Investors trying to assess what the Covid-19 crisis will mean for their portfolios have started to look to previous crises – and in particular the global financial crisis (GFC) – for answers. It’s understandable, and in some cases the comparison may be instructive. However, it is important to note that the Covid-19 crisis is very different to the GFC in many ways.
Novel virus, novel crisis
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Volumes have been written (and indeed, movies made) about the causes of the 2008/2009 GFC. Its essential element though, was a collapse of trust between undercapitalised/overleveraged banks. Covid-19 is not the same. Bank balance sheets are far less geared and much smaller than in 2008. Funding is also more stable.
The heart of the Covid-19 crisis is essentially an unprecedented collapse in demand in the real economy. Measures to contain the virus have hit small businesses especially hard, and unemployment has rocketed in the short-term as global governments seek to curb physical social contact. Analysts now are watching how close viable businesses are to reaching the limits of available credit lines, and whether they have enough capital to ride out the demand shock.
The implications of a “people’s crisis” versus a banking crisis are therefore very different and will impact private markets very differently than a decade ago. Private assets are also not uniform. Drivers of return vary significantly, and not just between equity and debt based segments.
The effectiveness of government stimulus packages for different parts of the economy, the nature of cash flows in underlying businesses and duration of debt-based private investments all contribute to the variation in impact.
In depth: Private equity
During the Covid-19 crisis, some companies will be mostly unaffected and others will face only a temporary decline in activity without requiring additional capital. Certain companies however, will need additional capital injections to weather the storm.
The need for capital injection depends very much on the depth and length of the current crisis and on the ultimate size and applicability of government stimulus packages. Both of these are still highly uncertain. There are also different dynamics for buyouts on the one side and venture/growth investments on the other. For venture/growth investments for example, it is normal to have several funding rounds and fund managers typically hold certain reserves for follow-on financings.
Taking a base case scenario – single lockdowns in most countries, with a length of several months each - we estimate the required volume for equity injection for buyout portfolios in the single digits in terms of percent of current net asset value.
At a high level, there are two types of reserves and follow-on financings. Defensive capital injections provide liquidity or refinancing. These typically have strong downside protection for new investors and are punitive to existing investors. The quality and strength of a company and the outlook for its specific business are key determinants for defensive follow-on financing decisions.
Proactive capital injections aim to provide flexibility to benefit from the current situation. These might include buying competitors or add-ons at especially attractive valuations. It might be purchasing debt (in the same company) at discounts, or buying out other shareholders at discounts.
As external financing sources may be difficult to find in times of crisis, fund managers will use uncommitted capital in their funds, recycling provisions or credit facilities to inject capital in existing portfolio companies, if and where indicated. In some cases, fund managers might also decide to raise top-up funds to finance existing portfolio companies.
As defensive follow-on financings typically have preferential economic terms, we believe investors should be prepared to participate in those top-up funds or additional equity rounds of direct/co-investments. This might mean reserving additional allocations in their portfolios.
If the portfolio companies can weather the crisis, the additional financing could prove to be an exceptional source of enhanced returns for otherwise healthy portfolio companies.
Private assets can be part of the solution
Overall, private assets portfolios are expected to be resilient, particularly relative to listed assets, through the crisis. Moreover, private assets are generally capable of supporting portfolio companies, and thereby the real economy, given dry powder and longer-term funding structures. For equity investments, this can mean capital injections at potentially attractive terms and for debt investments there can be various degrees of debt restructuring, providing downside protection for investors.
Click here to learn more about the implications of Covid-19 on various private assets and how investors may position against the pandemic.
The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks.