With private funds sitting on upwards of $1.7 trillion in cash, and COVID-19 creating distressed companies as tempting targets, CFOs can help keep their funds from purchasing false "bargains," experts say.
Gareth Clark, a Dechert law firm attorney specializing in advising private equity sponsors and their portfolio companies on transactions and commercial matters, says one red flag CFOs can alert their funds to is inconsistent information coming from the distressed target.
"If the data doesn't make sense, it could be a sign of a lack of internal controls," Clark warns. This can indicate an absence of strong compliance framework.
Dechert attorney Jonathan Stott, who specializes in advising private equity sponsors and operating companies in complex corporate transactions, points to another red flag: a lack of critical data on key customers.
This problem can be especially acute, Stott said, when the target doesn't provide enough quality data on short-term customer relationships.
Both attorneys say external factors in a deal are more important to the potential purchase of a distressed company now than it was pre-COVID.
A target's strong balance sheet and growth prospects could be undermined down the road by COVID-induced bankruptcies in customers and suppliers, supply chain disruptions and incremental costs, Stott said.
Downside protection for buyers
Clark says the structuring of deals is likely to be similar to what it was following the 2008 financial crisis.
Before that crisis and the current one, deal terms were favorable to sellers, and so investments were completed with less contingency around the form and timing of the payment of purchase price.
But following the pattern after the earlier recession and the current one, Clark says, we are likely to see a shift where deals are structured to include tools that provide downside protection for buyers but allow sellers to receive liquidity immediately, and perhaps more down the road if the target meets agreed upon financial goals.
"It allows deal making to happen in an uncertain economy," he explains.
Providing liquidity now, but structuring a deal that allows for both upside and downside protections, allows all parties to transact, Clark said. In particular, it allows for fund protection if a deal goes sour, and the acquired company owners to be rewarded if the purchase performs as originally expected.
Targeting deals has become one of the PE industry's greatest challenges recently, and it’s important to work with CFOs to find attractive targets at valuations that will continue sustaining attractive returns to investors.
Given the amount of dry powder, competition for quality assets has been intense, and, for those investors seeking to avoid bidding wars, there has been a need to be more creative in deploying capital.
In current purchases, Stott says, CFOs must understand how the parties intend to allocate coronavirus-related risks.
Parties have frequently used representations and warranties insurance over the past decade to allocate risks to an insurance policy instead of the seller.
As a result of uncertainty and changes arising from COVID-19, many representations and warranties insurance policies now exclude or limit coverage of losses relating to COVID-19, which is a material modification to one of the most popular tools to allocate risk and one that CFOs should consider at the outset of a potential transaction.
Clark says a personal rapport between a fund’s executives and managers and board members can be an asset or a liability. Friendliness and trust can lead to a strong working relationship, or hide faults within a distressed company being taken over. "Deal making is premised on relationship building includes a chunk of marketing. The best deals are those where the parties work together so risk and reward is appropriately balanced," Clark said.
Keep eye on changing conditions
Karl Sjogren, a venture capital expert based in Oakland, California, stresses fund principals need to be on guard from becoming too enamored of the personalities of the target’s leaders:
"If somebody tells you what you want to hear, you are less likely to dig," he said. In digging for external dangers in the future that could make for a bad deal, Sjogren advises anticipating:
- Changes in economic conditions
- Changes in competitive positions
- Changes in societal conditions
- Changes in technology
With the recent emphasis on technology development, funds could continue to put a large amount of focus on tech without considering the substantial societal changes afoot, Sjogren said. "Things that seemed reasonable a few months ago may be unreasonable now."
Private fund CFOs must look out for delays in payments by customers and changes in fixed costs in a target. Supply change risks also must be examined for future impact, he says, noting increased tensions between the U.S. and China could raise the cost or lower the availability of products and components for the target.