COVID-19 has had a profound impact on the economy and the business community at large, and private funds and portfolio companies were not immune. While fund managers are focusing on the impact on their portfolios, they are also keeping a close eye on the many industry-specific issues resulting from the pandemic, and the longer-term investment opportunities COVID-19 has created.
As the fund community continues to manage through volatility and the new normal, preparation, planning and strong leadership is crucial. Developing a comprehensive playbook to navigate change will be necessary.
Some key considerations are being evaluated by many fund managers to ensure both short-term and long-term success throughout the pandemic. Here are six of these considerations.
1. Work from home
Many funds have been moving away from viewing the physical office as the only — or even the best — collaborative workspace. As a result, companies will need to look to implement the right remote work technology to enable seamless communication and productivity over the long haul. Remote work technology brings a whole host of new concerns which will need to be assessed by management.
2. Data security
Private funds should reassess data security risks, with particular attention to the added risk of many third-party provider employees working remotely. Institutions should understand the risk and make sure the third party protects data against the additional risks of an overly stressed security platform. Reassessment of appropriate cybersecurity insurance coverage is also recommended.
3. Fee pressure
Fee pressure is likely to become a fact of life for a growing number of firms. Some larger funds may appear immune, but resistance may not be sustainable. Fund managers will need to revisit fee models to better align with the current environment.
4. Risk management
Risk management is once again paramount, just like it was during the 2008 global financial crisis. Fund managers will need to focus on managing risk not only in their investment portfolios but in their business overall. This will require revisiting current risk management policies to ensure they properly address risks associated with a post COVID-19 environment. Fund managers should not assume old risk management policies are sufficient.
5. Tax considerations
The Tax Cuts and Jobs Act of 2017 (TCJA) created a sweeping overhaul of the U.S. tax landscape. One item TCJA addressed was the taxation of “applicable partnership interests,” such as carried interest. Under the provision, if one or more “applicable partnership interests” were held by a taxpayer at any time during the tax year, some portion of the taxpayer’s long-term capital gain with respect to those interests may be treated as short-term capital gain. At a high level, the provision requires that to obtain long-term capital gain treatment for applicable partnership interests, the required asset-holding period must be greater than three years. After the TCJA was enacted, some hedge fund managers began setting up S corporations, in states including Delaware, and PFICs (passive foreign investment company). However, the proposed rules under Internal Revenue Code Section 1061 disallow the use of S corporations and PFICs to avoid the requirement that the carried interest must be held for at least three years, instead of one year as under previous law, for taxation under preferable long-term capital gains tax rates, rather than ordinary income rates.
In addition, the green book published by the Biden administration includes additional changes on how private funds are taxed and eliminates some loopholes. This current tax environment impacts transactions in some significant ways, whether it is tax due diligence, valuation, deal structuring or any post-deal integration. Private equity funds should be proactive and engage a tax advisor early in the deal process to ensure they are considering the current tax environment and what it could look like post transaction.
6. M&A and SPACs
During much of 2020, deal activity slowed as a result of COVID-19 and economic uncertainty. In 2021, deal activity is very strong, and while deal volume seems to be outpacing 2020 by double digits, company valuations are very high and it is a seller’s market. Demand for high-quality assets is accelerating deals that were originally years away. Tax policy uncertainty, discussed previously, will likely generate more deal activity as fund managers look to lock in gains before any capital gains tax increases. Another significant consideration in merger and acquisition (M&A) activity has been the emergence of special purpose acquisition companies (SPACs). Many fund managers now have added pressure to match or beat SPAC valuations. Fund managers should focus on ways to differentiate themselves in a post-COVID-19 environment.
The impact of COVID-19 will be long lasting and will change the way many fund managers evaluate deals, manage volatility, and, in some cases, develop new strategies to accelerate returns for its investors. It’s critical that fund managers embrace change and look for ways to continue to differentiate themselves while also consulting their advisors to ensure they are positioned for both short-term and long-term success.