The private equity landscape has fluctuated significantly over the last two years. Following the record investment of 2021, 2022 began strongly but finished the year in a much quieter state. So, what are the prospects for 2023? Marcus Shah, a Partner within our Private Equity practice, spoke with Simon Hill, an experienced Partner at Liberty Corporate Finance, to gain his expert insight into the current state of PE, and offers some fascinating views and advice for the next 12 months.
Marcus Shah: Simon, how would you characterise the current state of the PE sector?
Simon Hill: There is a definite difference between mid-market and large caps. The market generally got a bit tougher in H2 last year because of a range of economic and macro headwinds. It was harder to get deals done in the mid-market, but the better-quality assets and/or those in less exposed sectors were still viable whereas for large caps – things almost entirely ground to a halt.
For the deals which did successfully trade, in many cases there were pricing gaps to bridge. Some vendors may have held on a little too long for a price they would have achieved earlier in the year, so had to take some hard decisions on whether to bank a return or pause.
There is a general expectation that deals will pick up across the board as we move towards Q3 and Q4 of this year. Nobody knows quite when the floodgates will open; it feels as if someone needs to unleash the capital and get things moving.
Very recent events with the US bank insolvencies, SVB in particular, will no doubt have a bearing but hopefully can be contained through the swift action of regulators and market participants. It is clearly too early to tell on that…
MS: How is the market different compared to two years ago?
SH: You’ve almost got to erase 2021 from the record books. It was an extraordinary year; because of COVID deals were being transacted almost entirely over Zoom at premium prices in just a few weeks.
We have returned in some ways to a more traditional style of deal-making, with processes themselves taking longer again; four to five weeks in round one alone. Even when we do get back to a buoyant market – which will happen at some point – despite the efficiencies that a Zoom meeting might offer, people will want to have key meetings in person with the various counterparts on the deal. You simply won’t be able to cram in the number of deals that were driven by the unique circumstances we saw in 2021.
With continued uncertainty and nerves in the markets the quality of the assets is in greater focus and, as a result, the hold period for owners may stretch out.
If you are coming to market, you need to have a good story to tell, you must expect people to scrutinise it more closely and commit more time to the diligence process.
You need to prep a deal thoroughly and not cut any corners, which might have been an option a couple of years ago. There is a higher level of rigour around that prep and information gathering. As a consequence, the timeline of hold periods has generally been extended. People are less inclined to rush into anything, with timing of exit being a topic on many boardroom agendas.
Where there is less of a rush to launch processes, that has perhaps led to more management change. If people have more time to hold and prep their assets, they may look to replace that member of the team who is good, but not great, or bring in new roles to bolster the team and make sure it is properly built out before the deal is launched.
Another trend we are seeing in the market now is a greater degree of creative deal-making. People are not just simply buying a business in a competitive auction, holding it for four years and then selling it on in the same way. Often the “angle” for the buyer here may have simply been their ability to buy quicker and pay more than the competition.
There is a greater inclination to buy a business because of a real strategic benefit; it can be merged with another in the portfolio, a fund has experience in the sector from past successes and is buying to create a new platform to buy-and-build, or a fund is buying in a club with another fund, because they have a complementary focus and can thus combine strategic knowledge with, say, tech expertise.
MS: How does that change the protections that are built into deals?
SH: Generally, the management teams (and their investors) are thinking more about the what-ifs – the things that could happen that you need to protect against that you probably did not need to think about five years ago.
For instance, we have seen a number of deals where the buyer is acquiring our client’s business and has then merged it with another to create a bigger group – which is entirely possible in the current market – and we have had to think about specific protections thinking around what could happen to people’s roles within that new structure and their invested instruments.
There has also been the growth in PE owners considering selling assets to themselves; fund to fund, or extending hold periods through the use of continuation vehicles. What happens if the current fund therefore decides not to sell the business to a market tested third party buyer, but puts the business into a continuation vehicle? What happens if it sells a minority share because they take on investment from another fund? How should management ensure they are fairly rewarded and protected in these situations?
Those layers of complexity, which are often driven by people trying to think of creative ways to get things done, add (even more!) layers of complexity to deals where independent unbiased professional advice is crucial.
So, we are now in a world with greater uncertainty, challenges with valuations, different and potentially more complex transaction types, and in many cases a longer runway to exit.
People are quite rightly being more imaginative and deal-makers, investors and managers of businesses are having to think more carefully and strategically about what they are doing.
MS: What are the main considerations for management teams in 2023?
SH: In terms of the practical impacts on the core commercials of deals, the first is the cost of debt, particularly in the UK. Because the banking interest rates have gone up so much, traditional leverage on a deal costs more than 10% now, having been several points lower than this for years – so with the bank debt costing potentially more than the typical investor debt, historically this has carried a coupon of 10%, the investor coupon on their debt is now moving more to the 11% and 12% level.
We’re also seeing more in the way of performance-orientated incentive plans. While you should still expect a rewarding base pool, there might be an element now which is linked to delivering a certain performance for the investor. This performance focused structure can, of course, be structured to be very rewarding and motivating to management however due to the link to overall performance it also gives more downside protection to the sponsor so that, if things don’t quite deliver, they haven’t shared quite so much of the pie.
As teams also look to retain and reward their talent, with the well documented inflationary pressures on wages, there has been a greater use of wider equity incentive programmes, which we expect to see more of going forward. Where the value of the equity schemes can be properly articulated and communicated it can make a real difference to the culture and performance of a business, as well as to staff retention and hiring of new talent. Offering people a stake in their own business, alongside the CEO and other senior Execs, is something that many of our clients in recent times have embraced. They see real cultural and performance improvements through a balanced package of fair comp packages alongside an exciting longer term incentive plan which is directly aligned to the overall business’s performance.
As mentioned earlier, the management have to be aware that the runway to exit may take longer than expected and the prep phase, which is always a distracting time, may be more arduous on them and their teams.
When it does come time to go to market, the likely outcome in terms of the deal shape and size can be quite a broader church than ever. It might be a strategic buyer, but you need to reinvest? It may be the PE deal you were aspiring towards, but are you then being merged into another business they own? Will your current sponsor actually stay invested for a minority, or indeed majority, interest? Most teams would still say that a straight PE deal is still the ideal and will be the easiest to execute, but there can be both attractions and risks to a more imaginative style of deal.
MS: How do you see things playing out in the rest of 2023?
SH: It feels as if there is a growing desire to get things done. Q4 this year could be interesting, if that is the moment when the capital starts to flow again. Clearly events such as SVB may impact timing of deal flow too.
Right now, things are a little uncertain and maybe you will not get the absolute best price. But if you have a really strong software asset that ticks all the boxes, you can still command an excellent price. Maybe not the 30x EBITDA you could have achieved back in the heyday, but certainly well north of 20x multiples.
That is a small cohort of companies right now, but I wonder if that funnel will expand towards the end of the year as the capital and appetite does come back.
Get in touch with Marcus for a confidential discussion around your Private Equity needs. Marcus is responsible for delivering interim management solutions for Private Equity clients by supporting both funds and their portfolios throughout the investment lifecycle.
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