The Deal and Donnelley Financial Solutions recently broadcast “The State of Private Equity: Current Trends and Outlook,” a panel discussion featuring host Daniel Perez, Director of Business Strategy for Venue Virtual Data Room at Donnelley Financial Solutions. Daniel sat down with Andres Saenz of Parthenon-EY Practice, Richard P. Prestegaard of High Road Capital Partners and Shamit Grover of MSD Partners to discuss the current state of private equity and the trajectory of transitions among private equity firms. This is part two of an overview of the hour-long M&A discussion, which is available online from The Deal. Part one is available here.
Deploying Dry Powder
Firms competing to invest their dry powder, in addition to chasing platform deals, are buying smaller companies that together add up to the desired EBITDA minimum. So instead of acquiring an organization with $7,500,000 in EBITDA, they will find one company with an EBITDA of $4,000,000 and another of $3,500,000. Together these businesses meet the desired $7,500,000 minimum. Carve-outs are another popular option, where firms focus on beating down the doors of large industrial or tech conglomerates to see where they can invest in parts of a company or companies instead of buying whole businesses outright.
On the smaller end of the market, sellers are aware what businesses are trading for in their niche. If their advisor tells them they should be trading for 9-10x, even if that’s far higher than reality, it creates another hurdle private equity has to clear to close the deal. In this case earnouts can bridge the gap. While not as clean or desirable to the buyer, earnouts are one way to overcome inflated expectations on multiples.
Trends are also emerging in the area of deal financing. Many funds now have their own lines of credit, a competitive weapon which has actually been around for years but is just now becoming more popular among private equity firms. A line of credit gives a firm something to leverage prior to a close or to fund the closing of a transaction. It also allows firms to shave off a lot of the time it takes to close a deal, because funding a transaction with credit eliminates the need to run around calling capital and arranging lenders.
The Trump Effect
Because these high multiples have been where they are for a couple of years, the panel discounted the notion that the increase is linked to the recent presidential election. The election may be affecting deals, but it’s too early to tell. Some sectors may be impacted, for example, by Trump’s campaign promises to reinvigorate investment in infrastructure. With talk of financial deregulation, spending on infrastructure and tax reform, the general sentiment is seen as more positive than negative. However, there is a lot of uncertainty around these and other policies, such as what will happen with international business deals.
While we can create models around different scenarios of what could happen, but there is no certainty around what will happen. It will be important for private equity to pay attention and respond to the impacts of forthcoming legislation. Certain sectors will be impacted more than others, such as businesses that seek to reduce the cost of healthcare or build homes.
High Level Trends and Exit Strategies
From a high level, larger organizations are able to try more things, from different types of funds to different forms of capital to different geographies. At the same time, we are seeing a great deal of specialization. So while firms can cast a wide net, they will only win the right deal at the right price if they have the knowledge, infrastructure, network and an idea of how to create value in that specific instance. People will get creative on a big scale as well as on a granular level.
Ideally, a private equity firm will sell an acquired company outright, as opposed to doing a public offering. There are times when IPOs are attractive, but currently an outright sale is more desirable. In smaller markets, an IPO is typically not even viable. And while strategic buyers are usually able to pay higher multiples based on the post-deal synergies they expect, this is becoming less of a factor as private equity has more capital to deploy and assets are limited.
Ultimately the best exit comes down to what’s best for the company in transition. A strategic buyer could be the best option for the business and the management team in place. Over the last few years, more than 70 percent of private equity sales on the large end of the market have gone to strategic buyers, a much higher percentage than previous years.
This is part two of a three-part series. Check back next week for part three and f you missed part one you can find it here.
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