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The pandemic and private equity

Edward Golding discusses the MD Platinum Global Private Equity Pool – how it has performed, how the pandemic has impacted the asset class, and why its still a unique investment opportunity.

 

 

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In this episode of the MD Market Watch Podcast, Assistant VP and Portfolio Manager, Edward Golding came in to talk all things private equity. As an alternative asset class, private equity presents many interesting opportunities. In this episode, we quickly reviewed private equity basics, how the asset class has been impacted by the pandemic, how the MD Platinum Global Private Equity Pool has fared, and more.

What is private equity, how does it work, and what are the merits to investors?

Ed [0:51] Sure Alex. Private equity is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity comes from investors and firms that purchase stakes in private companies or acquire control of public companies with plans to take them private, eventually delisting them from stock exchanges.

Most investors are more aware of public equities. Generally public equity investments are lower risk due to lower debt levels compared to private equity. They're also more readily available for all types of investors due to its liquidity. As most publicly traded stocks are available and easily traded daily, through public market exchanges. An example of this would be RBC which their shares can be easily purchased on the Toronto Stock Exchange.

There are several merits Alex to investing in private equity. First, I would note that private equity is focused on long-term value creation, giving investors the opportunity to achieve superior returns. Second, private equity does have a lower correlation to other asset classes, which contributes to lowering the overall risk to a portfolio when included. And third, private equity is not subject to daily price fluctuations and can to focus on strategies that drive growth without the pressures of being a publicly listed company.

We know how equities and fixed income have faired during the pandemic, how have things played out for private equity?

Ed [2:18] That's a great question, Alex. We are inundated with news about the impact on public equities from the ongoing pandemic. However, getting clear data on the impact on private equity is a bit more difficult. However, we can make some inferences from the impact of previous economic shocks on private equity. If we look back at the global financial crisis from 2008-2009, it can provide us some insight on the expected impact from the pandemic.

So first, let's start with deal activity. Deal making fell off sharply when global financial crisis hit in 2008. And we expect this has occurred during the current crisis. Most private equity investors have shifted from trying to make a new deal to diagnosing the challenges of their current portfolio companies. And sellers have been reluctant to part with assets given the initial steep drop in equity values. The combination of these two factors are going to have a significant impact on deals being completed.

Next, let's look at credit markets. Most private equity transactions involve a significant portion of debt to finalise the transaction. Equity investors will generally put up a portion of the purchase price that is less than half the total purchase price and the remainder of the deal needs to be financed with debt. Since the pandemic hit in February, lenders have become more reluctant to lend and are working with existing borrowers to avoid a default. While the risk is abating, underwriting scrutiny from lenders has increased dramatically. The past several years of easy money and covenant light deals for private equity investors is reversing. In 2019, about three quarters of all deals were financed with debt that exceeded 6 times a profit term we call EBITDA, which is earnings before interest, taxes, depreciation and amortisation. As deals at those multiples compress, buyers will have to contribute more equity to get deals done in the near term.

With respect to exit activity, it is inevitable that the number of exits will drop as well. This means that owners of a business will have to extend their holding period and potentially develop new strategies to deal with the new reality. However, public markets have recovered most of the losses earlier this year. And this could lead to a faster rebound in exits than what was experienced post the global financial crisis.

Are there new opportunities or spots of weakness in private equity as a result?

Ed [4:35] Like public markets, private equity returns have taken a hit in the first quarter. There's no doubt about that. You know, as owners of private equity businesses mark down their portfolios in step with the drop in public market valuations. We are still uncertain of the longer-term impact on private equity performance as future path of lockdown restrictions are not known at this time. However, judging by the remarkable recovery in public equity in bond markets, we anticipate private equity valuations will mirror public markets and rebound materially in the second half of 2020. Even with the expected rebound, some pockets of weakness could persist in the travel and leisure sector. So, you think of hotels for example, the aircraft industry, obviously not a lot of people are flying these days, and possibly the industrial sector, which could experience disruptions to their supply chains.

The global financial crisis was quite detrimental to private equity performance for investors who invested before the crisis hit. However, investors who stayed the course and did not lower their allocation to private equity were rewarded significantly the following decade. As PE returns generated were superior to most other asset classes. The recession generated from the pandemic appears to be different. And with public markets rallying so strong from the March 23 lows, it may be more challenging to find bargains as few investors were willing to sell during the downturn. And valuations are expected to rebound to pre-crisis level within just 6 months.

How has the MD Platinum Global Private Equity Pool performed?

Ed [6:05] That’s a good segue Alex. As a reminder, the MD Platinum Global Private Equity Pool began investing in August of 2018. So, we are now 2 years into the investment period, and the investment period is expected to last another year to year and a half. As of June 30, The MD Platinum Global Private Equity Pool has committed approximately 65% of our client’s capital and invested approximately 25%. The 25% invested is important, as it illustrates that 75% of our client's capital is still to be invested, which could provide a buying opportunity in a period of uncertainty.

Of the 65% of the pool that has been committed, about half of that is invested in the U.S., the other half split between Europe and Asia Pacific. From a sector perspective, IT and industrials are the sectors that have the highest allocation.

Since inception through to the end of March 2020, the pool has generated a net internal rate of return of 6.04% and a net multiple of capital of 1.06 times and that is in U.S. dollars. We are very pleased with the progress of the pool since inception and are confident in generating superior returns relative to public market equivalents over the life of the pool.

The impact of the pandemic was felt within our MD Platinum Global Private Equity Pool, just like any other MD Pool was impacted as well. With only 11% of the primary funds invested so far, the impact of the pandemic on those investments has been quite muted. The co-investments in Q1 were marked down about 10% compared to the end of 2019, which is only about half of the decline of the MSCI World Index, which was down about 20% over that same time period. The reason behind the lower decline in the value of the companies within our pool, compared to the MSCI World Index are twofold. One, private equity companies are valued on a quarterly basis and therefore are not subject to the inherent volatility of a public exchange. And two, I think it speaks to the higher quality of the pool’s companies with investments in quality IT, insurance and healthcare companies.

While we are pleased with the downside protection of our portfolio companies through the pandemic in the first quarter, there are two companies we are closely monitoring. The first is an investment in a company called Envision Healthcare Services, which is a provider of outsourced physician services and ambulatory surgical centres. The investment has been negatively impacted from the pandemic as all elective surgeries had to be cancelled, and the surgical centres do account for approximately about one third of the company's EBITDA. This has had a significant impact on cash flow, and since the deal was heavily leveraged at inception, the company's ability to meet debt payments has come under scrutiny. The sponsor on the deal is working with lenders and additional investors for further capital injections to ensure the viability of the company long term.

The second investment is a company named Venture Metals. The company provides industrial recycling services and specialises in buying designing and processing Industrial scrap and obsolete metals. The investment has been negatively impacted, due to the large decline in industrial production and low demand for recycled scrap metals. The deal was struck at a low multiple of EBITDA, so debt service is more a factor of declining cash flows, then burdensome debt levels, and with a rebound in economic activity in the third quarter, we remain confident in the long-term thesis for the company.

It should be noted that both investments however accounted for less than 2% of the pools invested capital and is not expected to drag materially on long run performance.

Analysis and due diligence are obviously very important when it comes to identifying good private equity investment opportunities. What are some of the adjustments that we've had to make as a result of the pandemic?

Ed [9:47] Now that's a great question, Alex. I want to assure our clients that our sub-advisor BlackRock Private Equity Partners will continue to adhere to its philosophy and process, which has served them and their clients well for over two decades now. In my discussions with BlackRock, they have identified and are employing some enhanced monitoring practices such as re-forecasting financial projections for all portfolio companies and stress testing covenant compliance, refinancing risk and liquidity. They are launching a portfolio company outlook monitor for each investment and monitor the bonds and loans trading to assess how debt markets are perceiving the company. BlackRock is also opportunistically assessing debt purchases where markets have traded down in lockstep without differentiation of asset quality. And finally, they are assessing hedging programmes and seeking opportunities to extend with respect to currencies, energy prices and interest rates.

Lastly, I just want to reiterate that our client’s investment in private equity is receiving the highest degree of oversight from BlackRock and MD. And we are very pleased with the investment pace to date. And with the performance 2 years in. As a reminder, the pool has a 10-year lifespan, so remains early days and we are excited about the future returns of this innovative investment vehicle.

If you have any questions about these topics, questions about your portfolio, please don't be shy. Reach out to an MD advisor. Whether you're a client or not, we are here to help.

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The information contained herein provides key information about the respective MD Platinum™ investments and is not intended to be taken by, and should not be taken by, any individual recipient as investment advice, a recommendation to buy, hold or sell any security, or an offer to sell or a solicitation of offers to purchase any security. The Platinum investments described in this podcast are subject to additional terms and conditions set out in the Platinum investments’ operative agreements and regulatory suitability requirements as considered by your Portfolio Manager, MD Private Investment Counsel, an operating division of MD Financial Management Inc. The Platinum investments’ operative agreements will also set out additional information about the investment objective, terms and conditions of such fund, tax information and risk disclosure that are a material terms regarding a fund. Any investment in a Platinum investment would be speculative and would involve significant risks.

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