Three key trends: Bracing for change

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Last year was record-breaking for US mid-market private equity firms. Data from Pitchbook shows that deal values for the group reached $600 billion across 4,121 deals, while North American mid-market funds collected an exceptional $273 billion, according to data from affiliate title Buyouts.

Against such a backdrop, and combined with fresh challenges such as increasing inflation and lingering pandemic concerns, it is perhaps unsurprising that this segment of the market is unlikely to top last year’s activity levels. However, market onlookers say opportunities are still available for private equity firms able to position themselves favourably against incoming headwinds.

Here are three trends that are set to impact the US mid-market over the coming months.

Planning for the future

Such a steady year for deal volumes in 2021 may have been great news for swathes of US mid-market firms but, as with all waves of activity, there will be peaks and troughs, industry commentators warn.

Joe Hartman, national co-leader of private equity transactional services at KPMG, says: “We are seeing deal volume down about 15 to 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.”

Taking a long-term view on investment strategies may be the best solution for private equity professionals battling uncertainty among portfolio companies. 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.”

Peter Witte, global PE lead analyst at EY, adds: “What will differentiate the winners from those that don’t do so well is having a strong, differentiated and really compelling value proposition.

“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.”

Zeroing in on value creation

Rising interest rates and an increasingly uncertain environment could impact the amount of debt that private equity firms are willing to use. As such, value creation is becoming an increasingly important lever for firms looking to offset debt challenges and generate returns.

“When markets are more jittery, private equity starts talking more about value creation,” says Christian Zabbal, a managing partner at Spring Lane Capital. “The challenge is it cannot be done in a few months. It takes years to build an operating group that works well. And if you don’t have that culture of adding value, it’s very difficult to shift gears.

“Setting up an operating group is getting more in vogue now… and more firms have been forced to create a strategy where they add value.”

Tensions between the deal team and the operating team can cause friction during this process, according to Zabbal.

Firms looking to drive value creation within their portfolio companies amid this uncertainty have several options available to them. According to Matthew Frankel, a managing partner at Levine Leichtman Capital Partners, useful levers can include revenue growth, geographical and sales force expansion, add-on acquisitions and boosting operations and supply chain opportunities.

Technology is another part of the solution, according to Peggy Roberts, managing partner for the Riverside Company’s Riverside Capital Appreciation Fund, who says that companies can also use technology and automation to build a more defensible position and better manage their supply chains, which can help them to create more value in challenging environments.

Another key consideration for US mid-market firms’ success over the coming months will be the impact of a slowdown in PE fundraising. Due to a crowded marketplace, overallocated LPs and other factors, many in the market may find that a rising share of LP capital will be split among fewer – either trusted or big, brand-name – PE firms.

According to data from Buyouts, some 164 vehicles secured almost $132 billion in the first quarter, down 24 percent from a year earlier, reversing a trend of major post-pandemic growth.

Drew Schardt, Hamilton Lane’s head of global investment strategy, tells Buyouts: “If you’re an LP in today’s market, life is not easy. You have a lot of difficult choices to make: ‘Which managers do I lean into? Which managers do I lean out of? Do I stay the course?’”

But smaller PE shops are not necessarily going to be shut out by LPs, according to several in the market, who say that investors value the relatively specialised approach of mid-market firms in comparison with their larger rivals.

“This is not a zero-sum game,” adds Schardt. “Most LPs recognise the value of diversification, of accessing different segments of the market. They know, ‘If I’m only doing large and mega-managers, I’m missing out on alpha.’”

LP allegiance

Another key consideration for US mid-market firms’ success over the coming months will be the impact of a slowdown in PE fundraising. Due to a crowded marketplace, overallocated LPs and other factors, many in the market may find that a rising share of LP capital will be split among fewer – either trusted or big, brand-name – PE firms.

According to data from Buyouts, some 164 vehicles secured almost $132 billion in the first quarter, down 24 percent from a year earlier, reversing a trend of major post-pandemic growth.

Drew Schardt, Hamilton Lane’s head of global investment strategy, tells Buyouts: “If you’re an LP in today’s market, life is not easy. You have a lot of difficult choices to make: ‘Which managers do I lean into? Which managers do I lean out of? Do I stay the course?’”

But smaller PE shops are not necessarily going to be shut out by LPs, according to several in the market, who say that investors value the relatively specialised approach of mid-market firms in comparison with their larger rivals.

“This is not a zero-sum game,” adds Schardt. “Most LPs recognise the value of diversification, of accessing different segments of the market. They know, ‘If I’m only doing large and mega-managers, I’m missing out on alpha.’”