The Best Vintage: Surfacing private equity value in the depths of the pandemic

The volatility caused by the COVID-19 pandemic is driving a fundamental reset in private company valuations. What's more, the crisis has created a highly challenging economic environment to which private businesses aren't immune. Even against this backdrop, Craig Ferguson, IMCO's Managing Director of Private Equity, says there are many reasons to be optimistic about long-term private equity returns.

How are you thinking about private equity asset class in the context of the pandemic?

It's clear that we are heading for some form of recession – either mild or more significant – and in that context you have to think about where you play in private equity in the next three to five years. Everyone had been expecting an economic pullback, and now it's finally here so at least COVID-19 has crystallized the economic picture to some extent.

At the same time, we're looking to build out our private equity program over the next several years, and it's likely that we'll be doing that against a recessionary backdrop in the near term.

That sounds like a daunting challenge.

It's actually a huge opportunity. If you look at other contractions or recessions, the strongest private equity returns occurred in the funds and the deals that were done in the depths of the downturn. Coming out of the great financial crisis, the 2008 and 2009 fund vintages produced very attractive relative returns. So, at a base level, we're excited to deploy capital at more attractive valuations because of COVID-19.

Which sectors do you believe represent the most significant opportunity right now?

Picking the winners is definitely part of the challenge, especially when you consider the still-limited visibility with which we're operating.

Our strategy begins with selecting a small group of managers, doing primarily buyout transactions and typically diversified across four or five different sectors, including business services, consumer, health care, financial services and technology and media.

We're looking for managers who have deep expertise in those industries and can help us pick subsectors that will outperform. We're focused on value creation on a business level, from improving operations and growing revenue to making acquisitions and rationalizing cost. We're trying to drive fundamental value.

The next layer to our strategy is to drive co-investments with those managers, where as a team we can selectively choose the situations that are really well positioned relative to the economic backdrop.

What has COVID-19 done to deal private-equity flow?

The pandemic has really split the market into three broad buckets in terms of deals.

First, there are the deals that were already in market before March 16, which is roughly the date when everyone started working from home in Canada. We have a handful of those in our pipeline and the screen level on them is very high because they were priced before COVID-19. Some managers are stuck with a bit of exposure here because they thought they would be able to sell these deals down. So we're looking to see if we can find attractive valuations and companies that can thrive through the recession.

Second, there are credit-driven distressed situations like hung financings, businesses that are in urgent need of liquidity or attractively priced credit opportunities. We're working closely with our global credit colleagues to examine those opportunities.

And then third are the deals that have been reset for the new environment. Those are actually the slowest to come to market. If you look at what happened in the great financial crisis, normal deal flow slowed quite a bit because sellers and buyers of good companies could afford to wait. Sellers in this bucket don't have urgency because they have capital, and buyers don't feel the need to stretch because they can be patient and keep their powder dry. We expect to see more of these deals in late 2020.

Outside the pandemic itself, is there anything else keeping you up at night?

The shape of the recovery we're going to have is still uncertain, so it's challenging to invest and build manager relationships with a long-term view while the intervening six to 12 months are really unknown.

The other element is that we have an existing portfolio that is performing relatively well. We are actively working with our transaction partners to provide support and guidance to our portfolio companies as they deal with COVID-19 challenges. I think we have a good handle on this, but it is still evolving and very fluid.

What keeps me grounded is how prudently we're approaching the private equity asset class. We're not racing into building the portfolio, yet we are mindful that the near-term economic environment could be a relatively attractive period to make investments. We're still targeting approximately $1-$1.5 billion in commitments across six to eight managers in 2020, so for the most part it's business as usual – just with an extremely heightened awareness of the current environment.