Much of the merger and acquisition activity in the landscape services sector in recent years has been driven, directly or indirectly, by private equity investment. To understand the overall impact of COVID-19 on landscape industry M&A, we need to consider the impact on private equity.
Here is a brief overview of how private equity may react to the current business climate and COVID-19.
To understand the potential impact, it is important to understand that private equity comes in many flavors. There are three major strands of private equity – “traditional” private equity, unfunded sponsors and family offices. The difference is where their investment capital comes from. Traditional private equity funds raise funds from groups of investors, usually limited partners and then proceed to invest the funds raised over a period of time. These investors are typical institutional investors, such as endowment and retirement funds, along with some wealthy individuals. Unfunded sponsors identify investment opportunities and then recruit similar investors on a case by case basis, otherwise acting much as traditional private equity. Family offices seek to invest the funds of an individual, family or group of families and do not raise outside investment funds.
The first priority of all private equity firms right now is to make sure their existing portfolio investments are stable through this period.
To the extent they have investable funds, you can expect that they will continue to look for good investment opportunities. It is very hard to generalize, but it is probably more difficult to raise investor capital in the short term. But among traditional private equity and family offices, there is a lot of capital that needs to be invested. That capital that needs to be invested is sometimes called “dry powder.” Unfunded sponsors may have greater challenges in recruiting investors in a turbulent economic period, but many have established relationships with a limited number of investors, making them look and act more like traditional private equity funds.
We would expect to see some private equity firms aggressively looking for great opportunities that may arise post-COVID-19 and others to be more cautious.
Dry powder doesn’t normally sit in a bank account waiting to be invested. Uninvested committed capital from limited partners is usually drawn via a series of capital calls that the private equity firm makes as investments are made.
While it is not common, it is possible that a limited partner could default in a capital call. There are a few stories of limited partners defaulting in the current situation, mostly in Europe. What exactly happens in the event if a defaulted capital call may vary based in the specific agreement, but it will likely reduce the ownership stake of that particular limited partner.
One reason that private equity funds may have problems raising capital or have a higher risk of limited partner defaults is that investors may be rebalancing their portfolios. Many investors have investment policies that limit the amount of private equity and other alternative investments in the portfolio to a certain percentage of the portfolio. If the value of the traded securities in the portfolio goes down, it can reduce the acceptable alternative investment allocation. As an example, if an investor had a $100 million investment portfolio, with 20% allocated to alternative investments, the allocation to alternative investments would be $20 million. Of the overall portfolio value declined 25%, the total value would be $75 million and the 20% allocation available for alternative investments would be $15 million. Under its investment policy, the investor would take steps (within the timeframe permitted by its investment policy) to rebalance its portfolio to reduce its exposure to alternative investments by $5 million. The fact that an investor may rebalance its portfolios does not mean that the investor has lost its appetite for alternative investments, it just means that it is constrained by overall risk assessments and its portfolio strategy.
To summarize, in addition to the uncertainty of how long it may take to recover from the effects of COVID-19, other factors will affect private equity activity. However, as a whole, private equity will still be investing and the same factors that have made landscape services attractive in the past are likely to continue to make landscape services attractive as an investment in the future. As we mentioned in other articles, we expect to see an investment theme for some investors of investing in “essential services”. Landscape services should appeal to many of those investors.