Will COVID-19 Ignite Private Equity's Dry Powder?

July 27, 2020

Written By Byron Tse, Bryan Haynes and Ian Michael

The COVID-19 pandemic has pushed global financial markets into a prolonged period of volatility and uncertainty (see our article on the impact of COVID-19 on M&A deal flow), reminiscent of the 2007-08 financial crisis. Many businesses have languished since March. Private equity professionals are optimistic for the industry to adapt and play a meaningful role in a global economic recovery.

Takeaways

• Private equity firms are sitting on a highly concentrated source of capital available for deployment given fruitful fundraising efforts in recent years.
• The pandemic has spawned a number of potential investment opportunities from: (a) assisting existing portfolio businesses; (b) investing in emerging industries that have thrived in light of the current economic conditions; and (c) purchasing distressed assets or providing businesses with additional capital.

Powder Reserves

Generally speaking, liquidity becomes a primary concern during market turmoil as financial institutions begin to retreat from their traditional role as market makers for bonds and financial assets. The "Big Five" banks of Canada have recently announced billions set aside during the second quarter of 2020 as loan loss provisions, concentrating on helping existing borrowers avoid default instead of extending further credit. The Bank of Canada has established a number of asset purchase programs to help increase liquidity in core funding markets, but funding remains an ongoing issue.

In private markets, the term "dry powder" refers to the amount of committed, unallocated capital that a firm has available at its disposal to be invested. According to Bain & Company, private equity firms around the world had stockpiled approximately US$2.5 trillion in uncalled capital, with US$830 billion for buyouts alone, by the end of 2019. Market optimists have pointed to this staggering amount of available capital as a reason to be hopeful that private capital may provide highly sought-after cash to help fund transactions and market liquidity.

Investment Opportunities

The COVID-19 financial reality is flush with opportunity. Here are some examples of where and how private equity firms have been looking to put their committed capital to work:

1. Existing Portfolio: As the health crisis unfolded in March, many private equity firms have focused on their own portfolios, looking to offset supply chain disruptions, manage employee health and well-being, and shore up balance sheets. Depending on the makeup of portfolio businesses, capital deployment strategies may shift from growth opportunities to focusing on bolt-on or strategic acquisitions to assist portfolio businesses in weathering the ongoing crisis. 
2. Emerging Industries: In response to these trying times, a number of businesses have successfully pivoted, adapted and/or have pioneered unique solutions and now represent potential growth opportunities with significant up-side. These range from lesser-known industries, to an accelerated adoption of technologies that have been long in the making:
   1. Supply Chain Management: Prior to the pandemic, the focus of supply chain models had been cost reduction, resulting in a general outsourcing to countries with cheaper labour costs, particularly China. The over-dependency (and fragility) of this model has been exposed by COVID-19, and businesses may start looking to establish domestic and multi-jurisdictional alternatives to mitigate against current and/or future disruptions.
   2. Medical Supply and Technology: There is a strong demand amongst institutional private equity investors for specialized funds for health care and technology. Medical and sanitation suppliers are facing shortages following the drastic spike in demand for ventilators, masks and other personal protective equipment (PPE). The gradual reopening of Canada will take time, and the need for PPE and continued sanitation standards will likely extend well into 2021, if not longer. The public health emergency also meant that almost overnight, the need for telemedicine and virtual care services has surged to the forefront of Canada's healthcare system.
   3. Remote Working: What was seen as a sudden and necessary adaptation to the widespread closure of office buildings may now emerge as a push to transform the workplace—among others, Shopify has announced it plans to transition to a permanent remote working force and the Bank of Montreal has announced that as much as 80 percent of its staff may adopt blended home and office working arrangements on a permanent basis going forward. The need for cybersecurity, robust IT infrastructure and teleworking technologies are quickly transforming from an afterthought to an indispensable reality.
   4. Real Estate: Coupled with remote working may be a paradigm shift in how office, retail and warehouse space is utilized in the future:
      1. Workplaces may consider reducing downtown office footprints and traditional office-centricity in exchange for flexible workplaces where employees can transition seamlessly between work and home.
      2. The decline of brick-and-mortar retail has been accelerated—according to a UBS report, out of the 883,000 retail outlets in the United States, 100,000 will be forced out of business by 2025. As retail shops have been shuttered for several months, consumers have flooded to e-commerce solutions and questions remain as to what percentage will return to traditional window shopping. 
      3. The shift to e-commerce is also transforming traditional warehousing and distribution models. Businesses such as Calgary-based Attabotics Inc. represent a new wave of innovation that are remodelling warehouses from large, open structures relying on forklifts and pallets to compact and agile automated distribution centres using artificial intelligence to store and fulfill orders directly to consumers.
      4. While demand for traditional retail or office real estate may drop, the need for data centres is increasing. According to a UBS report, the top seven hyperscale enterprises are projected to spend nearly US$90 billion combined in 2020 (tripling from 2015 expenditures) on data centre leasing. 
   5. Essential Industries: Not all industries were adversely affected by widespread economic lockdowns. The pandemic has realigned views on what are deemed to be essential services outside of the healthcare space—among others, utilities, food distribution, banking and transportation.
3. Distressed Businesses: Unfortunately, the pandemic has been far more detrimental to broad swaths of the economy, indiscriminate of industry. As the effects of the economic lockdown continue to percolate, businesses desperate for capital may represent investment opportunities to some private equity firms willing to take some risk of economic recovery. We have seen some private equity firms take on evolving roles as lenders providing capital, or as purchasers of distressed assets:
   1. Private Investment in Public Equity (PIPE) Transactions: Many private equity firms have invested directly into public markets, purchasing shares, debentures and equity warrants from issuers whose valuations faltered in the stock market. See our review and analysis of PIPE transactions.
   2. ATB Private Equity: Locally, ATB Financial has formed ATB Private Equity, a private equity fund with $50 million of committed capital dedicated to providing minority interest equity to Alberta businesses. As of May 8, 2020, ATB has invested $30 million in nine separate transactions across a variety of industries from food production and health care to manufacturing and energy services.
   3. Private Debt Partners: A team of experts in the Canadian private debt alternative asset industry launched Private Debt Partners which specializes in lending institutional capital to mid-market Canadian businesses and is currently raising a $750-million senior secured direct lending fund as it eyes opportunistic investments in businesses with diminished valuations.
   4. Agriculture and Food Business Solutions Fund: Farm Credit Canada launched a $100-million Agriculture and Food Business Solutions Fund in partnership with Forage Capital Inc. to provide businesses in the agribusiness space with additional access to capital and various financing solutions.
   5. Retail Revitalization Program: Brookfield Asset Management recently announced it will launch the Retail Revitalization Program, a US$5-billion program to help re-capitalize retail businesses globally.

Outlook

The impact of the pandemic is far from over, and the path to economic recovery remains unclear. In spite of this, investment opportunities abound and private equity firms have the potential to reap the benefits of discounted assets, attractive valuations and long-term investments in emerging industries that are helping transform and revolutionize the global economy.

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