With a majority of venture capital and private equity firms expecting a recession to hit within two years, a massive volume of “dry powder” may be targeted at distressed businesses in 2020.
In a survey of 100 VC fund managers and 100 PE fund managers by BDO, 40% and 39% of them, respectively, said they expected such businesses to be a “key driver” of deals next year.
That represented an enormous departure from BDO’s previous survey of such investors a year ago, when only 1% of PE respondents anticipated distressed businesses being a key investment driver in 2019.
BDO acknowledged that the current availability of distressed opportunities is “quite low.” However, the professional services firm noted, during the Great Recession private capital flocked to distressed debt funds, which typically outperform other private investment strategies during an economic downturn.
“The opportunity in distressed [businesses] is clear, as lenders are highly motivated to move troubled assets overleveraged during the last economic cycle out of their portfolio,” said John Krupar, managing director of restructuring and turnaround services for BDO.
However, Krupar added significant challenges exist that require expertise in the distressed buyout market. Considerations for private capital funds include the following:
- Feed the beast: “Between their financial condition and, in all likelihood, a tense lending arrangement, distressed businesses may be starved for capital. Determine whether capital investment or necessary working capital investment will need to be put into the business by the new buyer.”
- Don’t forget the people: “Turnover and the lack of appropriate incentives to retain the best performers often leads to a demoralized management team and a troubled workforce.”
- Understand the technicalities: “The business may potentially need to go through a Chapter 11 process to accomplish the transaction. The use of a Section 363 sale, which allows the buyer to acquire the assets of [a business] while leaving behind certain liabilities and contracts, can be an effective tool.”
- Be the stalking horse: “When it comes to the auction process, the stalking-horse bidder has the clear advantage. They set the terms of the transaction and are given certain protections by the court, such as breakup fees and reimbursement for expenses.”
In the survey, 72% of private equity respondents and 56% of venture capital respondents said they expected an economic downturn to arrive within two years. And 92% and 87% of them, respectively, anticipated a downturn within four years, which BDO characterized as “less than the length of most investment holding periods.”
“It pays to invest during a downcycle,” BDO wrote. “Assets can be bought ‘on sale’ and, if managed well, can be anticipated to return to pre-recession levels as the market recovers.”
In fact, the firm added, the pre-downturn period is more difficult for PE and VC funds. It incites “a shift in strategy: more defensive investments, more conservative bids, and tweaks to financial modeling to factor in downside scenarios.”