Recently, I was a panelist for an event focused on trends in middle-market private equity. As our moderator was reviewing potential questions, I knew the standard “What broad themes are you seeing in middle market PE?” would be asked of me. I quickly jotted down the following: unused allocated capital toward PE, competition for deals, access to cheap debt capital, etc. I stopped, reviewed my answer and quickly asked myself, “Is this 2018? 2017? 2016? 2015?, etc.”
What to do in this environment if you are a PE firm (or family office, independent sponsor or strategic)? As the lower-to-middle M&A market has become more transactionally efficient—information flow is very strong—the flow of capital to
PE firms from LPs has increased dramatically due to PE’s attractiveness as an asset class. Leverage is easy to access and remains relatively cheap, and valuations have increased. Pitchbook and other information data services regularly address this trend in their reports—the consensus seems to be that acquisition multiples have increased roughly 2x in the past five years.
The days of financial engineering are long gone. The opportunities for strategically sourcing undervalued, proprietary deals are scarcer as time passes. And upward pricing pressure on operationally complex (read: hairier) deals has increased. A banker friend of mine, whose firm specializes in marketing storied (again, hairier) situations, tells me that the multiples have grown and tangentially thinks the delta between storied and well-performing companies is not as wide as one would think! Same characteristics, higher price. Even larger PE funds that developed sophisticated direct sourcing efforts have changed their focus. As an ACG New York Board member, it surprises me that they are aggressive in their direct outreach to their smaller PE brethren in order to understand their portfolios and develop strategies to get ahead of the inevitable auction processes, as evidenced by the successful PE to PE Deal Source Event held in May 2018. As a result, many larger PE funds now go so far as to maintain full-blown “shadow portfolios” of companies they like, drawing up detailed business plans long before they ever come up for sale so that they are ready to pounce.
Here are the three major areas in which a PE firm can be competitive:
Value creation counters high entry multiples and drives returns. There is a shift among PE firms to focus not on cost cutting but instead on tangible value creation activities that are growth-oriented. Operating partners, supply chain consultants, talent management strategists and IT professionals are all examples of value creation providers who are seeing significant growth in their practices with PE portfolio companies. Growing top-line revenue, combined with prudent cost-containment management and an effective add-on acquisition program, is an effective investing strategy to counter higher entry multiples and drive returns.
Industry specialization expands rapidly. Many generalist firms in the lower-to-middle market have recognized the need to focus their sourcing and investing activities on a small, select group of industries. By refining their industry knowledge, they can source better deals, become more attractive buyers, close deals in shorter time frames, and build stronger, more relevant businesses. Sellers and management teams do not care if you know and invest in many industries—they only care that you know their industry well. As one GP of a multi-billion-dollar fund told me, they can compete with speed due to industry specialization.
“Buy, build and enhance” is the way to go. A focus on just financial engineering does not work anymore. Leveraging up and paying down debt by cost cutting alone will not deliver the returns that LPs expect, especially when considering a 10x deal is standard in today’s market. A true “buy, build and enhance” investing approach, in which there is meaningful industry consolidation and also the ability to focus on value creation and leverage synergies, continues to be an effective strategy.
At ACG New York, we are committed to helping our members grow their businesses and remain relevant in a fast-changing M&A world through quality networking and value-added content. Our network of dealmakers, transaction advisory firms and value creation providers forms an ecosystem where everyone builds off one another. While it is true that our ecosystem starts and ends with dealmaking, the other components of the ecosystem are critical contributors to the success of any investment. And the ACG New York network is an efficient, productive and fun way to build and grow relationships that are relevant to your business or firm’s success.
David Acharya is President of ACG New York and a Partner at AGI Partners LLC (www.agi-llc.com), a PE firm based in New York City