Feb 14, 2021

Pandemic dealmaking is high risk, high reward

written by Lisa Eason

My private equity firm last week announced its second investment since the pandemic started — Curious Drinks, the beer and cider business of British wine-maker Chapel Down. In theory, there should be a lot of assets going cheap given the economic chaos caused by lockdowns, but the reality of trying to do deals at the moment is rather different.

Both Curious and our other acquisition, the online gardening retailer Primrose, were bought out of administration. Inevitably, not all buyers are interested in such distressed opportunities. These situations often involve turnarounds that need a lot of hands-on attention. Also, the two companies are consumer businesses — many investors are shunning these sectors entirely at present.

Sophisticated sellers understand these issues. Given the turmoil across most industries, few owners are choosing to exit their companies willingly. Hence many transactions are forced sales, because lenders are foreclosing or the shareholders have given up and cannot fund more losses.

Buying companies out of insolvency typically means an all-cash deal financed with no debt. Occasionally, it is possible to get incumbent banks to roll over a portion of their exposure, but usually they want to cease all involvement with what has turned out to be a bad bet. Buyers of assets out of administration almost never receive any warranties or indemnities, so caveat emptor applies. Moreover, insolvent deals usually mean limited due diligence, and no exclusivity — so money spent on advisers’ fees is wasted if another buyer outbids you.

Administrators tend to be highly focused on which bidder will actually complete the purchase. They need to be sure that the buyer has the ready cash, and understands the risks attached to acquiring a business in such circumstances. Of course, these buyers do not take on liabilities — such as to trade creditors — save for employment obligations. In general, contingent claims fall away when the assets are sold out of administration.

I imagine that owners of most sound businesses are reluctant to sell now, because they are suffering from lockdown-related disruptions and costs, which affect profits. Vendors prefer to sell when they think profits are peaking, to maximise the value they receive.

Some industries are booming, such as e-commerce and healthcare, so perhaps some sellers are keen to take advantage and offload. Advisers tell me that a few entrepreneurs are trying to sell before the budget on March 3, fearing that the government will raise capital gains tax. Not many will be lucky enough to meet that deadline; let’s hope their fears of a tax increase are not justified.

Not surprisingly, private equity has once again underspent allocations in the past 15 months, and therefore has more “dry powder” than ever needing to be deployed. Overall, with interest rates heading into negative territory, investors across all asset classes are desperate to put money to work. This explains why equity markets are mostly so high, despite the pandemic/lockdown havoc. By contrast, the majority of banks are extra cautious about lending criteria, and are fretting about loan impairments in their existing portfolios, which means deals require higher levels of equity.

I spent months last year looking at investments, including a big American restructuring opportunity in hospitality and a provincial British restaurant chain, but in each case, I either gave up or was outbid. I’m not unhappy about missing out. Like many, I thought the crisis would have essentially finished by now: I never imagined we would be in the midst of a third lockdown. Those investments would have needed additional working capital to survive the extended restrictions on trade had I bought them six months ago.

This latter point is possibly the biggest challenge facing any buyer at the moment: how do you prepare a business plan? Who can predict the future during such volatile times? Financial projections are always something of a guess, but since last March, there have been far more unknowns. Consequently, budgeting is significantly harder than it used to be. For many businesses, it is still unclear when they will be able to reopen, and on what basis. They can’t be sure what government support will be available, nor how creditors will behave, such as landlords after the moratorium on enforcement measures ends.

Buying a private consumer business during a lockdown is a high-risk/high-reward wager. The safer option is to buy shares in big quoted stocks. Typically, most fund managers are overweight in highly rated tech companies. By contrast, my preference will always be to seek value in unloved special situations that offer recovery potential. I will let you know in a few years whether my contrarian investments pay off.