In early March, the founders and CEOs of start-ups backed by Sequoia Capital – a leading Silicon Valley VC – received a memo titled ‘Coronavirus: The Black Swan of 2020’. A stark wake-up call to the difficulties ahead, it warned that “private financings could soften significantly, as happened in 2001 and 2009.”
Other VCs agree: prepare for funding rounds to take longer to complete and involve fewer parties issuing term sheets. An article featuring interviews with several industry executives concludes that “founders who take investment over the next few months are likely to raise at lower valuations, and part with more equity.” Oft-maligned convertible loan notes may return to popularity in order to fund promising companies that need cash quickly, whilst allowing time for valuations to settle.
However, Sequoia’s note also served as a means for imparting wisdom and reason for positive action, noting that “a distinctive feature of enduring companies is the way their leaders react to moments like these.”
“Having weathered every business downturn for nearly fifty years, we’ve learned an important lesson — nobody ever regrets making fast and decisive adjustments to changing circumstances.”
“Many of the most iconic companies were forged and shaped during difficult times… Constraints focus the mind and provide fertile ground for creativity.”
The Black Swan memo echoes the ‘RIP Good Times’ presentation Sequoia gave to a similar audience during the financial crisis in 2008, which has since become part of Silicon Valley folklore, and is emblematic of how VC and PE funds will be deploying their financial and human resources over the coming months.
The focus in the short term will be on shoring-up their portfolios. “Most funds reserve 50% of their capital for follow-on investing and the intention is to use those reserves to double down on the most obvious winners, not to bail out questionable companies” says Paul Murphy, a partner at Northzone.
Difficult decisions will need to be made. Some companies will be in crisis, others may be experiencing unprecedented levels of demand. All will need to adapt in one form or another and, in addition to capital, will require more regular communication and hands-on support from their investors.
A McKinsey article titled ‘Private equity and the new reality of coronavirus’ provides detailed guidance to fund managers, including criteria for determining how to prioritise support to their portfolio companies.
Sharing Sequoia’s focus on safeguarding liquidity, McKinsey’s ‘Covid-19 response playbook’ also advocates stabilising supply chains by “moving swiftly to create visibility” and “identifying alternative supply sources for critical parts”, in addition to reviewing commercial structures with customers:
“consider tailoring product or service offerings to help customers weather the downturn” and “reconsider contract structures and identify ways to increase customer ‘stickiness’.”
However, particular emphasis is placed on the sixth and final section of the playbook: ‘Prepare for recovery and future growth’ which states that:
“After taking initial actions to recover and stabilize, portfolio companies can prepare for growth. In the last downturn, many portfolio companies had success by investing at greater rates than their competitors.”
McKinsey’s specific guidance to “prepare for M&A” by developing an add-on strategy aligns with one of the key messages in a slide deck presented by Bain & Company to PE executives and the CEOs of their portfolio companies on 15th March:
“During and post this crisis, PE firms will be presented with unique opportunities to invest—important to be ready to act.”
This view is widely shared and is fuelled by optimal conditions in financial markets, as summarised by Paul Aversano, Managing Director at Alvarez & Marsal Global Transaction Advisory Group, in a Q&A on how coronavirus is affecting M&A and private equity:
“I am bullish on M&A activity in both the medium and long term once the market adjusts to the ‘new normal’. There is a tremendous amount of dry powder that needs to be deployed, record high valuations will likely decrease, we will continue to have a very favourable low interest rate environment and access to financing”
This ‘dry powder’ – the reserves of cash raised by PE firms but not yet spent – has reached record levels; the Financial Times cites research from Prequin in 2019 placing this at almost $2.5tn.
However, it may take some time before the touch paper is lit. Similar dynamics are at play in the world of venture capital: “There are a lot of funds out there with a lot of capital to deploy, but they have years to do it. VCs can and will slow down,” states Murphy.
When the spending spree does arrive, what will it look like?
It will likely reflect a long-term structural shift taking place in the private equity industry, which is forcing firms to specialise and develop differentiated investment strategies.
The reason why PE has attracted so much investment capital is its track record of outperforming the stock market, averaging net returns of 13.1% vs 8.1% over the last 30 years according to Bain’s 2020 Global Private Equity Report.
However, the flood of capital chasing these returns has created a crowded market. Finding the right opportunity, at the right price, and fighting off the competition is becoming increasingly difficult. This has kept powder dry and suppressed returns.
This dynamic is the result of an industry that has reached maturity, explains Section 3 of Bain’s report, titled with the provocative question of ‘Public vs. Private Equity Returns: Is PE Losing Its Advantage?’. Worryingly, data shows that global private equity returns “have been trending downward over the past 30 years” and show signs of converging with stock market returns.
This signals trouble for many funds because “parity with public markets is not what PE investors are paying for.”
However, “an elite group of firms has found a way to buck the trend. While average returns have declined over time, top-quartile returns have essentially held steady.” The Darwinian outcome is that “a large majority of the capital flowing into private equity is targeting these top-tier firms.”
So what’s their secret?
“Data can’t really capture how these firms consistently outperform, but a more qualitative and experience-based analysis suggests it boils down to focus: The best firms know what they are good at and wield that as a competitive weapon. In a world of high prices and intense competition, they understand that expertise matters.”
The Bain report identifies four focus strategies:
1.Sector specialist: more knowledge of a given sector than anyone else
2.Focused hunting ground: e.g. narrow geographic focus, buy-and-build strategies
3.Differentiated playbook: execute well-defined value creation strategies, e.g. operational efficiency
4.Scale: leverage size and breadth, bringing massive resources to complex deals and long-term plays
How might the strategies of leading funds evolve in response to the crisis? And which new areas of focus may arise?
McKinsey believes that now is the time for PE firms to place a deeper emphasis on values when shaping their investment strategies:
“At a time when public expectations of business’s role in society are shifting rapidly, firms should consider doubling down on their commitments to environmental, social, and governance (ESG)-related investing and evaluate their actions through a lens of social citizenship, taking a long view as they plot their course.”
This is just one example of the pandemic accelerating a pre-existing trend: a McKinsey article from November 2019 states that “ESG-oriented investing has experienced a meteoric rise—global sustainable investment now tops $30 trillion.”
Mark Carney, writing in the Economist, believes that a re-think of values will be a ubiquitous economic theme as we emerge from the crisis: “value will change in the post-covid world”. Beyond the impact to valuations in financial markets, “more fundamentally, the traditional drivers of value have been shaken, new ones will gain prominence, and there’s a possibility that the gulf between what markets value and what people value will close.”
Carney references philosopher Michael Sandel’s view that “in recent decades, subtly but relentlessly, we have been moving from a market economy to a market society… The price of everything is becoming the value of everything.” The Amazon rainforest for example “appears on no ledger until it is stripped of its foliage, and converted to farmland.”
“This crisis could help reverse that relationship, so that public values help shape private value.”
“The great test of whether this new hierarchy of values will prevail is climate change. After all, climate change is an issue that (i) involves the entire world, from which no one will be able to self-isolate; (ii) is predicted by science to be the central risk tomorrow; and (iii) we can only address if we act in advance and in solidarity.”
Another key theme in Carney’s article, and perhaps the most widely referenced macro-economic consequence of the pandemic, is a reversal of globalisation: “the crisis is likely to accelerate the fragmentation of the global economy… local resilience will be prized over global efficiency.”
This too is a trend that was gathering pace pre-pandemic. Commentators have claimed for many years that ‘Peak Globalisation’ has already been reached: a Harvard Business Review article from 2010 states: “the tide of globalization washing across boundaries for so long has reached a peak and is receding.”
The Economist believes this to be one of three key factors that will ‘change the world of commerce’:
“in the long run the firms that survive will have to master a new environment as the crisis and the response to it accelerate three trends: an energising adoption of new technologies, an inevitable retreat from freewheeling global supply chains and a worrying rise in well-connected oligopolies.”
These trends, particularly the first two, are interconnected. Another Economist article quotes Rich Lesser, CEO of Boston Consulting Group, who says that “robotics and other new approaches to manufacturing make the case for moving factories closer to home more compelling, because they reduce the cost difference.”
This is a view shared by EYQ, the think tank of Ernst & Young, in its article titled ‘Beyond COVID-19: Will you define the new normal or watch it unfold?’:
“The COVID-19 pandemic has revealed just how vulnerable globally integrated supply chains can be.”
“In the world beyond the crisis, the response to COVID-19 could accelerate the transition to approaches such as additive manufacturing (3D printing), which has the potential to deliver significant advantages in speed, cost, precision and materials… It may also cause businesses to move from offshoring to near-shoring and even reshoring of production. This could boost the anti-globalization trend that has been visible for the past few years.”
At least during the early stages of this shift, cost increases will be an important factor. Philipp Hildebrand, Vice Chairman of BlackRock, explains that a reversal of globalisation “can have some pretty far-reaching repercussions, not least around price behavior because, in a way—if you think about deglobalization—it’s really quite likely to be inflationary at the margin. It’s an additional cost.”
Companies will therefore be forced to reassess their value proposition – can they justify higher prices, or will cuts need to be made elsewhere?
This suggests that high-end brands able to command a premium for their goods will have more room to play with and be better placed for success than those with less differentiated offerings that have previously competed on price. This is especially likely to be true in the future state envisaged by Carney, where “the acceleration across our economies from moving atoms to shifting bits” results in a world of reduced physical consumption, where purchases are fewer but more considered.
Regardless of where a brand lies on the spectrum of perceived value, there will be an increased focus on cost control. In this environment, material flows will come under greater scrutiny. Closing the loop on outputs and inputs can offer reduced raw material costs and waste management expenses and, for those that get it right, the possibility of justifying higher prices than their unsustainable competitors.
The circular economy can be the antidote to the cost increases associated with deglobalisation. The conditions are perfect: localised supply chains, greater visibility (and regulation) over material flows, pressure to reduce cost, and an increasing awareness of environmental concerns driving consumer demand for sustainable products.
With so many macro-economic tailwinds, it is likely the move to the circular economy will accelerate. Whilst deglobalisation may at first thought seem regressive, localised systems offer much greater potential for efficiency. The zenith of which is often cited as a Mars base: nothing will be taken there that cannot be recycled and turned into another useful object.
The key to the realisation of the circular economy is its ability to deliver the holy grail it has prophesied: to demonstrate that closed loop is not a CSR sideshow, but a critical driver of efficiency and a legitimate means for cutting cost and boosting margins.
However, the crisis has hit whilst the industry remains in its nascent stages, characterised by its fragmentation: a nebulous dispersion of young, innovative companies yet to fuse into a synergised force able to effect closed loop technology at scale.
Consolidation was always going to be necessary to realise the holy grail and now it will likely be accelerated. Many of these fledgling companies – big and small – will fall into difficulties as a result of the crisis and the technology they possess will briefly become available on the open market through fast-track M&A processes and insolvencies. This will not deter potential acquirers.
“As the PE industry learned during the global financial crisis,” notes Bain’s ‘Investing in a Time of Crisis’ article, “putting money to work during market downturns produces higher returns on average than during upcycles.”
This is especially the case for special situations, turnarounds and recapitalisation deals; of investments made in the eight years from 2005 to 2012, the highest returns were achieved on deals completed in 2008 and 2009. Even for mainstream buyouts, 2009 represented the second-best year over the same period.
In simple terms, as stated in a recent Pitchbook article, “investments made at the bottom of any downturn and into the early stages of recovery are generally outperformers”.
This has not gone unnoticed. A thriving subsector of the PE industry has specialised around this thesis, often referred to as distressed investment funds. Armed with recent wartime experience gained during the Great Recession and dry powder stockpiled for future conquests, such funds are unlikely to remain on the sidelines for much longer.
The long-term value of the circular economy and the opportunity to acquire unique technology on favourable terms may be impossible for private equity firms to ignore.
Furthermore, there is neat alignment with an investment strategy that is increasingly in vogue. As reported by the Financial Times in July 2018, buy-and-builds – “the bolting together of smaller companies into business empires” – experienced a meteoric rise to popularity and account for nearly half of all global PE transactions.
Buy-and-build strategies – a successful ruse of the outperforming funds identified by Bain – are perfectly suited to fragmented markets. However, as the title of one Bain article warns, it is ‘A Powerful PE Strategy, but Hard to Pull Off’. The key lies in finding the right platform company – the cornerstone onto which other businesses are bolted.
Firstly, “the platform company usually makes the add-on acquisitions—not the PE fund—so it’s critical that the company generates consistent free cash flow to finance deals in succession.”
Furthermore, “the buyer needs the right foundational infrastructure—robust IT systems, a strong balance sheet, repeatable financial and operational models, and assets like distribution and sales networks that are set up for expansion… It’s an enormous benefit to start with a strong existing management team that has already demonstrated its ability to pull off acquisitions.”
The circular economy therefore finds itself in a catch-22:
Significant investment is required for it to reach maturity. But finding a suitable platform company to lead the necessary consolidation will be a challenge in an industry that is still finding its feet.
Thankfully, an increasing volume of capital is targeting responsible investments that achieve impact alongside returns.
And the financial reward for solving this conundrum is huge: the World Economic Forum states that the circular economy “can yield up to $4.5 trillion in economic benefits to 2030.”
The key to unlocking this value lies (unsurprisingly) in data. Currently, materials are allowed to fall out of ownership: a vast, untapped goldmine exists in the form of landfill and incineration plants. Huge amounts of value trapped in discarded materials is simply being buried or burned.
The most lucrative terrain of the circular economy will be the interface between the digital and physical worlds – this will become the means for monetising and governing the value in those materials.
The identity – and intentions – of its eventual overlord will shape the future of commerce and the climate.
Positioned in the slip stream of so many macro-economic forces, it is only a matter of time until the circular economy is realised.
Those that act now have the very real opportunity of becoming a leading force in an economic system that will not only define the future of our planet, but will be central to the advancement of humankind as an interplanetary species.