The ‘New Normal’ Has Arrived and It’s Not All Bad! Deal Making and LP–GP Relations Into a New Era
Nearly 8 months after the WHO first declared COVID-19 a global pandemic, the virus continues to blaze across the world. Although the industry-wide lockdowns and quarantines imposed in the early days of the pandemic have given way to a staggered revival of most sectors, social distancing norms continue to burden businesses which now need to function with fewer onsite employees and limited infrastructure. Moreover, the current resurgence of COVID-19 in countries like France which were thought to have successfully curbed the outbreak, highlights the fact that the global economy is still far from being stable.
Even during these uncertain times, we see that deal making is again on the rise, and private equity players are on the lookout for an opportunity to earn outsized returns resulting from low valuations. However, identifying the right partners and deals requires adapting to the changing social and economic landscape which has affected nearly every aspect of deal making and LP - GP relations - from how primary diligence is conducted to communication between the LP-GP at large. Fortunately, many of these changes, including the broader use of technology, are likely to create value and help make the funds industry more efficient even after this current crisis subsides.
We are summarizing below some of the key shifts in the deal making process that we see are shaping up in the new normal.
Due diligence is a critical part of the deal making process and has become even more important now when GPs are expected to make investments not just to maximize a return on investment, but to support the portfolio company’s survival. A proper diligence highlights potential issues, helps the GP to understand the business and promoters of the company, and ensures that all issues (legal, financial or otherwise) are either remedied prior to deal closing or appropriate indemnities are built into deal documents for safeguarding against future claims arising out of such issues. Traditionally, GPs have relied on face-to-face meetings and on-site visits for conducting the due diligence and negotiating deals. However, with new social distancing norms, physical interaction between GPs and promotors, as well as between diligence teams and the portfolio company have been significantly curtailed.
In response, GPs and their advisors are relying heavily on technology which has its own challenges. For example, GPs have had to ensure that each party to the deal has access to technology which is compatible with the other. GPs, their advisors and the portfolio companies have also had to work together to ensure that appropriate infrastructure is in place so that a proper diligence can be conducted remotely. This has meant everything from using portable cameras for ‘on-site’ visits to investing in secure cloud-based data rooms.
Lack of physical access to original documents was a real challenge earlier in the year when the sudden implementation of strict lock-downs left no time for companies to digitize their documents. Over the course of several months, many of these companies have now had the chance to upload the relevant information and remote diligences are being conducted as a matter of ordinary course. One of the critical challenges that comes with conducting these diligences through virtual data rooms is with respect to the maintainability of data security and privacy. While GPs are competing for limited investor capital to pursue rapidly emerging investment opportunities, some may struggle with balancing transparency and keeping data secure and firewalled against potential cybercrime.
Like every other crisis which gives rise to an innovation, new technologies are constantly developed for the protection of cloud-based data storage. Parties have realized that conducting a virtual diligence is saving on travel time, is easier, more cost effective and more efficient than a physical diligence, and accordingly GPs have already put, or are currently in the process of putting, in place the relevant infrastructure and protocols to facilitate a smooth deal making.
Risk Assessment and Mitigation
Along with driving GPs to integrate technology more fully into their deal making process, the pandemic has forced GPs to be adaptable enough to leave behind many of their pre-pandemic assumptions with respect to the growth, valuation, and sustainability of businesses in sectors in which the GPs may have had decades of experience. Instead of relying on precedent, GPs are having to newly assess multiple scenarios of cash flow forecasts with respect to each portfolio company based on variations of how long the crises may last and the extent of its impact. GPs are also undertaking more robust valuations and playing a more active role in overseeing that portfolio companies undertake timely, accurate, and predictive financial and operational reporting to help direct triage activities.
Along similar lines, GPs are also paying closer attention to the (i) security of channels use to access customers, (ii) stability of supply chains needed to obtain raw materials, (iii) durability of the workforce and enabling infrastructure, and (iv) overall crises resilience, where extra credit is given to business models that aren’t closely correlated to the economic cycles or social proximity.
At the fund level, incorporating risk management practices, including expansion of insurance coverage applicable at the manager, fund and portfolio company levels, as well as hedging risk associated with currency exchange, has also become key while structuring.
GP – LP Communication and Monitoring
While GPs have been primarily focused on evaluating the impact of the pandemic on their existing portfolios and assessing future risk and opportunity, it has become equally important for GPs to communicate with LPs to keep them updated on ground realities.
In this age of technology, it has not been difficult for GPs and LPs to transition from in-person discussions to virtual meetings held over various e-conference platforms. Although several GPs find something lacking in such virtual interactions, the fact remains that the amount of travel time saved by conducting virtual meetings has been an unexpected boon and should be used to provide relevant updates on a more frequent basis to LPs. In addition to simply using conferencing tools, GPs should also take advantage of the internet to deploy content such as videos, conduct webinars, and host town hall meetings for employees to which LPs may be invited.
However, more important than the method of communication, LPs are concerned about the details of their investments. Due to the current pandemic, GPs have been forced to change not only investment strategy, but also how and when they draw down from investors. In light of such fundamental changes to fund terms and GP strategy, it has never been more vital for LPs to closely monitor the steps taken by their GPs and question the rationale behind each decision made. Moreover, LPs should consider what levels of consent should be required to approve changes to the investment strategy, and whether any limitations should be implemented to cap the level of investment into alternative asset classes
Gone are the days when quarterly reports were sufficient sources of information and accurate indicators of the financial health of the portfolio. Now, LPs should request detailed information with respect to how their capital will be used and the fund’s new short-term investment strategy with respect to each pre-mature or unscheduled draw down notice.
Further, depending on the performance of the fund, LPs may not see the levels of distribution they had anticipated, which may impact on their own position. LPs should monitor that relevant provisions with respect to distribution are being complied.
While many GPs seem to be addressing LP demand for greater transparency by proactively providing relevant information like which investments are at a higher risk along with a supporting strategy by which to realign such investments to ensure liquidation, other GPs are inundating LPs with information which lacks real insight and fails to provide a concrete and a clear assessment of the existing portfolio and the path ahead. There is a balance to be struck between the frequency of reporting by GPs and the need for them to focus on the performance of the fund's assets themselves in a climate that is changing by the day.
While the pandemic has caused no small amount of upheaval for both businesses and investment funds, several improvements to deal making and GP – LP relation management are emerging from the chaos.
Social distancing norms have pushed GPs into rapidly adopting new technologies to conduct diligence and communicate with stakeholders faster, more efficiently and at a lower cost. In the coming months and beyond, what is likely to set one GP apart from the rest will be its (i) access to a reliable and secure video conferencing system, (ii) investment in easy-to-use and widely compatible data rooms, (iii) protocols for managing digital documents, and (iv) implementation of appropriate security measures, which may include operating its own secure proprietary servers.
Moreover, the current economic crises as well as the continued risk of resurgence of the virus and the resulting lockdowns that it may bring, has also forced GPs to pay closer attention to valuations, portfolio company operations and risk mitigation practices, as well as provide more transparency to LPs on a more frequent basis. This attention to detail, involvement at the portfolio company level, risk mitigation practices, and greater transparency and frequency of communication with LPs are positive trends that are likely to continue even after the crises subsides as LPs will have grown accustomed the more hands on approach.