Preparing for a Distressed Market
Insights from the Accordion Roundtable...
Finding the Upside in a Downturn
“Normalcy. The market wanted it, the market needed it, and now the market is taking advantage of it.”
Since October, we’ve witnessed the slow, but clear, emergence of market volatility. Not enough to officially declare it the first steps toward a down cycle, but enough to wonder about it, aloud.
The volatility might well be considered a foreboding sign on an otherwise unblemished economic cycle but, the truth is, the private equity community isn’t reacting to it as such. While deal makers may never welcome a downturn, there is a growing sense of relief that this may mark a return to some degree of economic, valuation, and deal normalcy – the long-awaited pivot.
So, we gathered an intimate group of leading investors to discuss the potential of a distressed market over doughnuts and danishes at our most recent Accordion Breakfast Roundtable in midtown Manhattan. Participating firms included The Carlyle Group, Blackstone, Goldman Sachs, and Harvest Partners, amongst others.
What we learned can be boiled down to one word: uncertainty. There’s a very real push-pull dynamic between market euphoria and investor hesitancy that, in the long-term, will lead to the eventuality of a downturn. But, just when that longer-term cycle starts, and just what the impetus is for a sustained period of market distress, remains unclear.
As a result, the private equity professionals around our table highlighted three interesting take-aways, not only in relation to the when and why of a downturn, but to the how, as well: how private equity firms can best position and prepare for a distressed economy. They include:
The Crystal Ball is Cracked:
“Yes, there’s volatility, and yes investors are pushing the pause button, not feeling the urgency to put their money to work. A lot of that is driven by end of year emotion. Sure, tariffs and trade and China are ongoing concerns, but we anticipate Q1 will return to a deal friendly environment.”
If there’s consensus on anything, it’s that there’s no ‘one thing’ forewarning a recession. While recent volatility has hastened hesitancy, private equity professionals expect this new ‘first, do no deal harm’ investing approach will last only as long as the 2018 calendar year.
“People are saying, ‘we are at the end of the year, and it’s been a decent year, which I don’t want to mess up now.’ As a result, deals are still continuing to get done, albeit slowly. That said, some of the more opportunistic deals, which arguably shouldn’t have gotten done in the first place, are getting shelved. But, on a macro level, there’s nothing fundamental that we can point to and say – that’s the reason a downturn is on the horizon, and so I think we’ll return to a deal-charged first quarter.”
In fact, firm economists are predicting not just a deal-charged Q1, but a healthy 2019 in aggregate, suggesting the recessionary warning flags may not fly for another 18 months or so.
Some of the continued, outsized deal making in the industry is a nod to that: “This entire year, valuations have been crazy, and we’ve lost a number of deals where we went in with a preferred structure and we thought it was pretty downside protected, but we got blown out of the water by somebody willing to take equity risk at crazy multiples. We’re still seeing that.”
But, we’re also seeing the cracks – the multiple fault lines that won’t, on their own, lead to a slide, but together make it easy to understand how a combination of factors may start us on a slippery descent: Brexit, China, trade, potential GE downgrade, etc. These fissures aren’t translating into immediate valuation adjustments, but they’re leading to cycle prediction adjustments – or at least questions about our prediction optimism.
“They’re not predicting a recession until 2020, but that seems an almost impossible distance away.”
Gumby is king:
“Our PE side is now underwriting their deals full-flex.”
Preferred structured deals are both a nod to heady valuations and doomsday market scenarios. On the former, huge multiples have meant underwriting accommodations in the form of alternative approaches to covenants (covenant-lite), or more inspired adjustments/definitions of EBITDA.
These more unique underwriting terms have taken on new life as downside protections, as well. Given the cushion on existing portfolios, firms are focusing their recessionary concerns on new investment terms.
“The way we are underwriting is similar to ’08-’09, in that our downside case is Draconian, and we’re pushing hard to be able to flex with debt packages, and we’re being more conservative in the amount of debt we put on it in the first place. On the whole, were looking for much more flexible structures.”
That flexibility may include more preferred structures: ”In terms of downside preparedness, more than 50% of the deals we have done this past year were preferreds or other sorts of structured securities. This has been very intentional, creating downside protections with costs on the upside.”
But while they give firms the ability to hedge against distressed markets, many of these alternative structures also impede the ability to employ other operational tools in support of downturn preparedness. Preferred structures, for example, don’t allow fund sponsors the ability to replace or manipulate management.
“That’s a critical operational handcuff.”
Management is mined and managed:
“One of the blunt tools we have to fix a business that’s not behaving the way we want it to behave, or that is stunted by an unfriendly market environment, is to put our person – our grey-haired, seen it all person – in the CEO or CFO seat.”
The CEO makes a nice throat to choke (turnover rate of 50% post-deal), but it’s the CFOs head that’s more often on the private equity chopping block (73% turnover).
The question, of course, is why. There’s the default blunt tool rationale, but there are also more nuanced reasons, company lifecycle being one. The growth-charged founder CEO can help scale the mountain, but s/he may not be the right choice to plant the IPO flag.
There are also important market dynamics: “Nobody goes into the deal saying we are going to generate our returns based on a downturn. As firms, we like to use our investment materials to boast about having the best management teams in the business, but what we really mean is, we have the best team to generate the returns that we underwrote to.”
The skillsets needed for leadership in a distressed market can be very different than those needed for growth, or scale, or acquisition. “Boom cycle PE is so focused on adjusted EBITDA, that many management teams have forgotten about the importance of liquidity and day-to-day cash management. The controls aren’t in place, and they haven’t needed to be: there’s been enough cash and everything’s an add-back. Existing portfolio management may not have the discipline, experience, or expertise to look at a P&L and make sure EBITDA is tracking.”
Short of replacing the C-suite, what are private equity firms doing to help manage management during a downturn, (or at least, hedge against their gaps)? They’re dating during diligence. They’re using substantive psychographic analysis pre-close to understand the management gaps to be mindful of down the road and in crisis situations.
In rare cases, some of these assessments serve to kill the deal: “We turned down a deal because the interviews came back as an exceptionally inflexible management team who wouldn’t work with us – which wasn’t going to work for us, because we had a big operational plan to put in place.”
Though deal-killers are the exception, these assessments may also be used as justifications to replace the management team. But that too, should be the exceptional case: “These results are less about kick the team out, than they are about being aware of the holes. We need to know about a management team in total: Do I have someone who can step up and fill in the holes where they exist? And, do I have someone who can manage during unfavorable investment periods?”
In other words, “the point is not that these assessments solve management issues. But, they give you the 6-month head start on knowing what the issues will be down the road.”
Another operational way of backfilling for skillsets – particularly those that will be needed during distressed market scenarios – is to create a hedge management model from the outset.
“Every new deal we underwrite has to have a Chairman who can step in during crisis or if current management goes south. I call them my grey-hairs and it’s critical for me to get them into the deal and into diligence early. Now, certainly there are other benefits to this model. We’re creating viable mentor-mentee relationships, and I spend a lot of time encouraging the Chairman and CEO to go heads down over a beer or a bottle of wine as often as possible. But, the real reason for that Chairman role – the reason s/he exists – is as a hedge. We’re not just occasionally using this approach for distressed market preparedness, we’re doubling down on it.”
Of course, armed with historical precedent from the ‘08 crisis, and with ten years of a bull market behind us, the real danger isn’t that the private equity community hasn’t prepared for the down cycle. “The real danger is that we’ve convinced ourselves that we’ve taken risk off the table, altogether…I chuckle at the concept of preferred structures. When the end of the world comes, no structural preference will stop it.”
So while nuanced approaches to a recessionary environment are important – and they are – so too is the more blunt Armageddon model for when an outsized bubble bursts.
“The trick is to prepare for the second order effect. When the real down market hits, even the best, most assessed, most mentored management teams may do little to stem the tide. Instead, what’s my pull the plug, parachute out of this thing solution? Those are the real – and last – questions we’ll need to ask, and answer, to properly prepare for a distressed market scenario.”
And then, as is the beauty of private equity, we’ll start all over again with the next cycle…