After US mid-market private equity dealmaking reached record heights in 2021, a drop-off in deal volumes this year was not wholly unexpected. M&A activity more widely has also slowed down across the US mid-market – the number of M&A transactions in this segment declined by 18 percent in H1 2022 compared with the same period in 2021, according to the latest Refinitiv data. When you throw in a raft of macroeconomic and geopolitical headwinds, the fact that volumes haven’t fallen further is a sign of a resilient space ripe for more private equity deals, say commentators.
It is not an easy market in which to operate. Jared Broadbent, head of fund services for North America at Alter Domus, says: “Although 2021 was the busiest year on record for US mid-market private equity activity, despite an ongoing pandemic and supply chain issues, a host of new uncertainties promise to create additional headwinds for activity in 2022.
“These challenges include the ongoing war in Ukraine, historically high inflation, and a Federal Reserve Board that is aggressively raising rates to try and combat the impact of inflation. As a result, the US IPO market experienced a significant slowdown in the first half of 2022 as valuations decreased and the ability to finance acquisitions efficiently was impacted by rising interest rates.
“Private equity managers are already dealing with reductions in profit due to increased labour and material costs. They’re also facing an increased cost of capital due to rising interest rates, while facing a reduction in deal values leading to smaller than anticipated exit values.”
“There are a lot of opportunities to buy compelling companies at good valuations not seen for a while”
Against this challenging backdrop, dealmakers say activity has paused but far from dried up. Joe Hartman, national co-leader of private equity transactional services at KPMG, says: “Our clients see interest rates up and debt availability down by a turn or a turn and a half. That is putting some pressure on the capital structures of assets, and all of that plays into valuations. There is a short-term pause as buyers and sellers align on the changes that have taken place in the last couple of quarters and what that means for valuations.
“We are seeing deal volume down about 15-20 percent on a year ago and we envision that playing out for another six months or so as things stabilise. But there is record capital available to private equity, fundraising is still very strong, and long term we know that private equity invests through the cycles, so we will get back to where we were.”
Howard Morgan, a managing partner and co-founder of Argand Partners, a US mid-market private equity firm focused on manufacturing and business services companies, still sees opportunities in the market, particularly when it comes to add-on deals. “Given our desire to really dig in on maybe 10 deals at any given point in time, we are definitely staying busy today,” he says. “There is a disproportionate number of very interesting add-ons out there, some of which are large enough that they might otherwise be platform deals.
“The market remains active for those kinds of deals and we are definitely finding opportunities and spending more time in that area. Add-ons are a lower risk proposition for us – we know the industry, we are a strategic buyer and we are bringing a lot more to the table than just capital structure.”
Opportunities among disruption
While there is an expectation gap between buyers and sellers on pricing right now, there is an argument that deal activity will pick up again around a new normal later in the year. Morgan says lessons were learnt in the global financial crisis, when many private equity firms backed out of the market and then wished they hadn’t, because there are typically great deals to be done during periods of disruption.
Indeed, Hartman expects private equity firms to capitalise on the challenging climate: “Generally, when we see recessionary dynamics or a pause, more capital comes into private equity because they are looking to invest in assets for the next five to seven years,” he says. “We are still seeing record levels of capital coming in and we think that will continue or expand into next year.”
Despite the pressures companies are facing, Peter Witte, EY’s global PE lead analyst, also believes there remain plenty of opportunities: “People are looking for idiosyncratic situations that can withstand the volatility we are seeing, which means avoiding things that look like fixed-income bonds and looking for things with price protections under long-term contracts, or things that have a measure of barrier to entry.”
As conditions become more trying, firms are placing a greater focus on
value-creation fundamentals. “There are a lot of opportunities to buy compelling companies at good valuations not seen for a while. But in the portfolios, private equity firms are probably going into a period of margin compression and financing is getting more expensive,” notes Witte. “That means it all comes down to the operational value piece: supply chain management, human resources, digital transformation, pricing, sales force optimisation and all those things that private equity does to help companies get better. Private equity firms have built out those capabilities to a significant degree in the last decade and they are in a good spot to deal with this volatility.”
“There is a short-term pause as buyers and sellers align on the changes that have taken place in the last couple of quarters”
During times of volatility, PE firms may also benefit from taking a longer-term view. Anthony DeCandido, a partner at advisory firm RSM, says: “The right thing for any GP right now is really a walk, not run, approach. It is all about measured thoughtfulness. If you had a five-year plan, the level of volatility in the markets today means it is a much tougher exercise to even model out earnings. The good news is that, for those continuing to take a longer-term view, most of the inflationary shocks observed in the US historically have proven to be short-term in nature.”
There is also a lot more scrutiny required going into transactions. “The investing climate in the near future will prove tricky for managers who hold record amounts of capital to deploy,” says Alter Domus’s Broadbent. “As the cost of debt rises, performance will likely suffer compared to returns created over the last decade. Due diligence will be essential to ensure managers are purchasing companies at appropriate valuations in the face of significant headwinds to growth.”
So far, there is little evidence of distress in mid-market private equity portfolios, though managers are doubling down to understand the impacts in each business.
“Clearly our clients are seeing commodity and input costs rising pretty substantially, and at the same time we have some pretty challenging labour access and rate dynamics,” Hartman says. “Each client is taking a very active evaluation of pricing power and for the most part portfolio companies have been very successful at pushing those increases back to end-customers and expanding margins a little bit.”
Witte adds: “We have not yet seen any significant distress in portfolios, but firms are preparing for that, and frankly the playbook for that is not so different to what they went through in the pandemic. It is all about having good visibility into the portfolio, understanding where the issues might be and understanding whether today’s environment meaningfully shifts your strategic priorities such that you need to pivot.”
“There is a disproportionate number of very interesting add-ons out there”
With so many headwinds across supply chains, interest rates, inflation and geopolitics, it is hard to point to resilient sectors because the impact tends to be company-specific, dependent on factors such as debt burdens, pricing power, the ability to recruit and barriers to entry. But private equity firms investing in the mid-market have long built such considerations into their selection criteria, meaning portfolios look broadly robust.
In this environment, the managers that continue to attract investor appetite are likely to be those with a differentiated and operational approach.
“What will differentiate the winners from those that don’t do so well is having a strong, differentiated and really compelling value proposition,” says Witte. “It is hard to be a generalist in this or any market, and that has been the case for years. So it is about specialisation in a particular vertical, theme or subsector and having a clear strategy for adding value to the companies you are acquiring.”
At Argand, Morgan says the firm has long focused on the global mid-market, working with both US- and Europe-headquartered businesses that operate in five or six different countries. “Clearly one of the concerns right now is geopolitical volatility, and that is an issue. But a more meaningful long-term analysis of risk is the diversification that comes with globalisation, because if you’re a single plant in Indiana, with a single supplier of raw materials in Texas, you are really not very diversified and that is a risky place to be.
“In a really fast-growing market, you could shift a lot of resources to revenue generation and make as much as possible, so there was a big focus on the sales structure for driving revenue. We are well disciplined and equally focused on operational issues, understanding costs and supply chains. In this sort of environment, that is even more important and is where people will be spending more time trying to add value.”
“The spirit of private equity is always to drive operating agendas and when better can they do that than in uncertain times”
Indeed, today’s challenging environment could be private equity’s time to showcase its value-add credentials. As DeCandido says: “The spirit of private equity is always to drive operating agendas and when better can they do that than in uncertain times when financial performance is so mixed? The propensity for companies to struggle is increasing and that increases the opportunity for private equity firms to drive earnings for the benefit of investors.”
However, the exit environment could yet create some challenges. “One thing we will be watching closely is the exit markets, because those need to respond more quickly to this public market volatility,” says Witte. “In the first half, it was a surprise just how much the IPO markets declined – with a 95 percent drop off in the number of private equity-backed IPOs – and the same with special purpose acquisition companies. It will be interesting to see how that dynamic plays out because that is an exit route that was robust and has now closed. On the other hand, the secondaries market is much more robust than a few years ago.”
Still, Hartman argues that the mid-market is less impacted by the pressures of rising interest rates and debt availability than the big deals, and he expects the asset class to continue to do well. “Even with some short-term pressure dynamics, capital inflows to private equity are at record levels, capital in the market is at record levels, and private equity really does invest in all cycles,” he says.
“We believe [PE firms] will continue to invest in this cycle, because that’s how they have generated returns in the past. We fully expect to see private equity as the leading asset class coming out the other side of this.”