When domestic concerns about COVID-19 began rising in early March, an initial reaction from investors was to announce they were "open for business," pandemic be damned. Roughly 6 weeks later, the noise is starting to die down, government intervention has taken some shape, and we're left with reality. The reality is that the future is murky. Although interest rates are at record lows, the required rate of return being demanded by investors in illiquid investments has skyrocketed. Not only has the immediate risk of permanent loss increased, but since no one knows what the other side looks like, it's difficult to determine a fair value. Access to capital markets are nearly shut for SMBs (small and mid-sized businesses, GM&A). Deals can transact, but the terms will be structurally different.

WHY WILL DEALS CHANGE?

As long-term investors, opportunity is not defined by current circumstances. But for owners, operators, and investors in private businesses, any attempt to be thoughtful requires consistently reevaluating "truth" in light of new information. Up until Wuhan's shutdown, the idea that an entire region could be forcibly closed sounded like an outdated risk better ascribed to previous centuries. This pandemic has introduced new information. Here is how we, as investors, intent on continuing to invest, are thinking about those shifts:

EMBEDDED RISKS

This pandemic highlights the risks embedded in every investment. It's impossible to name, let alone underwrite, every risk (although kudos to Wimbledon for underwriting against pandemics) and still invest. This modern example will not easily be forgotten, not only because of underappreciation of its likelihood, but for the magnitude of resulting global disruption. Risk is always present, especially when you least expect it.

FUTURE CONFIDENCE

Towards the end of last year, we heard repeatedly that there were no known weaknesses in the economy outside of labor constraints. COVID-19 illustrates that weakness can be natural, largely uncontrollable, and escalate quickly. Therefore, while hockey stick projections -- always up and to the right -- have usually been taken with a grain of salt, they will face increased scrutiny, as will reliability of past performance. Evidence of structural stability, agility, and optionality will mean more.

SOLVENCY & CASH RESERVES

Up until now, questioning what happens if demand dips dramatically was largely seen as a theoretical exercise. The current state of affairs not only pushed theory into reality, but the sharpness of decline demonstrated the value of the thought experiment. There has been plenty of public debate about responsible levels of liquidity and balance sheet strength. Going forward, transactions will include more working capital and less debt.

CREDIT CONSTRAINTS

As a buyer not keen on leverage, looking for opportunities to invest in the past few years has sometimes been frustrating. Competitors were willing to pay more by adding turns of debt. Over the past few weeks, credit has frozen with most lenders having no appetite for underwriting anything new. Credit markets will reopen, but, like equity investors, their appetite for risk will have shifted. This will likely change debt-to-equity ratios and valuations meaningfully.

HOW WILL DEALS CHANGE?

We've been talking to many peers, intermediaries, and owners over the past two weeks about the impact of COVID-19 for them and the organizations they represent. Everyone generally agrees about the new information above, but there is little consensus on how and when deal-making will operate in the future. It has been suggested that very few deals will close in 2020, and perhaps in 2021. Valuable businesses exist that need liquidity and a transition. Owners are still aging, or lack the desire and will to slog through the next recovery alone. With a new fund to invest, we are active and exploring opportunities. Here's how we're approaching deal-making for the foreseeable future:

CAP TABLE FLEXIBILITY

Because of our intent to partner long-term, we've historically only considered opportunities where we can buy a majority or all of the equity. Changing circumstances call for adjustments and we're now considering alternative types of investments, including minority equity investments and providing debt. There will be good businesses that don't want to value the majority of the company in the mid-term, but want to initiate a relationship. Any minority investments we consider an on-ramp to a long-term relationship.

RISK SHARING

Given the renewed appreciation of risk and current economic volatility, transaction structures will likely include additional risk sharing. Beyond cash at close, future payments are more likely to be dependent on future performance.

NO EXPLORATIONS OR GAMES

Over the past few years, many business owners have "explored" a sale, getting a sense of what types of buyers and valuations the market would yield while confidence was high on both sides. Many intermediaries have focused on broad processes with strict deadlines. As a lack of leveraged capital diminishes high-risk offers, we expect certainty of close, conservative capital structures, and sensible timelines to be priorities.

NO OUTSIDE PARTIES

We intend to continue investing with structures that provide the easiest path to close. Due diligence is conducted in-house by our financial, operating, and legal teams. Our offers rarely include outside funding sources.

MESSY SITUATIONS

We've always been willing to explore messy situations and that remains true now more than ever. People are messy and businesses are collections of people. When the current situation is mixed in, we anticipate brainstorming around some unusual, unexpected, and undesirable circumstances.

LONG-TERM ORIENTATION

As Munger and many others have said, no one knows what's going to happen. Fair deals can be designed to appreciate both current volatility and long-term viability. As always, the first step for us is to do no harm. If a transaction now is not prudent, we will say so. However, if there is a win-win path forward, we will do the work and put in the time to get to know one another.

It's easy to say "We're open for business," and many investors are saying all the right things. So yes, we too are open, and by that we mean we're actively in discussions, diligencing opportunities, and have the team and capital available to close transactions in the coming months.

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