Well, 2020 is finally leaving us. As vaccine distributions bring us ever closer to putting COVID-19 firmly in our rearview mirror, the past year will become remembered as a period of cancelled plans, mask mandates, and bizarre events unlike anything most of us had seen in modern history.
As individuals sadly lost their loved ones to this disease, businesses around the globe struggled to stay afloat through forced closures, capacity limitations, industry shutdowns, and crippled supply chains. A liquidity crisis slammed businesses across the board, and COVID-19 added a new layer of complexity for companies who tried to obtain capital to weather the storm.
As the world headed into the uncharted territory of a worldwide pandemic, investors in both debt and equity markets reacted to shifts and changing conditions in several interesting ways, and the lessons they learned and the actions they take this year will set the stage for everyone’s access to capital in the years to come.
Prior to COVID-19, some analysts and debt underwriters encouraged debt issuers to exercise caution after the tenth straight year of economic expansion . Several years of substantial increases in total lending had created an environment with a high potential for defaults and losses in the case of an economic setback;  the total value of corporate debt due in 2020 had surpassed $1T .
As we have been reminded throughout history, growth isn’t perpetual. All economies experience slowdowns after long periods of growth for one reason or another. As we saw this past year, the warning of an impending downturn proved prophetic, though no one was expecting the cause to be a global pandemic.
When the initial wave of uncertainty around COVID-19 set in during March 2020, the debt market flipped on its head, paving a path to the worst debt-raising year since 2015 . Starting in mid-March, the corporate bond market completely crashed, as investors sold off their holdings and fled to safety amid fears of downgrades and defaults.
Many institutional and private investors found new homes for their cash in distressed debt funds, which caused the total size of those funds to quadruple, to nearly $1T between March 15 and April 1 . Simultaneously, other special situation funds ballooned as institutions sought to hedge against losses amid the new market and economic turmoil.
These funds offered high-yield debt capital to companies in shambles that were regarded as too risky for loans by other conventional or direct lenders, often costing borrowers two to three times more than conventional loans and establishing a place of last resort for businesses being pushed towards bankruptcy .
Meanwhile, the same uncertainty caused a free fall in conventional lending and direct lending as the impact of closures wracked the economy. The wells of direct lending activity that had been steadily growing over the past several years quickly dried up as conditions brought on by the pandemic created a liquidity crisis for both businesses and creditors.
Companies that were unable to access PPP or SBA loans often found themselves unable to qualify for credit as banks tightened their credit requirements for new loans. Business owners who lacked longstanding relationships with creditors found themselves without many options, and forced to utilize distressed debt and special situations funds.
These distressed debt and special situation funds — often labeled “COVID-19 opportunity funds” — were the source of 29.9% of debt funds raised in the first half of 2020, and arose from after contributing only 19.7% of debt capital raised in 2019 .
The first half of 2020 saw an annualized decline of more than 30% in total debt funds raised compared to 2019 . By June 30th, total funding came to $48M — down significantly from the $145M of capital raised over the course of 2019.
The second half of the year saw significant support from PPP loans, with Federal Reserve purchases bolstering the corporate bond market and interest rates falling to historically low levels, which allowed firms that had survived the first wave of closures to refinance their debt.
The Federal Reserve’s buying activity helped calm the corporate bond market, and provided a backstop to many companies rated above BBB . Most unrated or downgraded companies have found issuing bonds to be significantly more expensive under COVID-19.
Though to a significantly lesser degree than in the early months of COVID, look into the rest of 2021 and beyond features continued uncertainty in the debt market. The size, impact, and prevalence of distressed debt funds are expected to remain large until business restrictions and limitations (such as closures, limited capacity, and limited functionality of various businesses) are lifted.
The debt overhang among companies that took on debt to avoid closing shop is going to create ripple effects across the debt market for years to come. An increase in high-yield debt offerings will likely lead to a wave of loan defaults and bankruptcy proceedings in the coming years. Confidence and general feelings of stability will take time to return.
However, the near-zero interest rates anticipated by analysts at PwC through 2021 should promote recovery and growth for those businesses that will have survived through the pandemic .
Prior to the advent of COVID-19, equity markets were poised to extend a decade-long surge that saw a 270% increase in the number of private equity deals between the low point of 2009 through 2019 . Growth in PE deals was expected by firms of all sizes ranging from less than 25M up to 500M, and with a record of $1.25T in “dry powder” available to investors, everyone though 2020 would be a very good year .
With the onset of the virus, equity markets exhibited highly volatile behavior, free-falling during the first half of 2020, followed by a steep recovery in the second half of the year.
COVID-19 hit the equity markets quite early in 2020. As uncertainty set in, many would-be sellers decided to delay going to market, and chose to wait for a better exit environment to materialize before continuing with their plans. Those that couldn’t hold out often sold their distressed companies at a significant discount.
Meanwhile, fundraisers suffered a significant reduction in new investments — on pace for the lowest annualized amount since 2015. The initial shock gave both buyers and sellers cold feet, resulting in a general market freeze.
According to Pitchbook, deal volume contracted by 26% compared to Q1 2019 and featured the lowest volume since Q2 2014 . Most of this initial decrease came from a reduction in middle-market transactions that involved companies valued between $100M and $500M .
Their difficulties only got worse in Q2 2020, when middle-market deal activity (valued under $500M) saw a 55% decrease in transaction volume compared to Q1 2020 and a 61% drop compared to Q2 2019 . COVID-19’s impact on M&A activity varied across industries, with some reaping the benefits and others not being so lucky.
Consumer and discretionary goods made up 8% of Q2 2020 activity, down from 17% the year prior . Industrial companies saw a similar drop, from 17% in Q2 2019 to 8% in Q2 2020 . Meanwhile, the healthcare industry dominated Q2 2020 M&A (which is understandable given the state of the world) with 30% of deal volume — more than double the concentration in 2019 — while most others remained within a few percentage points of their five-year average .
The drop in overall deal volume over the first two quarters did not change the character of the investors, with 84% of buyers being strategic, and domestic U.S. buyers accounting for 90% of transactions, consistent with the preceding few years .
After an incredibly rocky second quarter, the private equity market made a significant recovery in the second half of 2020. Jonathan Simnett from the corporate law firm Hampleton Partners was reported as saying in mid-May, “[t]he brakes have been slammed on funding until investors are able to create maps to navigate uncharted territory” .
As dealmakers adjusted to the new normal and learned how to complete deals remotely in a shutdown world, Q3 saw transaction volumes spike by 76% over Q2  as higher valuations and slightly more stable conditions attracted sellers and increased confidence in the short term. Fundraising efforts yielded substantially better results, thanks in part to a rise in institutional investing in private equity with 66% of institutional investor contributing to PE in 2020 , which gave buyers the resources and confidence to return to market and seek new opportunities.
The upward trend that started in Q3 continued through the rest of the year. In all, 2020 deal volume ended 16% lower than in 2019, and deal value dropped by 19% . Though far short of 2019’s predictions, this outcome was far better than the 50 to 60% losses experienced in the first half of the year.
According to a survey of 200 PE firms conducted by the National Bureau of Economic Research, managers believe that 40% of their portfolio companies were negatively affected by the pandemic to a moderate degree, while 10% of holdings were significantly negatively affected .
So where do we go from here? Analysts are at odds about what to expect in the short- and long-term of 2021 and beyond. Most believe the impact of COVID-19 will continue to weigh down deal volumes until COVID-19 restrictions are lifted, vaccines distributed, and businesses return to functioning at normal capacity.
Some predict a negative future, and argue that the lost growth potential, contractions in business, reductions in revenue and cash flow, damaged supply chains, and increased debt balances for many firms will result in lower projected returns for private equity funds and overall discouragement.
Others argue that record-high “dry powder” (which has reached over $1.45T as of March 2021, all of which is expected to be deployed within the next 5 to 7 years) will drive a prosperous 3-to-5-year climb. As more buyers compete in the marketplace, valuations will increase, and thereby benefit sellers, exiting PE firms, and companies in need of capital as they reassess their strategies going forward.
If you add that 53% of surveyed US executives plan on increasing their M&A investment in 2021 , it appears that the coming years will be prosperous for middle-market companies looking to transact, whether they intend to grow or sell their business.
The COVID-19 pandemic created a level of uncertainty that few private companies had ever experienced, and according to most observers, its effects are likely going to be felt for the next few years. It is difficult to predict what the future will bring.
As JP Morgan CEO Jamie Dimon recently put it, “This [was] not a normal recession. The recessionary part of this you’re going to see down the road” . Risk of high inflation due to unusually high government spending throws a wrench into things, but assuming the Federal Reserve is able to maintain the general state of the economy (as it has often proven to do), the continued release of pent-up investment demand, low interest rates, and the encouraging downward trend of coronavirus hospitalizations and cases in the US and abroad should bring optimism and hope in the coming years.
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Kaden LeFevre contributed to this report.