Barber: We’re sitting here it’s May 2020, we have a global pandemic, COVID-19 has really brought a significant amount of displacement to communities and industries and businesses. We at IMS, we conducted some research back in March, 95% of our attorney clients, so we’re talking Am Law, 250 law firms, major Metro areas, 95% of them reported being displaced from their normal office.
Barber: When we see that across communities, a lot of disruption, a lot of pain, a lot of difficulty. But even so, most of our attorneys, most of our clients were reporting, they’re still able to get work done. They’re still able to conduct business. Even seeing courts moving into virtual platforms, how are you handling disruption and displacement right now and in general, what have you been noticing?
Murray: I have been able to work remotely. But I think there’s something missing without having the face-to-face teamwork that I would typically have in an engagement. So typically when I work on an expert engagement, I have a team that I’m working with, which consist of anywhere between two to 20 people, depending on what the engagement is. And there’s a kind of an excitement and a sense of team play that goes into these engagements, which are often quite time constrained. And I have typically been a very hands on manager of those engagements where I’ve sat in a conference room with my whole team for days and days on end. So I do miss that. We are able to work remotely unfortunately, The Brattle Group has a very robust IT system for working that way and everything’s on a shared drive and so we can do it, but there’s clearly something that’s missing.
Murray: I think the other comment that I would make is that this has been felt unevenly across individuals. So there are individuals who are able to work at home. It’s very easy for them to work at home. They don’t have small children at home. Their families are healthy and so this is maybe an inconvenience, but it’s otherwise okay, whereas you could be interacting with somebody else who’s had a serious health issue in their family or God forbid, a loss in their family. And there’s a sensitivity there that I feel it’s very important for me to be aware of because I don’t really know what somebody else has been going through throughout this pandemic. And it’s just something that I try to be aware of and sensitive to.
Barber: Yeah. Well put Marti. I know that you’ve been closely monitoring the pandemic too and you’ve been looking at implications of COVID-19 and potential litigation dispute areas. One area you and I were having an earlier conversation about relates to PE (private equity) firms. Could you talk to us a little bit about that unique business model of private equities and opportunities that you’re seeing for them?
Murray: Yeah, sure. So I think maybe to provide a framework for this discussion would be good to talk about what the basic business model is of a private equity firm and why this crisis is creating a range of both opportunities and frankly threat to the business model. Private equity firms own a lot of companies in the United States. In fact, The Milken Institute did a recent study that showed that private equity firms own twice as many companies as are traded on the public exchanges in the United States. So what happened was around 2007 or 2008 right before the depths of the financial crisis, those lines crossed in terms of how many firms private equity funds own versus how many were publicly traded. And the lines have been diverging ever since.
Murray: So private equity firms control many, many companies and as a result, what they do and the road that they take out of this crisis is going to be very significant in terms of the US economy. So that’s one of the reasons I have been spending my time focused on what’s been going on in the private equity world. But just to talk a little bit about the basic business model of a private equity firm. Private equity firms manage investment vehicles, which are referred to as funds, on behalf of end clients. And the end clients are typically public and private pension plans, sovereign wealth funds, university endowments, family offices, and other institutional investor clients.
Murray: And traditionally the main line of business, the private equity firms that sponsor these funds is that they are making investments in companies in order to get a control ownership position in the company. More recently, private equity firms have entered adjacent lines of business, like private lending. And in private lending, what the private equity firm is doing, is extending credit to other companies or acting as the lender.
Murray: But traditionally the bulk of private equity firm activity was in buying control equity ownership States in companies. Now typically the underlying fund has a life span of something like eight to 12 years. So the underlying business model of the fund is that it’s going to initiate investments in what’s referred to as portfolio companies. So the portfolio company is the underlying operating business that the private equity firm is purchasing. And they’re going to initiate those investments using borrowed funds, which we call leverage.
Murray: So the idea is they’re going to buy a portfolio company with some equity, which is the firm’s own money. They’re going to leverage that equity up. And then the idea is over the lifespan of that fund, which is eight to 12 years, that the portfolio companies are going to appreciate in value. And then the PE (private equity) firm is going to execute an exit strategy at a profit.
Murray: So they’re either going to exit that portfolio company investment, either by selling the company in a private sale or by doing an initial public offering. So when they do the exit strategy, it’s going to pay off the debt that they incurred to buy the company in the first place. And it’s also going to provide an attractive return on the equity investment that the PE fund had originally made. So in recent years, the average multiple of cash flow for an acquisition that’s been made by a PE fund, has been something like nine to 11 times cash flow.
Murray: Generally when we’re talking about cashflow, we’re referring to EBITDA, which is earnings before interest, taxes, depreciation and amortization. So about 60% of all of these acquisitions that the private equity funds are doing have leverage of six times EBITDA or greater. 40% of them have leverage of seven times EBITDA or greater. So you can see that these are highly leveraged transactions.
Murray: Now different private equity firms may have different risk appetites. So some PE firms will skew more towards the lower end of the leverage because they have a lower risk appetite, they don’t want the portfolio companies to be carrying as much leverage. Well, other PE funds and firms will have more of an appetite for risk. And so their leverage multiples will skew more towards the higher multiples. It can also be the case that different leverage levels can be appropriate depending on what industry you’re talking about. If you’re talking about an industry which is incredibly stable, then it may be appropriate that you could have a higher level of leverage, whereas a business that is inherently more risky, you may want to have a lower level of leverage.
Murray: So I think it’s important to understand that basic business model when we talk about opportunities that private equity funds have right now in the wake of the pandemic. There’s a tremendous amount of what’s referred to as dry powder that is available right now to employ in new investment opportunities. So dry powder is capital that has been raised from the private pension plan, so sovereign wealth funds, so university endowments, that’s pretty big, been committed to a private equity fund, but it has not yet been put into use in a particular investment.
Murray: So there’s cash that is available to deploy into new investment opportunities, which may become available as a result of this pandemic. So there are funds that are right now actually in the market to raise incremental dry powder. They’re looking to raise what’s called dislocation funds. So they’re in market right now marketing to prospective investors to raise a dislocation fund. The purpose of which would be to take advantage of the fact that markets are dislocated right now. There may be opportunities to deploy and make acquisitions that might be at a lower multiple of cash flow, that multiple EBITDA I was referring to before.
Murray: Maybe they could have done pre the pandemic. Well, one of the issues there is going to be that as I mentioned, part of the whole business model of a PE fund is that you take the funds equity and then you borrow money on top of that to use to buy the company. So the issue is going to arise as to how much leverage now you can get. In the past if we were talking about, you could get six or seven times leverage going into a new PE investment. One of the questions is going to be, well post this crisis, what multiple of EBITDA will a lender be willing to lend against so that you can initiate a new investment?
Murray: But that is an opportunity that a lot of funds are looking at. They’re looking to raise these dislocation funds to make new investments. Now that could be in the form of an equity investment, but it also could be in a form of rescue financing where the private equity fund is not acting as an equity investor in a new investment. They’re actually acting as a debt provider for a company that is having issues as a result of the pandemic and needs some kind of a bridge to get the company to the other side.
Barber: Well Marti, we were talking a little bit about opportunities. You also mentioned some threats that PEs right now really should be mindful of, are watching. Could you talk a little bit about what kinds of threats you’re seeing on the horizon right now amid the pandemic.
Murray: Yeah, sure. So I would break that into two categories of threats. I think there are upfront threats that are right now short term upfront threats and then there are longer-term threats. So when a private equity fund has a portfolio company that starts to experience financial distress, typically one of the primary objectives that the private equity fund is going to have is to what we call extend the runway for that company. Extending the runway means that if a company is having an immediate liquidity issue or say they’re in breach of a covenant under their bank loan agreement, they want to get a forbearance or they want some kind of a short term fix so they have more time. That’s what extending the runway means. That increases the funds optionality that they are going to be able to ultimately extract value out of their portfolio investment.
Murray: So what’s happened as a result of the pandemic and the resulting stay at home orders and shut downs and decline in demand for certain goods and services, is that there’s been a tremendous loss of revenues for a lot of these portfolio companies. And we’re not talking about 5% or 10% loss of revenues. We’re talking about situations where companies revenues have gone down 50%, 70%, 90%.
Murray: Revenues have just dried up. So what happens when revenue is dried up? You start to have liquidity issues with the portfolio companies. You potentially need your lenders to forebear. You may have difficulty submitting compliance certificates that a company has to submit to their banks on a periodic basis, making certain representations that they’re solvent. There’s not an event of default under their operative agreements. So extending the runway is an activity that the private equity firms are involved in right now.
Murray: The other short-term threat before I get to the long-term threat is that remember again that, the basic business model of private equity is that you exit these investments at some point. So there’s a sale that needs to take place or there’s an IPO (initial public offering) that needs to take place. This is not a great environment to consummate a sale or an IPO. So that’s another issue that these private equity firms are going to have to face. Typically if you were going to run a sale process for a portfolio company, you hire an investment bank to run that process. And the investment bank does an analysis and contacts a universe of potential buyers that they think might be interested.
Murray: And then they get those parties to sign nondisclosure agreements and they set up a virtual data room and then they get letters of intent and all along the way there’s due diligence going on and then you get to a final result and you either get an acceptable offer for the transaction to occur or you do not.
Murray: So there are certain aspects of that process that maybe can be done remotely, but there are other aspects of the process that will be highly challenged. Due diligence visits, looking management in the eye and really talking to them, make a decision about whether or not you actually want to buy a company may make it much more difficult for these transactions, these exit strategies to occur. Also, it may be more difficult to the buyer to get the financing they need to complete the exit strategy. So I think that’s another challenge or threat to the private equity community is how are we going to complete these exits are a vital part of our overall business model.
Barber: And so this sounds a little bit different. One thing that we can draw comparisons between previous economic downturns, market crushes, but there is a level of difference between what’s going on right now with the displacement, with just the normal business disruption that’s going on and the ability to sit down and meet face-to-face with business leaders and use that opportunity to really dig deep and understand is this viable? Is this leader going to make decisions that I’m comfortable with, that I feel I can trust? What other challenges are PEs facing right now? This is a bit of a unique scenario. So what other challenges would you point to that your seeing PEs are having to look at and handle with their portfolio companies?
Murray: Yeah. I think another aspect that makes this period different from other recessionary periods or periods of market dislocation, at least that I’ve experienced is it’s not just that you have a recession, it’s not just that you have market dislocation, it’s that you have a health crisis. And also, it’s that there are probably long-term implications from this particular health crisis in that it may actually permanently impact how people live their lives. It may permanently impact how people work, how people spend, how people go to school, the types of goods and services that people want.
Murray: And this goes to another big challenge for private equity is evaluation of their portfolio companies. Because not only do you have issues with respect to, well, my revenues just went from 100 to 20 and the resulting impact that that has on cashflow and how long is that going to last and how should that affect how I think about the valuation of my portfolio company. But you also have questions about how this health crisis is going to affect the future demand for the goods and services that your portfolio company produces. Well, I think that that makes this period different than other periods of recession or a market dislocation, at least that I have experienced.
Barber: Yeah. It’s a whole new level of interplay and uncertainty. Very well. Well thought, Marti. Are you seeing any private equities that are taking uniquely proactive measures right now amid all of this uncertainty?
Murray: Yes. I think that what the private equity firms are doing in the short term is important because they have to keep in mind that most of these portfolio companies that are owned by private equity funds, now, there are going to be some exceptions to this, but most of the portfolio companies, their management teams have not experienced this kind of an environment before. They haven’t experienced a scenario where their revenues went from 100 to 30 and in such a short period of time.
Murray: So I think that one of the things that I’ve seen the PE firms do is to provide support to the portfolio company in terms of dealing with those near term threats. And sitting down with the portfolio companies and devising a detailed cashflow and liquidity management plan for the company, which they may have not really needed to do before. And also assisting them to think about drawing down on available sources of liquidity that the portfolio company may have.
Murray: So that is something that we saw early on in the crisis that portfolio companies were drawing down, for example, on available lines of credit that they had with the banks. Another area that we’ve seen is investigating which if any of these government backed funding programs might be available to the private equity portfolio companies. Now, there’s an issue there because there are some limitations on the availability of these government programs for private equity owned firms because there are rules about how your revenues and the number of employees that you as to whether or not you’re eligible for some of these programs.
Murray: And as I understand it in terms of determining revenues or number of employees, the private equity firm is required to aggregate all of their portfolio company-
Murray: … which could make an individual portfolio company be ineligible for the funding. So I think that the private equity firms are looking at ways to shore up the upfront liquidity and solvency of their portfolio companies, which is paramount because again, back to that concept of extend the runway. Extend the runway in the short term so that we can get through this and then figure out in the medium to longer term what we want to do with these portfolio companies and what is going to be possible for these portfolio companies. And that gets more to the challenges in the medium to longer term. Because we were talking about as part of the business model that these portfolio companies carry a lot of debt.
Barber: Mm-hmm (affirmative)
Murray: So let’s say you had a portfolio company that had $100 million dollars in cashflow in EBITDA, and it was leveraged as typically these private equity firms are, it was leveraged six times that cash flow. So six times 100, the portfolio company has 600 million in debt. Well now their cashflow is $30 million. It’s gone from 100 million and now it’s going to be 30 million and now they’re leverage 20 times. So that’s probably not sustainable. That’s probably not going to work.
Murray: So the private equity firm is going to have to develop a view on the value of that firm and make a decision as to whether or not it’s worth taking steps to preserve their equity and extend the runway even further thinking that in two or three years the company is going to be able to recoup and they’re going to be able to make a profit, which may involve the private equity firm having to put more money into the portfolio company to sustain it and create that bridge or conversely, the private equity fund may decide that they want to do what’s called throw the keys to the lenders and walk away from the portfolio company investment.
Barber: Definitely unique and difficult decisions. Talk to us a little bit about how you think the current unsettled, we’re using the term unsettled, there’s just so uncertainty right now in the market and you’ve been speaking about the interplay of health uncertainty, which may change consumer behavior, human behavior. What may resonate in yesterday’s market may not resonate in tomorrow’s market right now. So can you talk to us a little bit about how these current unsettled market conditions from the pandemic may impact the ability to establish fair value for PEs for portfolio companies?
Murray: Yeah, sure. So fair value is a really important concept for private equity firms because private equity firms are typically required to establish the fair value of their investment portfolio on a periodic basis, typically quarterly. And what that means is that they have to establish the value of their portfolio companies. Let’s say as of June 30, 2020. Now fair value is an exit price where a transaction would occur on an orderly basis. So the valuation of these investments is going to be a paramount issue for private equity firms and given the unsettled market conditions and the uncertainty with respect to future performance, establishing the fair value as of the given measurement date may become increasingly complex.
Murray: And as a valuation expert and someone who testifies to valuation on a regular basis, issues may arise with respect to whether any valuation performed now can really be considered to be based on an orderly transaction. And there’s a lot of discussion in the valuation community right now about how the pandemic should impact how evaluations are performed, whether or not it’s important to… The valuations are typically done using three accepted valuation methodologies of an income approach, which is typically a discounted cashflow, an asset approach, which is just basically looking at the value of the hard assets that a company has and a market approach. In the market approach we’re looking at comparable public companies and you’re looking at precedent transactions.
Murray: So there’s a lot of questions about whether the precedent transaction method, well, why would a transaction that was done two months ago before the pandemic fare on where our transaction is going to occur now? How reliable is that information for a discounted cashflow analysis, just kind of cashflow analysis relies on projections of the financial performance of the subject interest? In this case it would be the portfolio company owned by the private equity firm.
Murray: So there’s a lot of talk in evaluation community about projections, doing projections now, the reasonableness of the projections, the ability to rely on the past performance as a reasonable predictor of future performance. As I mentioned earlier, one of the things that this health crisis is resulting in is it’s going to change the way we all live, work, play, and go to school, which means that the historical performance of some of these private equity portfolio companies may no longer apply.
Barber: Sure, yeah.
Murray: So there’s many issues around the proper valuation and the establishment of fair value for private equity portfolio companies that I would expect to be at issue in the months, quarters to come.
Barber: Interesting. So we may see some new levels of precedents set new approaches to how these models may need to be applied. Can you talk to us about carried interest in claw back provisions to any implications there?
Murray: Yeah. So the business model of the private equity firm, it’s important to keep in mind how the sponsor of the fund is compensated. So the sponsor of the fund, which is the private equity firm as I refer to it, is compensated in essentially two ways. One is they receive a management fee, which is a fixed fee that they’re paid on a regular basis. But the real compensation is supposed to be in a form of incentive compensation, which is referred to as carried interest. And carried interest is calculated as a function of profits that are made on these underlying investments in a portfolio companies.
Murray: Typically the governing documents for a private equity fund will stipulate that if carried interest has been paid out to the private equity sponsor and there are subsequent losses in a portfolio or overall, the portfolio investments do not result in an aggregate return of a certain level. To the investors, there’s something called clawback provision, which means that the private equity fund sponsor actually is supposed to pay back some of the carried interest that they were previously paid.
Murray: So it may be that as a result of market dislocation as a result of the pandemic and a decline in the values of these portfolio companies or the private equity form actually throwing the keys across the table to the lenders of these private equity portfolio companies or heaven forbid, a bankruptcy or some other insolvency at the portfolio company, there may be private equity firms that find themselves in a clawback position where they actually have to refund money if they were previously paid.
Murray: As I mentioned, these funds typically have eight to 12 year life to them. The idea being that the end of their contractual life that the investments in the underlying portfolio companies will have completed and hopefully profitably and everybody will go their own direction or there’ll be another fund that will be offered by that same private equity fund sponsor. The issue now is that if you are in a late stage fund where you were counting on exit transactions being consummated in the near term, that may be more difficult to achieve right now. Certainly at the valuations that were expected prior to the pandemic.
Barber: Mm-hmm (affirmative). Marti, one other area I wanted to speak with you about. You mentioned earlier, university endowments and monitoring university systems with respect to COVID-19. What are you seeing right now with respect to those endowments?
Murray: When I’m thinking of in terms of the whole private equity ecosystem, the investors into the funds are clearly a very important component of the entire private equity ecosystem. And I think that it’s likely that many of those categories of investors may be under pressure, some more than others, but I think on the margin. They’re likely to be more under pressure in terms of being able to allocate additional capital to private equity even potentially to meet capital calls of existing funds. So far I’ve not heard that that’s been a problem. But it is something to keep an eye on. Now in the case of university endowments, they are a major source of funds for private equity. And I think that they may suffer because for one, they’re going to have under-performance of their investment portfolio. And they have an issue with respect to how much of their overall investment portfolio can be invested in private equity or alternative investments.
Murray: Generally if the whole pie shrinks and that private equity bucket starts to be a bigger part of the pie and may limit their ability just structurally to commit additional money to private equity. The other sources of pressure for the universities is lower revenues. They’re going to have lower revenues from their sports programs to the extent that that is a big part of their revenue stream. That could be very significant. Also, if the students are not living on campus and that seems to be the way things are moving, at least in certain areas of the country, you’re going to lose the revenues from on-campus residential charges.
Murray: There also likely to be an impact on international students who are not likely to be going overseas for their education, at least in the same numbers that they were previously. And in addition to that, there could be just a general decline in tuition because more students may be studying online instead of attending a traditional campus based program or the students that do want to attend may have a greater need for financial aid given the state of the economy and the levels of unemployment that we have now, which are really unprecedented at least since the great depression.
Barber: Marti, you mentioned, if I could, you provided a nod to the change in consumer behavior that we may start to see because this isn’t just an economic event, this is a health event that is affecting people’s lives, people with immune compromised family members, just everyone. So it’s adapting consumer behavior and I think you drawing that connection to the student, the family, how are you comfortable sending your child to school? Are you more comfortable? Have you gotten a taste for what that looks like in a remote environment during a period of crisis? And does that adapt that consumer behavior in the future? That is very interesting.
Murray: Yes, absolutely. I think that we’re all going to have to think about how the world is going to be changed in the medium to longer term. And I think for private equity, which now controls twice as many companies are publicly traded, these issues are going to be top of mind. I think the private equity firms are going to have to have a view on what the shape of the recovery is going to look like, first of all, whether it’s going to be a V, a U, a W, an L or now the more popular Nike swoosh, which is what the wall street journal has recently reported is the consensus of economists, which is very gradual recovery from a very steep decline.
Murray: But they’re also going to have to consider how their portfolio companies are going to fit in that recovery in our new world and what the demand is going to be for those goods and services. And take that into account in making the decisions that they’re going to be faced with in terms of where they want to invest their money and what the proper course of action should be for those of their portfolio companies that become stressed and distressed. So everything is related to everything else.
Barber: Interesting. Almost chaos theory. Marti, we covered our questions. I think we covered most of your notes. Is there anything that we didn’t hit on that sparked in your head as we were talking that you want to back up and include?
Murray: I think we’ve pretty much covered everything pretty well.
Barber: I have to give you a nod. You are an excellent communicator. I’m over here and you do a great job of boiling it down to the basics, communicating. So I can see how you would be a phenomenal expert able to communicate some of this very complex stuff with a lot of jargon and a lot of terminology to a jury. It’s fun to talk with you. You’ve got my sparks flying in my head and I’ve enjoyed it, really enjoyed it.
Murray: Thank you. I have as well. I want to thank you for the opportunity to speak with you and your community and I’ve really enjoyed working with IMS. I’ve been fortunate enough that you have sent some really great matters my way and some really great attorney, so I want to thank you for that as well and I look forward to continuing our conversation.
Barber: Okay. Marti, it was wonderful having you on as a guest today and the feeling is completely mutual, a lot of respect for you and just really appreciated the conversation and I’m glad we had a chance to connect you with our listeners today.
Murray: Thank you so much.
Barber: Thanks, Marti.
Murray: Stay safe.
Barber: You too. Bye.
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