Coronavirus concerns among GPs not solely focused on China vary based on their direct or indirect exposure to China, but gauging private equity responses to the crisis is like chasing a moving target
Of the 32 million people who visited Japan last year, nearly 15% came from China. Meanwhile, six million Chinese visited Korea, 34% of the country’s annual total. Japan and Korea remain each other’s second-largest inbound tourist markets after China. This gives some context to Japan’s recent decision to quarantine visitors from China and South Korea for 14 days as part of efforts to halt the coronavirus. Korea responded by announcing curbs on Japanese arrivals.
Concerns about the virus started cutting into tourist numbers before Japan's quarantine measures were introduced, with foreign visitor arrivals dipping below one million, the lowest single-month total in six years. Anyone invested in the long tail of services that leverage Chinese tourism – airlines, tour operators, hotels, fine dining, luxury and duty-free shopping – is inevitably taking a hit.
“Our portfolio is half in healthcare and half in consumer businesses. We have a couple of companies in hospitality – a group of hotels and an online travel agency. The hotels are probably going to be down 40% for the next couple of months, given the travel bans,” says T.J. Kono, a partner at Japan-based Unison Capital. “The impact is far larger than what we saw after the global financial crisis.”
Moreover, there is little investors can achieve through marketing spend to spark new demand and abate the decline, they can only pay close attention to costs and weather the storm. Even technology might work against them. Unison’s improvements to its hotel chain include moving reservations into the cloud and introducing dynamic pricing. This normally boosts operational efficiency – unless a neighboring establishment slashes prices, creating a domino effect.
It is instructive that private equity managers in Japan – which ranks eighth globally by number of coronavirus, or COVID-19 cases, excluding the Diamond Princess cruise ship that was quarantined at the Port of Yokohama – primarily highlight the impact on businesses that rely on external demand. They have much more confidence in the resilience of companies that serve local consumers, despite near-term challenges as people dine in rather than dine out. For example, Unison’s pub-style izakaya chain has seen a slowdown, but its udon noodle restaurants is holding up reasonably well.
Sentiment is much the same in Korea, where the number of COVID-19 patients is second only to China but more than three-quarters of all cases have emerged in the city of Daegu and the rate of new infections at national level appears to have peaked.
“We see it more as a temporary thing, which isn’t going to last into the second half of this year. Traditional domestic consumption will be impacted, but then it will be business as usual,” says Jason Shin, a managing partner at Korea-based VIG Partners. “However, even if Korea stabilizes in the next 2-3 months, which most people here expect, we have no idea what will happen in other parts of the world. The impact on the export economy and tourism-related areas is likely to be longer-lasting.”
The status quo
Gauging responses to COVID-19 within the Asian private equity community is like chasing a moving target. As it stands, concerns among those not solely focused on China vary based on their direct or indirect exposure to China. Rodney Muse, a managing partner at Navis Capital Partners, describes the virus as “worse than SARS and more of a black swan for Asia than the global financial crisis,” citing the willingness of governments to mandate or recommend behavioral change. Nevertheless, the Navis portfolio already demonstrates a range of outcomes.
First, companies that rely on Asian supply chains endured a few weeks of pain when shipments from China effectively stopped, but channels are now open again, albeit at lower volumes due to understaffed ports. Second, businesses in Southeast Asia that sell goods into China are also seeing supply chain stabilization. Third, companies with a physical presence in China that rely directly on Chinese consumption – such as restaurant chains – are struggling. Fourth, localized players in Southeast Asia that primarily serve corporates and consumers within the region are generally fine.
Muse adds one caveat: Navis is a buyout firm that doesn’t use much leverage. “Our model assumes these shocks happen and typically we have balance sheets that can survive such events,” he says. Similarly, GPs in Japan and Korea point to their reliance on relatively accommodating local banks for financing as a source of strength. According to one pan-regional manager, certain Korean companies in his portfolio have financing packages with covenants that don’t even kick in until next year.
For those that rely more substantially on leverage, the first red letter day will come at the end of March when companies have 30-60 days to complete their first-quarter covenant tests. Industry participants expect to see breaches, with some financial sponsors already reaching out to lenders and warning that if they don’t trip covenants in March then it will almost certainly happen in June.
Cov-lite deals financed via the international bond markets will, at worst, be subject to tighter corporate restrictions because they usually feature nothing more than an incurrence covenant that is tested when a borrower takes certain actions like issuing new debt or engaging in M&A. Structures that are cov-loose rather than cov-lite – deals backed by Asian banks or unitranche financing packages – are the ones to watch.
Covenants relating to leverage levels, debt servicing and interest payments could all feasibly be tripped by deteriorating financial performance. While documentation varies, it is relatively commonplace for deals to include adjustment provisions for declines in EBITDA but not declines in revenue. In other words, changes in costs and expenses can be absorbed with minimal impact; a drop-off in topline revenue large enough to dent the bottom line – due to factory closures, supply chain shocks or evaporation in consumer demand – are not. But will the banks enforce?
“There could be a range of outcomes depending on the bank, the relationship with the financial sponsor, whether the issue really is the virus and not something more fundamental, how quickly a business is expected to run out of cash, and whether there is an active market for enforcing,” says one leveraged finance lawyer. “I think banks will be sympathetic on virus-related dips in revenue. Absent other factors, it makes sense to work with the sponsor to restore covenants.”
Looking for deals
The current climate of uncertainty has inevitably dampened investor appetite for leveraged facilities to support new deals. Private equity firms also face logistical obstacles because they cannot access certain markets to conduct due diligence. Corporates have the same problem when looking to buy from financial sponsors, so exits are impeded too.
Asia buyout deals worth approximately $5.5 billion were announced in January and February. This compares to $7.1 billion in the first two months of 2019 and $7.7 billion in the last two months of 2019. Trade sales – including sponsor-to-sponsor buyouts – amounted to $1.2 billion in January and February, down from $7.1 billion and $12.4 billion, respectively, in the other two periods. Apart from China, where the government is trying to stimulate capital markets, IPO activity is close to nil.
Some investors in Korea, Japan and Australia claim their new investments are proceeding on schedule. “The number of deals that are well known in the market continue to go on as planned. Deals that are more private in nature are continuing. We have a couple in our system now that are going forward,” says Scott Hahn, CEO of Korea-focused Hahn & Company. VIG’s Shin adds that he is looking at three targets and nothing has changed because they are domestic consumer plays.
In addition, there is an expectation that near-term dislocation could create opportunities. There are plenty of examples of this in existing portfolios – Hahn & Co. took its used-car sales business online last year and 50% of business has come through that channel since the outbreak, while VIG has temporarily repositioned its facial mask manufacturer to focus on protective rather than beauty products – but it has implications for new deal flow as well.
While Unison’s hotels might be hurting, the firm is being approached by highly levered corporates that want to offload their own hotel management contracts. Similar opportunities are expected to emerge elsewhere in the tourism supply chain. More generally, several GPs say they would be in no hurry to complete deals even if everyone were in the office and working as normal. Why not wait two months and try to renegotiate the price? They are also paying attention to material adverse change (MAC) clauses should a deterioration in conditions necessitate a withdrawal from deals.
That said, some investors warn against being too opportunistic – or mercenary – when dealing with vendors as it could result in wider reputational damage. Relatively few dealmakers in Asian private equity, outside of special situations, have much experience enforcing MAC clauses even if they draw comfort from having the option.
“We try to be transparent with the vendors that there are certain circumstances outside of our control that could lead to us not to be able to transact at the stipulated time or perhaps restructure the investment itself,” says Muse of Navis. “You rely on lawyers and commercial common sense. You want it to be something where they understand the world has changed since we reached an agreement and we require some degree of flexibility around that.”
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