After a year during which uncertainty in the equity markets became the new normal, are the disruptions behind us? A look at key indicators might lead one to say yes. The S&P Loan Index has returned to pre-pandemic levels, the default rate is significantly below the peak of 10 percent that we saw during the great financial crisis, and there roughly $840 billion of M&A value has been realized in 2020 versus $802 billion in 2019 -- and $290 million so far in Q1 2021 alone.  But experts agree that under the surface, a number of COVID-19 related factors and other market shifts still have the potential to bubble up and lead to second-order or longer-term impacts.

Zombie Companies

Governments in the EU and UK have injected an unprecedented amount of stimulus into the European economy and there are still plenty of credits that have been propped up both by government stimulus and liquidity injections from both lenders and sponsors. It remains to be seen whether those companies can recover. A risk remains that a large cohort of “zombie companies” will never recover, and that liquidity may have gone to waste.

Though currently healthcare businesses remain focused on having the cash to get through the pandemic, experts agree that balance sheet sustainability is going to return to the fore, along with a reckoning that businesses that haven’t yet reopened are not likely to do so.

But those that were negatively impacted and can successfully come back to the market may present an opportunity, with low valuations, to deploy capital and create value through buying at a discount.

COVID Cash

The phenomena of COVID cash, or businesses that benefited by supporting COVID, is unlike anything the corporate market has seen before. There were no similar phenomena during the global financial crisis, when the .com bubble burst or after the debt malaise of the early 90s. In the COVID era, however, companies in sub-sectors like diagnostics, therapeutics or temperature-controlled logistics are likely to be sitting on piles of cash. Unfortunately, that cash is dissimilar to revenues made running a business in normal operating environments. COVID cash doesn’t have EBITDA or PE value to it. In the current zero interest rate environment, debt is cheap if you need to deliver it or extend that cash. And cash has a zero return. The result is that accretion dilution analyses are entirely different than at any time in history.

On the other hand, companies in sub-sectors like medical devices, orthopedics, stents or peripherals are likely to have had a terrible experience during COVID because discretionary surgeries were pushed into the future.

The challenge today is to normalize company performance, which requires corporate management to be credible and transparent as to whether they've had a good year and it's temporary or asserting that they are in a position that increased or decreased revenue will continue. Seeking the most realistic picture, investors are now predominantly pricing off year-end 2021, and walking away from partners and sellers who continue to try to advance non-sustainable COVID revenue scenarios.

Liquidity Gaps

One of the biggest structural shifts in the market is in liquidity sources for borrowers. Direct lending funds have, for the most part, taken a very pragmatic approach. But banks have not been able to do the same, and ultimately have completely retrenched from the market. For example, banks might have once had an appetite to look at super senior pieces or bifurcated structures, but they have ceased to do so during the last 12 to 18 months.

“Anecdotally, we continue to hear stories from corporate treasurers lamenting that because banks and other traditional lenders have been overburdened with liquidity requests, they have not able to deploy focus into other directions,” says Aymen Mahmoud, partner at McDermott, Will & Emery.

The European banking group is also likely to also face a large book of non-performing loans in 2022. It remains to be seen how they will react, and what their appetite to new lending will be in that environment. Experts predict that this retrenchment may signal a longer-term structural shift, and that it may be quite a while before banks come back into the market for PE transactions in a meaningful way.

However, on a positive note, efforts to plug liquidity gaps have resulted in more collaboration between private equity sponsors, borrowers and lenders, which may continue longer-term.

Looking for Longevity

“COVID ushered in an acceleration in innovation and a lot of assets to market,” says McDermott partner Ellie West. “The challenge now as we move forward into the next investment cycles is to determine which assets represent fads, and therefore should be avoided, and which assets have longevity.”

The influx of new healthcare ideas brought forward in 2020 is ultra-fragmented and competitive. Experts warn that though many of those assets realized significant revenue over the last 18 months, they are still two to three years away from “being ready for primetime” with a track record that supports long-term viability.

Increased Emphasis on ESG

Beyond the pandemic effects, evolving Environmental, Social and Governance criteria are presenting new challenges for the market, with Europe seeing the greatest impacts.

“ESG criteria are something that started in the large cap syndicated space that has now filtered down into the mid-market space,” says McDermott partner Mark Fine. “We're seeing it crop up on the majority of deals now.”

Though ESG has been a focus in Europe for some time, focus has historically centered upon internal governance. The shift now is to examine what primary debt lenders can actively do to promote ESG in the businesses in which they are investing.

With ESG considerations top of mind for investors and limited partners, sponsors and lenders are increasingly applying ESG factors as part of their risk mitigation and growth opportunity analysis process. It is becoming more common to see incentives proactively put in place to ensure all parties are working towards the same ESG targets.

Increasing ESG attention is also the result of a growing number of EU regulations designed to ensure that financing is flowing to more sustainable businesses in support of achieving the Paris targets, reducing carbon footprints and reversing climate change. Sponsors and lenders are seeking data to demonstrate net zero progress and commitments.

One of the greatest challenges is that ESG is reactive to legislation on a country-by-country basis. What is deemed a recommendation versus what is mandatory, particularly in the case of cross border transactions, is changing very rapidly, and that the evolution of requirements and expectations is largely outside corporate control.

Looking Forward

One of the most promising developments to come out of the pandemic was a recognition that meeting challenges on this scale requires operating with the greater level of collaboration that became commonplace during the pandemic. Partners on both sides the deals agree that one of benefits of the unfortunate situation we've experienced over the last 18 months has been increased information flow. A more collaborative partnership model made it easier to get things done to the benefit of all parties and has the potential to continue to do so.

The analysis presented in this article stems from McDermott Will & Emery’s HPE Europe 2021 virtual conference and a session examining the current challenges in healthcare private equity. McDermott partners Sharon Lamb, Stephen Rau and Anthony Paronneu served as session moderators, joined by industry professionals Andrew Cannon of Voyage Care, Garrett Turley of August Equity, David Furness of Independent Healthcare Providers Network, Dr. Michael Ruoff of Greenpeak Partners, Andre-Michel Ballester of Archimed, Françoise-Henri Boissel of Novadiscovery and Joris Pezzini or Alira Health.