The Covid-19 impact on global public markets makes nightly headlines, while the private markets slowly bubble into a frenzy. Inexpensive credit and investor diversification away from public markets fueled a burgeoning private equity sector throughout the 2010s only to be halted, at least momentarily, by this tragic black swan event. Investment committees are recalibrating portfolios to adjust for credit tightening along with sudden and predictably lingering cash flow constraints on their portfolio companies.
Massive amounts of dry powder remain eager to be deployed. In what is showing signs of a shift to a valuation depressed market, mid to large tier private equity firms and family offices are on the hunt for acquisitions.
For many others not in growth mode, it’s a matter of portfolio survival in search for liquidity. Those firms that can, will extend holding periods allowing additional time for deteriorated carry to rebound. The luckier firms will benefit from additional management fee generation as a result, while others defer fees lessening cash flow burdens on their investments.
As governments around the world empty their coffers to stave off the economic collapse triggered by the pandemic, private equity firms are ineligible for PPP loans and other public aid due to their speculative investment nature. A positive, however, their portfolio companies may afford the same benefit as all other eligible businesses. It just may not be enough.
Particularly in the cases of construction and service sectors where work has stalled, supply chains have constricted and liquidity is critical to prosecute backlog. With credit tightening and the cash flow spigot at a slow drip, PE firms invested in these strategies (especially those highly levered) are finding themselves in an unexpected squeeze hold, struggling to pay interest expense and meet looming debt obligations.
This has caused many a surety credit providers to panic. Some knee-jerk reactions have been to pull programs all together, restrict or significantly reduce available surety capacity and even trigger “place in funds” demands, leaving private equity and family office portfolio companies unable to obtain sufficient surety bond credit, threatening future cash flows once we normalize.
The current environment ushered in by the pandemic, will change the face of the global surety market from many angles:
- The 2018 & 2019 collapse of large international EPC contractors, including Carillion and Astaldi, triggered a tightening of underwriting standards for global firms, wounds which have yet to heal.
- AIG’s departure from the surety business last year no longer provides a capacity bridge for enterprise out of China, Japan, Korea or their regional neighbors.
- Companies with cash reserves will thrive while those lacking will struggle to survive having to endure shock losses, unfamiliar to even those that endured the 2008 crisis. Surety (Insurance) firms and reinsurers are not immune, both newcomers and household names that failed to stockpile will be susceptible and exit the market. Note the relationship between sureties and reinsurers is symbiotic. Available capacity and pricing for surety credit is a function of available reinsurance capacity and its cost. Commercial surety, taking the brunt of the economic hit over Contract (i.e. Construction), will globally diminish this capacity across all surety lines, requiring primary carriers to take on a larger chunk of the risk moving forward.
- Competitor fallout boosts the negotiation power of the established sureties which remain, hardening terms for larger programs. Outside of North America where they prevail, invoking ‘pay on demand’ triggers will inflict severe loss upon sureties and reinsurers forcing a stricter, credit model of underwriting.
- Surety bond rates will rise, capacity offerings will shrink.
Tightening facilities will carry into the second half of 2020 buoying bankruptcies as credit markets, surety included, flee to mature, quality corporate balance sheets. This leaves many companies reliant upon debt, lacking financing options, further challenging their surety availability. Construction has never been a lender’s favorite.
Global surety availability will be squeezed for the foreseeable future. Underwriters will require meaningful assets on the balance sheets of those seeking credit where they operate, not where they reside.
Again, no one is immune, especially here in the US. The combination of tightening credit markets with project cancellations and shutdowns will cause even well capitalized multinationals cash flow deterioration and blows to their balance sheets.
So, how can PE advise their portfolio companies?
- Carefully target your revenue stream. It has never been more important.
- Learn the specifics of performance guarantee / performance bond requirements where you intend to operate or acquire.
- Research the underwriting companies and criteria in those regions with the consultative support of a professional surety broker competent to help you manage through this period.
- Deploy your resources (financial, physical, human) to achieve a targeted plan.
And what can Private Equity firms expect?
Presenting a deal with the mere mention of private equity often causes underwriters pause.
The balance sheet and legal complexion of the target company tends to change post acquisition. This complicates underwriting and the surety credit extension as it relates to private equity placed leverage, ownership structure and strategy.
In the midst of the pandemic shift, heavier scrutiny will be placed upon:
Leverage & Liquidity. Highly levered balance sheets and thinning cash flows to cover interest expense can deter the extension of surety credit. Sureties seek tangible net worth and healthy liquidity, therefore a post-acquisition balance sheet showing stable debt to equity and adequate cash flow to cover debt service without straining operating profit carries significant weight.
Exit Strategy. Time remaining in the lifecycle of the fund is of importance relative to ongoing commitment to the portfolio company. If early in the investment, what financial condition is it in – refer to leverage & liquidity above. If closer to harvest, upon disposition what impact will the new ownership and financial structure place on the surety and mean for any outstanding performance bonds or other guarantee obligations.
Performance Duration & Size. Whether an investment grade credit or otherwise, sureties will look to limit exposure to shorter durations and ensure contract size remains in line with historical competency. Concentrate on modest growth with quick turnover.
Indemnity/Guarantee Requirements. Remains a sticking point for sureties since at the PE firm level is rarely offered. Still challenging, but not impossible.
In the private equity, merger & acquisition world, surety bond programs tend to be an afterthought, which can become a costly mistake. In our private equity practice, we’ve experienced acquiring firms execute sophisticated acquisitions that did not properly account for the surety piece.
What’s this mean?
The means to grow, let alone maintain, are not accurately being priced in at the deal table, which can significantly change the economics of the deal post-close.
More than ever it’s prudent to pull a seat up to the deal table for surety discussions. Engage an experienced surety broker that understands and employs astute risk mitigation tactics for both parties to achieve a mutually beneficial partnership during these tough times.