Sponsors and lenders remain supportive of portfolio companies as Covid-19 impact persists
As the initial shockwaves of the global pandemic subside, middle market sponsors and lenders have proven supportive of their portfolio companies as the financial challenges caused as a result of stay-at-home orders began to crystalize, according to analysis from Lincoln International, a global investment banking advisory firm.
The company's proprietary database includes over 2,100 portfolio companies primarily owned by private equity firms with median EBITDA of approximately USD30 million.
This is evidenced across a subset of approximately 450 portfolio companies wherein 67 breached their leverage covenant, a 50 per cent increase relative to 2019 levels. In addition, only one was taken over by its lenders. Flexibility among lenders was attributed, in part, to portfolio companies prioritising debt service and sponsors remaining supportive. Moreover, of this population of portfolio companies, over 120 received capital infusions from sponsors, demonstrating a continued desire to help these companies bridge through a challenging period.
"The fact that you can count on one hand the number of companies that have been taken over by lenders during this time shows that alternative investors have proven themselves benevolent players which genuinely believe in the long-term value and potential of their portfolio companies," says Ron Kahn, Managing Director and Co-Head of Lincoln International’s Valuations & Opinions Group. “When push came to shove, alternative investors stood behind their businesses, helping these companies achieve their strategic goals and contribute to the economy.”
The pandemic is having a material effect on company operations with over half experiencing declines in revenue for Q2 2020 compared to Q2 2019. As a result of these headwinds, year-to-date earnings are being negatively impacted and, for the time being, investors have pivoted to tracking liquidity, as opposed to estimating add-backs to EBITDA for perceived one-time hits to earnings. In this climate, where there is little consensus on how to accurately pinpoint earnings, investors have changed their barometer for evaluating companies. To this notion, liquidity covenants—which were virtually unheard of before March—are becoming more prevalent in loan agreements today. Moreover, of the total of new deals and amendments to credit agreements observed by Lincoln, approximately one-third had a liquidity covenant, whereas only 5 per cent added an explicit Covid-based adjustment to EBITDA.
“Given the times we are in, investors are evaluating the best way to measure portfolio company performance and, while earnings play a role, it's better to evaluate short-term company health based on liquidity to ensure they have enough cash to bridge through this period without defaulting on their obligations,” adds Kahn.
Despite evolving market conditions and a degree of uncertainty, middle market company enterprise values rose 3.5 per cent in the second quarter, bringing valuations near to levels at the close of 2019. This is according to the Lincoln Middle Market Index (Lincoln MMI), which measures changes in the enterprise values of private middle market companies over time based on a subset of Lincoln’s proprietary database, primarily owned by private equity firms.
Recovery in Q2 has not been as pronounced as the banner quarter seen in the S&P 500, however overall Middle Market performance did not decline as much as the S&P 500 in Q1. For the first six months of 2020, the Lincoln MMI decreased 4.3 percent compared to the S&P decline of 0.1 percent. However, the S&P 500 rally in Q2 was largely driven by the five largest constituents: Apple, Microsoft, Amazon, Google, and Facebook which comprise more than 22 per cent of the S&P 500. Excluding these five, which are generally not comparable to middle market businesses, the year-to-date S&P decline would have been 5.6 per cent, which is greater than the Lincoln MMI year-to-date decline of 4.3 per cent.
When digging into the results, the disparity in performance between industry becomes evident. Although Consumer companies rebounded 3.2 percent after declining 8.9 percent in Q1, there was a significant split between those with an online or ecommerce focus as compared to traditional restaurant and retail which continue to face headwinds. Similarly, the healthcare and technology segments recovered almost all of their declines from Q1. “Private equity investors likely had not previously considered pandemic resiliency as a key underwriting consideration. Now it’s become very important and low-COVID impact segments like ecommerce, healthcare, and technology saw valuations rebound more quickly.” added Professor Steve Kaplan, Neubauer Distinguished Service Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business, who assists and advises Lincoln on the Lincoln MMI.
As private markets recover, and amendments and capital infusions percolate, sponsors and lenders anticipate recovery as early as the end of 2020 in some segments of the market, with the recovery expected to take longer for heavily impacted businesses.
“As new coronavirus case levels rise across the country on the heels of states’ reopening, the outlook of private company earnings recovery remains cloudy. What continues to be evident however, is that sponsors and lenders have supported their companies through the pandemic thus far, however their continued support is uncertain,” says Kahn.