Our external contributor, Corporate & Commercial Team at Laytons LLP, offers a snapshot view of recent private equity transactions in China and the UK as well as the opportunities and challenges facing PE investors amid the pandemic. Establishing the right management incentives, IR35, and hybrid working arrangements throw up new challenges while investors may be encouraged by opportunities for portfolio acquisitions and the consequences of pent-up demand and company carve-outs.
Back in 2020, private equity (PE) investors were adversely affected by the pandemic. Initially, the focus was to stabilize existing portfolios. Then, investors turned their attention back to sourcing and executing new investment opportunities. Now, PE funds looking to invest face fierce competition.
PE transactions in China
PE transactions in China include both growth capital investments and buyout transactions. The period April-June 2021 saw an impressive array of investments into China. Inbound investments were made from several European countries, the UK also saw a handful of small investments as well as one major exit.
Q3 2020 was led by acquisition of controlling stakes across financial services, banks, investment banks, securities firms, asset and wealth managers, insurers, real estate, and logistics. China Investment Research indicated that the UK invested an estimated US$250 million into the acquisition of a majority (73 percent) stake in a small Chinese industrial company and the acquisition of a 10 percent stake in a regional Chinese freight organization as well as joint ventures (JV), including a JV involving China Everbright Fund (providing growth capital for IP Group’s China-based portfolio companies), a chemical manufacturing JV, a JV in life sciences/AI, a small petrochemicals JV (via Shell), and a data-focused JV involving Unilever, Alibaba’s Brand DataBank, and Fudan University.
On par, the new RCEP Free Trade Agreement, which is expected to take effect from January 1, 2022, will ease the process required of investors entering, expanding, or operating in RCEP countries. Although the UK is not a signatory to the RCEP agreement, there are indirect ways in which British businesses can access this market, including China – this is because the UK has signed free trade agreements with various member states who are part of the RCEP.
On the other hand, China’s recent ban on for-profit tutoring in core education has caused venture and private equity investors to find an exit plan. Some PE investors have opted to restructure their businesses to adapt to the new rules.
PE transactions in the UK
A year and more on from the UK’s first lockdown the impact of the COVID-19 pandemic on the world of private equity continues to reverberate and unfold.
While the early stages of the pandemic saw private equity investors focus on stabilizing their portfolios investors adapted quickly and the second half of 2020 saw a resurgence in activity as many deals previously placed on hold were revived and completed.
As we move into the last quarter of 2021, this update reviews briefly the prospects and challenges for the sector.
With a vast amount of uninvested capital at their disposal, there are a number of opportunities for deals.
- Portfolio acquisition: Private equity investors will continue to encourage and finance growth by acquisition among their portfolio companies. PE investors used the early stages of the pandemic to address and repair issues in their portfolio companies and identify those companies best-placed to grow. Having completed that exercise PE investors will be keen for their investees to pursue potential acquisitions particularly where valuations are depressed.
- Disruption: Private equity is renowned for its ability to prosper during economic disruption. The on-going business disruption caused by the crisis represents an obvious investment opportunity – particularly with the withdrawal of support through the UK government’s Coronavirus Job Retention Scheme (furlough). Many commentators predicted that the withdrawal of this particular support would lead to opportunities for distressed M&A.
- Carve-outs: As public companies and large private groups review their structures and redirect resources to their core businesses, transaction opportunities will arise whether in form of carve-outs or public-to-private sales both of which private equity is well-placed to execute and support.
- Demand: Pent-up demand and robust credit markets should mean a plethora of opportunities for private equity in the coming months.
As the impact of the pandemic plays out some of the more immediate issues confronting private equity include:
- Virtual world: Private equity firms and their advisers adapted quickly to the challenges posed by the shift to the online world and successfully navigated remote presentations, management meetings, due diligence and deal execution. While some innovations may become permanent and have helped investors improve the efficiency of their processes, elements of due diligence and portfolio management inevitably benefit from old-style face-to-face meetings. Meanwhile, continuing restrictions create obstacles requiring careful navigation by businesses.
- Hybrid working: Businesses continue to adapt working practices to the changes brought about by the various lockdowns. Portfolio companies will have an opportunity both to downsize and save costs while simultaneously being able to offer staff flexible working arrangements. Effective consultation is key and finding the optimum balance between individuals’ preferences and the organization’s needs, technological constraints and effective supervision. Monitoring the well-being of employees working remotely is also essential.
- Future proofing: While investors will have spent a large part of their time during the pandemic working with their portfolio companies, the need to improve businesses’ resilience to future economic shocks is an evolving theme and will continue to require the time and attention of management and investors. All this being said, inevitably some changes and innovations to business practices and models will prove to be less useful and not survive long-term. Identifying those sooner rather than later will be key.
- Prudence: Private equity investors will need to be discerning given the likely surge in transaction opportunities with a premium of sector expertise and sound due diligence.
A significant consequence of the pandemic for PE backed companies is the impact of its economic turmoil on management incentive arrangements. For example:
- performance conditions and targets – set in very different times – have become unrealistic
- Strike prices of options may be higher than market value
- exits may have been pushed back
The consequence is that management may have become disincentivized or incentivized to make business decisions not necessarily consistent with strategy – or both.
It also creates a challenge for the investor to recruit.
Solutions are various and broadly fall between refining existing arrangements and implement new versions. Examples include:
- restructuring of investor debt or ratchets
- exit cash bonuses
- modifications of performance conditions – for example, reset of hurdles or adjusting profit calculations or targets
- adjusting strike prices to reflect the impact on performance of the pandemic
- new ordinary share issues whose value is linked to the performance of specific parts of the business
While the investor’s attitude to the dilutive impact of any changes will of course be key, the tax implications – particularly where EMI or CSOPs are involved – will need careful scrutiny to ensure that the tax status of those arrangements is not jeopardized. It is vital to all stakeholders that management have a clear understanding of the return expected by the investor and at what point management equity becomes valuable.
The purpose of the IR35 regime (and of other regimes involving intermediaries) is to prevent the avoidance or reduction of tax and National insurance contributions by the interposition of an intermediary between the client and worker.
The government introduced new IR35 legislation changes earlier this year. Among other things these rules mean that certain businesses which previously engaged workers via an intermediary (for example, a personal service company) will now need to check whether those workers are disguised employees or office holders. These new rules may have significant implications for PE investors who typically with a large number of consultants and contractors – from appointees to portfolio boards to industry specialists sitting on PE advisory boards.
There are potentially significant implications for the portfolio companies too. The consequences of these changes may impact the proceeds of a future exit and have forced PE investors to look closely at their arrangements.
- Businesses whose models were immune to the worst effects of the pandemic will inevitably attract attention. Alternatively, those sectors which were harder-hit such as retail and leisure are likely to present opportunities of a different sort for investors experienced in turning around distressed assets.
- Similarly, businesses with models which are perceived as resilient to, or anticipated to benefit from, the socioeconomic changes being wrought by the pandemic will be a target for investment.
- The broader technology sectors – from financial services to gaming software – have been the focus of attention for several years before COVID-19 and that trend is likely to accelerate.
- Environmental social and corporate governance (ESG) continues to play a significant part in the investment strategies of many private equity investors. Leaving aside the connection between ESG investing and financial returns, there is little question that ESG has become essential to not merely fundraising but also engaging potential investees.
These are interesting times for private equity. Whilst the economic outlook has improved significantly it remains difficult to predict. There are likely to be significant opportunities for PE backed transactions in the short term and so too for incumbent management teams.
We have significant experience in advising management teams of PE backed companies at various stages of the investment lifecycle and of working with investors and management teams to devise solutions to restructuring management incentive schemes. If you would like to discuss any of the above we have specialists who can help. Please contact Johnathan Rees, Head of Laytons’ Corporate & Commercial Team to arrange a conversation.
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done so since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at firstname.lastname@example.org.
Dezan Shira & Associates has offices in Vietnam, Indonesia, Singapore, United States, Germany, Italy, India, and Russia, in addition to our trade research facilities along the Belt & Road Initiative. We also have partner firms assisting foreign investors in The Philippines, Malaysia, Thailand, Bangladesh.