can consist of either a direct investment in a private firm, or a buyout of a public company that results in a delisting. While private equity invests in existing businesses, venture capital is typically funding for startups or young companies.
The coronavirus had a significant impact on private equity as the challenges of the pandemic became clearer. During the first half of 2020, private equity deals fell nearly 20% to $326.7 bn, as managers withdrew from agreed deals. Social distancing has not only changed the dynamics of certain sectors, but it has also altered the method of how dealmakers can do proper due diligence.
As consumers and businesses adjust to the “new normal,” sectors that can push through and survive the global pandemic are best positioned. “Folks are still looking for yield from recession-resistant deals … Investors seem to be avoiding industries whose future has been decimated or unsure due to pandemic-related pressure”, according to Nate Nead, Managing Principal, MergersandAcquisitions.net.
Dry powder and the election
While the second quarter saw a reduction in the number of private debt deals and global buyout transactions, this has lead to a large amount of dry powder on the sidelines. The term “dry powder” refers to cash reserves kept on hand for firms to make future acquisitions. With lenders and investors pulling back, the number of private equity transactions fell in the second and third quarters, and the amount of dry powder has risen substantially.
Any election presents uncertainty — this year even more so. This uncertainty, combined with the unknown impact of the pandemic during the winter season, has many firms holding onto their dry powder. At the end of March, dry powder available was $1,532 bn for private equity — a record high, and $301 bn for private debt, according to data from Preqin.
With infections and social restrictions again on the uptick, we are unlikely to see a reversal in trends in the near future. How will businesses around the country fight to stay above water as they face the “new normal”? Companies that experience financial hardships and are unable to meet their debt may need to turn to new sources of capital. Many will turn to alternative forms of funding, and dealmaking may play a role as those firms with excess liquidity have the ability to leverage the crisis, explore new synergies, and find opportunities in the post-pandemic landscape.
Private debt and private equity are critical options as the pandemic has further limited lending and funding options for many small-to-mid-sized firms. And, with the potential for diversification and higher returns, private debt and private equity investors may look to alternative investments as well.
This information is for educational purposes only and should not be construed as trading advice. Past performance is not an indication of future results. Do not invest more than you can afford to lose.