In defining a downturn, one must differentiate between an economic slowdown/recession and a credit contraction. In the case of credit, a downturn “might not be such a bad thing,” remarked Michael Goodman, Managing Director, SSG Capital Advisors LLC. A credit expansion that has lasted so long is going to come to an end, especially for the middle market which has perhaps experienced the most inflated bubble in recent years. If the contraction is not as severe as the prior one, it can serve to rationalize business valuations and ultimately contribute to the long-term health of private equity funds and lenders and the businesses that those entities finance.
An economic recession does not necessarily cause a downturn in business demand for certain sectors and can create advantages for some businesses, according to Jim Caruso, CFO, Simplura Health Group. In industries like healthcare, the downturn could correct the labor markets and thereby help moderate growth in payroll expenses.
Certain funds like Graham Partners have enhanced their focus on portfolio construction in recent years, building their current portfolio with a downturn in mind. They have been acquiring businesses that are in less cyclical, more resilient industries (healthcare, consumer / food tech, industrial tech) that would do relatively better in a downturn while maintaining upside potential, and have been active in divesting their portfolio.
Speaking of a downturn, Rob Newbold, Managing Principal, Graham Partners stated, “Short term it’s going to be a negative” and “long term it’s a healthy positive.” A change in capitalization strategy, moving toward a simpler senior debt focus should also position them better to weather a storm.
An inevitable outcome of a credit contraction and moderation of economic growth will be a reduction in acquisition multiples, which will certainly be welcome by private equity funds with significant dry powder to deploy.
Plan ahead to best position your current portfolio for an expected downturn.
Key considerations to address with portfolio company CEOs:
It’s a great time to sell.
If you are in a position to exit, sell everything you can while multiples and the market are favorable. However, before that decision is made, take a look at the expected EBITDA growth of the business and develop a comparison of the expected sale value now versus waiting for that EBITDA growth when multiples may shift down.
Putting Capital to Work
As the market potentially heads into a downturn, how do you still put capital to work for new opportunities?
Diligence becomes even more critical at this stage of the cycle. In this bull market, fewer lenders are doing the fundamental credit work on a deal, and instead are relying on the sponsor’s diligence. This is further evidence that the credit market is overheated.
Newbold emphasized the importance of getting better terms from your lenders. “Make sure your company is well capitalized in a downturn, has adequate liquidity and cushions in the covenants, and consider leaving ¼ turn of leverage on the table in exchange for those looser covenants.”
With a distressed buyout thesis, Versa Capital Management expects a lot of opportunities in the turnaround market. Paul Halpern, Chief Investment Officer stated, “Distress is not a cyclical phenomenon, it’s a management phenomenon,” and in a forgiving environment like we have had, management teams will be bailed out.”