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Law360 (May 6, 2020, 3:47 PM EDT) --
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| Steven Keeler |
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| Clare Lewis |
That said, through the coming recession, family offices have a unique opportunity to enhance returns on their private equity investment allocations through a combination of reasonably valued investments in companies with good long-term prospects, sound due diligence and flexible deal structures.
The Shape of the Recovery and Institutional Pullback
No one has a crystal ball foretelling the shape and duration of the 2020-2021 recovery from COVID-19. The stock market usually rebounds more quickly than spending and the economy. In contrast to previous downturns, the Main Street shock from a nationwide quarantine occurred while Wall Street and economic fundamentals were strong.
Recession reality has only just taken hold and the evolving majority view may be that the recovery will be U-shaped versus V- or L-shaped. Private equity funds — from venture to growth to buyout — have stockpiles of capital and remain open for business, but the pace of investment has slowed dramatically at the start of the second quarter of 2020. Private equity funds will likely shift focus from new investments to existing portfolios during the second quarter and perhaps third quarter of 2020 depending upon the shape of the recovery.
Meantime, as traditional private equity players, from funds to corporates (including corporate venture arms and acquisitive consolidators), and including some growth and later-stage venture investors, likely pull back in the next two quarters, earlier-stage seed to Series A venture capital investments in life sciences and technology may again prove more resilient during a downturn.
Venture debt promises spike up in the short term to fill the demand created by new debt providers and to bridge valuation gaps. Private equity buyouts will fall back due to reduced leverage for deals and the valuation challenges of getting deals done with more equity. The impact of the 2020 pandemic on private equity will of course differ across stage and industry.
However, like angel investors who tend to make selective venture capital bets during difficult times, family offices are uniquely positioned to fill the gap left by funds and corporates that take a break from later-stage venture, growth and buyout investing during 2020.
Family Office Opportunities and Motives
Family offices have been increasing their slice of the private equity pie for several years now. As more patient, long-term investors, smart and sophisticated family offices were already preparing for and allocating assets to endure a recession.
Private company valuations will fall quickly, if only temporarily, and companies experiencing short-term stress but with good long-term prospects will have an unprecedented need for capital. As a result, equity will be cheaper and investors will have some leeway to structure or supplement their private company stakes as safer, current-pay debt.
Private equity is supposed to be an alternative or noncorrelated asset. "Buy low and sell high," as the saying goes. Many of the most successful venture-backed companies were founded during prior recessions. All logical, but this is not to say that venture and private equity investing are low-risk.
However, that is where family offices may foot the bill in 2020. They invest in what they know, and their relationship-building, term sheet and due diligence processes have always been more tailored to risk while at the same time being more company-friendly. Family offices with long-term investment strategies, including periodic rebalancing of portfolio allocations, will make 2020 venture or private equity investments in industries they know and industries that will better survive a recession.
Lower prices and less short-term competition for deals should present reasonable risk-adjusted return scenarios. And, family offices will be doing the right thing — by the economy, by science, for the common good, and by the families and charities they serve.
Win-Win Investment Terms and Company Housekeeping
Family offices have always been considered among the most collaborative, patient and fair private equity investors. Many of the tools and rules for making and managing private equity investments will not change, but some take on newfound importance during recessionary periods. For current portfolio companies and in connection with add-on or first-round investments, family offices and companies should consider (1) the optimal capital stack, (2) due diligence and cash management, and (3) the talent factor.
Short-term portfolio company bridge financing may become more popular. Family offices may look to fund short-term needs and valuation gaps with fixed-term, interest-only, part cash part payment-in-kind debt — which a family office can provide or obtain from a venture lender — with warrant coverage of (i.e., having a value equal to) 5% to 20%, depending on company stage and collateral, of the debt principal.
Convertible notes may not be appropriate with so little visibility on future equity financings, and security or subordination will depend on the company and any other lenders.
Family offices should look to balance downside and dilution. VC-style preferred equity structures may increasingly provide for a liquidation preference and possibly a preferred return to manage founder and legacy investor dilution. Family offices will also move toward trust-then-verify financings with tranched (multiple installment or advance) capital infusions tied to performance or other milestones.
Business, technology and market due diligence around product development and commercialization opportunities, risks and challenges should be supplemented with tailored legal, financial and technical due diligence by qualified law, accounting and consulting firms. Due diligence is the legal fee lark.
Family offices should budget for and pay reasonable fees for top-notch professional services, and, like private equity funds, demand excellence. Leave the right areas of due diligence and transaction planning to the right experts — technology, intellectual property, product and service review (in-house and industry consultants), customer contracts (part in-house and part law firm), labor and employment and employee benefits (part in-house and part law firm), quality of earnings, financial statements and tax compliance (a qualified accounting firm), international business considerations (law firm), and purchase agreement negotiation (parties and lawyers).
Get all third-party side deals addressed as early as possible in the process (customer, vendor, landlord, licensor, lender, early investor and other third-party consents, amendments, etc.). Target company "data rooms" are often non-existent or more hurtful than helpful to a good, efficient due diligence review, so the parties should be immediately prepared to establish a quality data room.
Everyone is writing about data privacy and security for a reason. Refocusing on data privacy and security and artificial intelligence (data exploitation) opportunities will minimize operational (including work-from-home and cloud) risks and enhance product and service offerings.
Reviewing critical company contracts and the financial strength of customers and outsourced IT, supply chain and other vendors will no longer be nice to have, but rather essential to financial health. Family offices will also hone in on the companies' burn rates and run rates. Companies should double down on cash management, striking the right balance between current operations and growth, and including consideration of Coronavirus Aid, Relief and Economic Security Act loan eligibility and tax planning.
Lastly, the talent factor will be as critical as ever since it is a difficult to replace asset and more than a line item. Cutting costs in a challenging and unpredictable market is just as critical as not being penny wise and a pound foolish. Family offices need to carefully analyze company personnel needs and risks and implement multi-faceted crisis and succession plans.
Run a Good Process and Get Value and Peace of Mind From Good Professionals
A family office and/or target company's in-house capabilities will dictate the scope of services that it may need from a law, accounting and/or consulting firm in connection with a private equity investment. Early involvement of professional advisers will help streamline and prioritize the process from letter of intent, through due diligence to closing, and dramatically manage and reduce professional fees.
Reputations are damaged by deals that do not get done, so family offices should plan to close deals under term sheet (short of due diligence discoveries that justify terminating the process), and target companies should be prepared to provide some reasonable period of exclusivity or expense/fee reimbursement if they go with a different suitor.
Get any target company executive side deals or expectations struck as early as possible in the process. If you are the target company founder or CEO, be honest and transparent, and earn investor trust by pointing out your concerns and the company's risks and challenges, and how you plan to address them.
If you are the family office investor, you will nurture your investment by backing up the company and team whenever you can, and by always doing what you say you are going to do. Relationships, hard work and communication keep management, investors and the board on track to weather difficult times and achieve success.
Safety in Numbers: Family Office Club Deals
Perhaps even more during a period of heightened uncertainty and risk, family offices should continue to partner with like-minded family offices to share risk and supplement company boards with broader experiences and expertise. The current environment will put a premium on efficient and fast investment processes, so working with co-investors with whom the family office has worked before will be a plus.
Family office consortiums can range from all common, deal-by-deal investment limited liability companies, to so-called pledge fund vehicles, to more fund-like pools providing appropriate incentives to lead and manager family office investors through carried interests (or promotes), closing fees and management fees.
Family Legacies and Capital With a Cause
In these unusual times, family offices have a unique opportunity to invest in good companies at bargain prices while playing a vital role in our economy and fulfilling their mission. Healthcare and emergency response workers, government employees, nonprofit organizations and private companies are all performing heroic acts during this pandemic despite the risks.
There may be no time in a generation — or three — like 2020 for family offices to achieve well-deserved returns for providing capital to small and middle-market businesses, thereby saving jobs and keeping the wheels of research and innovation turning for the common good.
Will family offices choose to sit this one out or roll up their sleeves and continue to build their legacy for the next generation? The world is watching.
Steven Keeler and Clare Lewis are partners at McGuireWoods LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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