COVID-19: Six key actions for private equity and venture capital fund managers
In light of the COVID-19 pandemic, private equity and venture capital (PE/VC) funds are preparing for a major and widespread economic impact.
Furthermore, from 11.59pm on Wednesday 25 March, New Zealand moved to Alert Level 4 meaning that all New Zealand non-essential businesses are required to close and either work from home where possible or otherwise not operate if working from home is not an option.
The COVID-19 pandemic starts and ends with personal health and safety above all else. We are actively prioritising the wellbeing of our own people and are helping many of our PE/VC clients to do the same for their teams and the many Kiwis employed by their portfolio companies. While we cannot predict how the next few months will ultimately unfold, the impact will be widespread. The following six key actions are being considered by PE/VC funds to optimise their portfolio company cash flows and maximise operational stability during this challenging period.
1. Consider equity funding, recapitalisation and capital calls
PE portfolio companies will face different issues from those of their VC funded counterparts. VC portfolio companies will generally be all too aware of their capital runway. More mature companies will, in turn, have more stakeholders from suppliers to customers where failure or business difficulties could flow through to affect the portfolio company’s own prospects.
PE/VC Fund managers should be familiar with the emergency funding provisions of the shareholders agreements and constitutions relating to their portfolio companies, fund documents and co-investment arrangements. Issuing equity on preferred terms or that otherwise varies the rights of existing shareholders will generally need the approval of (at least) 75% of shareholders.
In making capital calls to fund investors, PE/VC fund managers must ensure that all the technical requirements of the calls are met – as we saw that during the GFC some fund investors internationally challenged calls and the ability of the fund manager to make them.
PE/VC fund managers may want to consider implementing a capital call (or at least a binding commitment to provide capital) now, to help mitigate against timing constraints in shareholders agreements and fund documents.
For more mature, debt funded portfolio companies, equity cures injected following financial covenant breaches must usually be applied against debt and result in a proforma recalculation of financial covenants (resulting in lower debt and lower interest, but not increased EBITDA). Sponsors should carefully consider how equity injections are treated under their documents, and if there is a difference on whether or not a financial covenant has been breached yet. If a financial covenant breach has not yet occurred, it might be preferable to simply inject equity to support liquidity (and not have applied against debt).
For VC funded companies, more care may be needed in navigating shareholder arrangements e.g. pre-emptive rights or anti-dilution measures.
PE/VC fund managers may receive requests from their larger investors for better investment terms (i.e. lower management fees, etc). Fund managers may also encounter investors seeking to transfer or otherwise withdraw from their investment (particularly where paper loss in the investor’s more traditional assets require a re-weighting of their portfolio away from alternative assets). This may create opportunities for funds or investors looking to buy into funds via secondary transactions.
Finally, for PE/VC fund managers with mandate flexibility to invest in public companies, understanding the structures and processes for emergency recapitalisation transactions will be important. Heavily discounted rights issues, cornerstone placements, sub-underwriting of offers and the consequences of increased control will need to be navigated.
2. Maintain liquidity
PE/VC funded companies which are borrowers should consider drawing down working capital or any other available facilities in advance of immediate need and retaining the cash on balance sheet to use later. This may act as a buffer in circumstances where drawing the facility later may be in doubt, either because of liquidity issues in the banking market or because conditions under the facility agreement to make the draw cannot be met.
Borrowers should check gearing ratios which could prevent drawing a working capital facility to ‘retain cash on balance sheet’ where it might be netted off against term debt in the gearing ratio.
If there is a requirement to “clean down” a revolving working capital facility for a number of days in a financial year, a borrower would ideally satisfy this clean-down obligation as early as possible.
Borrowers may be able to create additional short-term liquidity by selecting longer interest periods and therefore deferring the payment of interest until a later date. This will be particularly beneficial for borrowers who have facility agreements that permit six-month interest periods to be selected.
3. Access tax relief
Inland Revenue has several relief measures available to support business cash-flow, and has supplemented that with new measures that respond to the COVID-19 pandemic, including:
Provisional tax refunds
As soon as the impact of COVID-19 on your business can be forecast, you should consider estimating or re-estimating your current provisional tax liability. Reducing the payment of provisional tax will help those adversely affected by the economic downturn to alleviate the reduction in cash-flows.
Inland Revenue has said that, given COVID-19, it can arrange early refunds if provisional tax has been overpaid. Further, the threshold for having to pay provisional tax will increase from $2,500 to $5,000. This will allow more small taxpayers to delay paying their taxes.
Instalment arrangements and extensions of time
If you need more time to pay tax, you should talk to Inland Revenue and seek an instalment arrangement to manage the payment of outstanding tax. With COVID-19 affecting normal business operations, Inland Revenue has said that extensions of time to file some tax returns may be granted. While those extensions cannot be granted for GST and PAYE returns, there may be relief for other tax types.
Remitting penalties and interest
Inland Revenue has announced that penalties for the late filing of some tax returns may be remitted. Further, they have said that under limited circumstances penalties for late payments incurred due to the effects of COVID-19 may also be remitted.
Inland Revenue will be given the power to waive interest on late tax payments for taxpayers who have had their ability to pay their tax on time significantly adversely affected by the COVID-19 outbreak. While the legislation has yet to be introduced, Inland Revenue has said that an inability to pay tax on time will include where income or revenue has reduced by at least 30% compared to the same month 12 months earlier, and all other options to obtain financial support have been exhausted. The relief will apply to interest on all tax payments (including provisional, PAYE, and GST) due on or after 14 February 2020 and will apply for an initial two year period.
The key here is for portfolio companies to engage individually with Inland Revenue to negotiate a position with them because they should not unilaterally pay tax late or file returns late without Inland Revenue’s agreement.
4. Review employee resourcing arrangements
All businesses will be considering what their staffing requirements are given the COVID-19 events and impact on the economy. Some businesses will be seeking to reach agreement with their staff about the use of leave, and a drop in wages or salary, and some businesses will be taking more direct action to reduce employees hours of work or pay, or disestablishing roles and making people redundant. In the midst of this, the Government has made provision for economic relief to support employers keep their employees in employment and paid, and for employees who have to take time away from work due to specific COVID-19 exposure or risk of exposure.
The Government has released (and updated) an Economic Response Package (Package) for organisations in New Zealand. The Package has been designed to support workers who are required to take leave as a result of self-isolation or sickness due to COVID-19 and businesses who are facing heavy losses in the wake of the impact of strict self-isolation measures and the economic effects of a reduction in trade and business. All businesses that meet the criteria are able to access the scheme to subsidise wages for all employees for a period of 12 weeks (the cap of $150,000 that was previously announced has been removed).
Payments of $585.80 per week will be available for full-time employees (20 hours a week or more) or $350 per week for part-time employees (less than 20 hours a week) under both the leave payment and the subsidy scheme.
Leave payments apply only to employees who are required to self-isolate and register with Healthline. Payments are applied for by their employer, who must verify the circumstances leaving to the enforced leave. If leave is due to a COVID-19 diagnosis, then the leave lasts until the person (or who they are caring for) recovers. Although employers can agree with employees to use any form of paid leave (such as annual leave) to cover the period of self-isolation, employees are not required to have used any or all of their leave entitlements before they can receive the leave payment.
Wage subsidies are for employers who are suffering a loss of revenue due to the COVID-19 crisis. The subsidy is intended to supplement employee wage costs, with an expectation that employers will top up wages to their normal level (one of the requirements is that entities applying for the subsidy use their best endeavours to keep employees at 80% or more of their usual work/pay levels). Employers must sign a declaration that the information is true and correct when applying for wage subsidies.
The Government has announced that it will deal with large scale employers that require specific support on a case by case basis. PE/VC fund managers should consider if any of their portfolio companies fit into this category.
Further income support is expected to be announced over the course of this week as the country moves into Alert Level 4. In the meantime, the Government is encouraging employers to talk with employees, and make plans for the next four weeks that we are expected to be in Alert Level 4.
5. Consider rent relief
The impact of COVID 19 and now, the Government imposed lockdown has had a significantly adverse impact on the turnover and now, the ability to operate, business in almost every sector of the economy. What had been in recent weeks a significant level of enquiry regarding the legal availability of rent relief (both from landlords and tenants) has now become a torrent. From a legal perspective, whether the present circumstances provide a legal basis for relief (such as rent abatement) is determined primary by specific lease terms. However, the unprecedented circumstances currently being faced by all is encouraging parties to voluntarily engage in good faith commercial discussions to explore options, as parties weigh the impact of reduced (or non-existent) tenant cash flow against landlord alternatives of temporarily reduced earnings or a temporarily vacant property. We’ve already seen cases of landlords in New Zealand proactively offering temporary rent relief as this is seen as preferable to having tenants become unable to continue to operate as a going concern and folding.
6. Arrangements with other suppliers
Similar principles to above apply to arrangements with other suppliers: for example, more flexible payment terms may be negotiated in exchange for other commitments such as term or pricing notwithstanding there may be no legal right for customers to access this. It will be imperative that PE/VC fund managers understand (where applicable) the logistics and supply chains of their portfolio companies, particularly if supply chains are local and will be impacted by the Alert Level 4 closures. It will be vital that communication with key suppliers and/or customers on capacity, liquidity and legal obligations is thoroughly explored and understood.
Aim to outlast disruption
Many PE/VC funds with exposure to bricks and mortar retail and services businesses have already been pivoting toward the digital economy together with other industries which are not as exposed to a wider downturn (e.g. healthcare, social services and infrastructure-like assets). We hope overall this will balance out any short-term turbulence, together with a mindset among all stakeholders to work through these challenging times together.
On a more positive note, already we are seeing profound social and behavioural shifts that are likely to outlast this temporary disruption. These should present opportunities for investment over the medium and longer term, including accelerated uptake of telehealth and tele-consulting, permanently decentralised working arrangements, critical reliance on internet and data infrastructure, a bias to domestic tourism, increased online delivery of primary and secondary education and even how panic buying could permanently shift attitudes to everyday shopping and food security. Out of a crisis comes, eventually, opportunity…
In the meantime, we are all in the same boat (waka eke noa) and must continue to be kind, and help each other do business in a difficult environment.