The past few years have caused a lot of uncertainty and change in the macroeconomic environment, in particular for private equity groups (PEGs). In 2023, the private equity landscape has seen:
- Exponential growth in company valuations from 2020 through a 2022 peak and more recently a decline back to normal levels (historically speaking)
- Significant amounts of dry powder (i.e., liquid capital on hand) available to be deployed
- Top-tier investments becoming more difficult to source and complete after many A-grade companies were acquired during the peaks of 2022 activity
- A more challenging leverage environment, with increased diligence requirements, stricter lender parameters and a higher cost of capital
- Rising interest rates across all transactions, which have resulted in a more expensive cost of capital than in recent years and contributed to reduced valuations
- Inflation impacting margins of existing portfolio companies and creating uncertainty about new opportunities
PEGs have a variety of tools at their disposal to respond to this environment, such as whether current conditions represent an opportunity to pivot from existing strategies. The ideal strategy for a specific fund can depend on numerous factors — including the stage in its life cycle, the amount of capital available and the overall risk appetite of the limited partners and fund managers.
For funds and managers that are bullish about the market, it may make sense to be opportunistic in what is otherwise perceived as a risk-off environment, especially in areas of deep expertise. Being opportunistic may require funds to develop frameworks for success based upon specific needs, such as ensuring the right management team is in place and quality systems are implemented to allow for real-time reporting and managing of the business. At the same time, it is important to allow for flexibility in approach provided the business fundamentals and post-closing frameworks are in place. This may mean executing investments that would otherwise not be considered or may have been superseded by other opportunities.
To take advantage of this approach, it is important that PEGs are able to quickly understand the drivers of a particular market or a business and then readily determine value in order to secure acquisitions at an attractive valuation while also being competitive. This will almost certainly have to include both performing and nonperforming businesses, as there are opportunities that lie on both sides of the market. This is an area where deep expertise will set PEGs apart from acquisition competitors.
The opportunities in a performing business lie in those that have a sound business plan and history of successful execution and may need support or expertise to reach their full potential. Businesses in a well-performing industry with strong management and a track record of hitting targets may require equity capital in order to scale. This capital may not be readily available from debt markets or existing equity holders for a number of reasons and represents an opportunity for PEGs to deploy capital to allow this business to scale and bridge the business to a higher valuation.
There are also opportunities for returns in nonperforming businesses, although they come with different and more pronounced risks, especially for equity investments. A critical factor is to balance due diligence alongside a sound understanding of fundamentals and a path back to desired performance. PEGs can then ensure the terms of their investment are commensurate with the risks involved in making an equity investment in an underperforming business.
After performing an appropriate due diligence process and understanding the reasons for underperformance, PEGs can ensure investment decisions are fully informed. For example, there may be an opportunity to turn around nonperforming assets by identifying executives to refocus the business; or looking at acquisitions to an existing portfolio company to allow the underperforming business to be nurtured back to health as part of a larger organization.
Diversification can be a key element in a PEG’s investment strategy and can take shape in multiple forms, each of which re-assesses a PEG’s prior evaluation of target market, such as:
- Expanding the geographic locations of investments, especially within the domestic U.S. to avoid overseas complications
- Engaging in a variety of deal sizes, especially for add-on opportunities
- Considering different deal structures — for example, minority investments, credit opportunities, etc.
- Exploring secondary investments
- Expanding to different industries
A diversification strategy seeks to allocate a firm’s investment risk across a variety of areas, each with different risk profiles. However, diversification is not a security blanket and can often result in lower returns in line with lower risk. If a PEG has expertise in a particular industry and maintains a disciplined approach in identifying and nurturing its investments, then long-term results can still perform well without the need for significant diversification. Diversification should not exist solely for the sake of reducing risk (though it can be a good tool for this), but instead represents an opportunity to expand the investible universe alongside the right expertise and discipline.
Diversification across geographic locations can be as simple as spreading investments across regions or as complex as across countries. This approach may not be as appealing to a broader audience due to limited resources and a preference for close physical presence. Further, global markets introduce a multitude of other factors, including foreign exchange risks, geopolitical risks and international tax compliance, to name a few.
It is important to consider the benefits of spreading investments across different locations. There may be beneficial opportunities in a specific area, often in the form of additional government funding provided to a city or country for economic development. PEGs may feel inclined to consider a new location if it comes with favorable regulations, macroeconomic conditions, demographics and other factors.
DIVERSIFYING DEAL SIZE
Deal size can be another way to incorporate diversity into an investment strategy. Smaller investments may provide some protection against losses, but they also can restrict returns in absolute terms. Further, smaller investments may limit the ability of a PEG to fully deploy a fund, resulting in more dry powder on hand that does not have the ability to generate desired returns.
That said, platform acquisitions with the ability to generate value through add-ons provide a strong mix of both and, after the flurry of 2022 transaction activity, they are becoming an increasingly common approach for PEGs to stay acquisitive.
DIVERSIFYING TYPES OF DEALS
Another form of diversification could be the types of deals being completed. With rising interest rates as the Federal Reserve combats and attempts to control inflation, it may be time to consider structured debt investments.
A fund can issue debt in the form of loans, convertible notes or — in the case of a struggling company — distressed debt. Debt investments also provide investors with incremental security in the event of default, at the expense of lower potential returns when compared to equity investments. However, given the opportunity to deploy funds at acceptable returns, many PEGs are introducing debt instruments as equity opportunities remain fewer, relative to recent years.
Alternatively, for PEGs who are unable or unwilling to establish a debt profile, such opportunities can be accessed by investing in existing credit funds, i.e. funds that are already engaged in debt investments. This allows a PEG to have access to multiple investments using fewer resources, albeit at reduced returns.
Most funds have a niche focus for their investments, with deep experience and expertise in the industry. If a downturn impacts a particular industry, there is a risk that the PEG will experience an outsized impact.
Diversifying between industries can help offset losses by participating in another industry that is performing well and experiencing gains during the same time period. However, many funds are set up and designed to serve one industry where the fund manager’s experience lies and where there is ample investment opportunity.
A fund with a proven track record is more likely to tolerate short-term swings in performance as it has confidence in business fundamentals, the confidence of its limited partners and access to expertise to navigate short- and medium-term business challenges. However, systemic risk in a specific sector is difficult to mitigate without broadening to new industries, even if those industries are somewhat related. This type of expansion also allows existing expertise to be leveraged in new markets.
DO NOT BE AFRAID TO HIT RESET
Many PEGs are “hitting reset” by reviewing the operations of existing portfolio companies as well as at the fund level.
To assess its current environment, some key questions to ask include:
- People: Do the fund and its portfolio companies have the right people and right roles in place. Are there any opportunities to acquire competitors, customers or talent in the specific market space?
- Strategy: Does the strategy require a different skill set to excel in these economic conditions versus the prior cycle, and does the current cycle require a fundamental review of strategy?
- Systems: Does the company have the right systems in place to analyze, understand and manage its business on a weekly, monthly and quarterly basis?
The private equity landscape is constantly changing. The success of a PEG is contingent on the group’s ability to adapt and redirect its course or continue to strengthen its investment strategy. Evaluate what has worked well in the past and what potential mistakes or pitfalls were made in the past, and then consider the impact of those results on the overall strategy.
Please contact GHJ’s Private Equity Practice to further discuss these strategies and how your PEG should respond to changes in the marketplace.