Private equity investment slowed sharply in the second quarter, as lockdowns took full hold and economic conditions worsened. Globally, deal activity fell by almost half from the first quarter as sponsors agreed $61 billion of deals, according to Preqin data. In Europe, the figure was even more stark, as investment declined to $6.8 billion from $37 billion in the first quarter.

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The figures mask a fast-moving trend, however. Increased optimism and more buoyant markets globally led to an acceleration in activity towards the end of the quarter. Ardian's agreement of a consortium deal for a co-controlling stake in Infrastrutture Wireless Italiane for ?1.6 billion is one of the larger deals agreed, while a host of mid-cap investments have started to flow, such as The Carlyle Group's deal for a majority stake in French listed monitoring services provider ENVEA, valuing the company's shares at ?186 million. As the focus of attention begins to move away from protecting current investments to investing dry powder, there is a growing pipeline of new investments coming to market, and an improvement in financing available for high-quality businesses.

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Resilient Sectors and Businesses in Focus

Companies in sectors that have been resilient during the COVID-19 pandemic are attracting the most attention, notably technology, healthcare and telecoms. Others in more consumer-focused fields are also generating considerable interest, especially where the targets have a successful history of working through e-commerce channels. Private equity firms are reported to be circling Gymshark, the UK-based online sportswear brand, with a value of up to £1 billion put on the company.

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Optimism in acceleration of secular trends - such as physical exercise outside gymnasiums for homebound individuals, or a longer-term shift to working from home - is supporting companies that have found niches in these spaces and is helping drive investment appetite. Behind the optimism, however, private equity firms still need to take an in-depth and thoughtful approach to due diligence in the current environment.

Enhanced Due Diligence in the Current Environment

The availability of financing for private equity deals is another significant factor underpinning the recovery in deal activity. Lending is returning as banks and other yield-hungry investors look for opportunities to deploy capital into relatively low-risk businesses at attractive margins. Debt capital markets more broadly are also improving. Recent bond issuance in Europe has demonstrated that sponsors are still able to secure considerable amounts of leverage at attractive coupons, while still benefiting from flexible covenants.

Downside Protection Strategies

While confidence is returning and deal activity improving, there are a number of structures that private equity firms are using or considering in order to protect against known or potential risks.

1. Earn-Outs

Typically unpopular with sellers, earn-outs are now increasing in prominence and popularity as a means of getting deals agreed and bridging the valuation gap. Future payments can account for as much as 40%-50% of the consideration, protecting buyers from a deterioration in performance while offering the prospect of a full valuation for sellers who are confident in the company's ability to perform.

2. Down-Round Protection

Borrowed from the venture capital playbook and suited to investments in minority stakes, down-round protection entitles investors to anti-dilution protections if a company subsequently raises money at a lower valuation. It is a tactic that has recently been employed on deals in Asia, and is now increasingly being considered in Europe.

3.Flexible Funding

Since the onset of the crisis, private equity firms have been using convertible notes or preferred equity structures with warrants as a means of providing financial support to existing portfolio companies. As deal activity recovers, there is increasing scope for such structures on new deals, offering firms debt-like downside protection and the option to tap into equity-like upside returns should the company perform strongly.

4. Tor-hold Investment

When sellers and buyers have different price expectations, toe-hold investments allow private equity firms to take a small minority stake and gain board representation at an attractive price. Over time, they can use their position to gain more equity and even take control - with the initial entry investment helping average down the overall acquisition price.

Evolving Fund Terms

Notwithstanding their recent move towards the offence, private equity firms remain cognizant of the need to implement or maintain defensive strategies in their existing portfolio. Where invested funds have little firepower or time left to deploy capital, sponsors are adjusting fund terms to enable them to support existing businesses - in some cases putting additional investment into affected businesses to protect value, while doubling down on their strongest investments in others.

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