Opportunities for value creation in today’s environment

Eight months ago, we were coming off a record year in private equity M&A. Investors were looking to ride the fundraising wave of 2021 into 2022.  We were seeing more deals and more profitable exits. Fast-forward to the present, and the focus has flipped to recession risks and concerns.

What’s different about today’s economic climate, and what does it mean for private equity?

If we do dip into a recession, its composite parts— higher gas prices, inflation, and increased borrowing costs— resemble more those of the recession of the late 1970s/early 1980s than of the Great Recession. What’s different today is the abundance of private equity capital that’s in play. We’re seeing firms venture into nontraditional verticals as they seek to put dry powder to work and generate returns for LPs.

There’s still a tremendous amount of competition, and as they look to insulate themselves from investments subject to cyclicality or volatility—think consumer-dependent sectors and tech, which has been hit hard—that competition only grows. For example, professional services firms looking to scale are encountering competition from PE firms looking to outright acquire them or provide funding to be able to roll up smaller firms into a super-regional presence. Firms are chasing yield into traditionally less attractive industries. To me, that underscores the trend that there are too few targets and too many players; but at the same time, it’s forcing the industry to get creative. Capital providers seem to be increasingly nervous.

How will capital raising strategies have to adapt? 

Economic volatility has made some lenders a bit more jittery and noncommittal. Where syndicated loans previously could come together and be finalized well in advance of deal close, these lenders have been pushing back on terms until they know the interest rates. This is anathema in an environment in which the ability to get to deal closed quickly has determined a fund’s success of winning a bid.

We’re seeing fund managers turn more and more to private credit firms and direct lenders. Even though these lenders are more expensive than bank debt, they generally have longerterm liquidity and funding and aren’t as susceptible to shortterm interest rate increases. Competition for deals combined with market volatility create an opportunity for direct and private lending to become more mainstream.

Confidentiality, speed to execution, and lower underwriting standards make private lenders an attractive funding source. As far as fundraising, we expect to see firms tap more nontraditional investors—retail investors, high-net-worth individuals—as well as sources of capital in South American, Asian, and Middle Eastern markets.

In this context, how may post-M&A integration challenges evolve?

While value creation has always been core to deal strategy, the sudden intensified focus fund managers are placing on post deal performance improvement strategies today is unprecedented. Anecdotally, I can tell you that in the fall of 2021, our clients were most interested in the exit planning. Now, they have been most interested in the value creation. In the last two years, value creation strategies have evolved. A firm paying 15x EBITDA with 8x leverage, for example, has to be on its game to service that much debt and generate the desired return on equity. Whereas before, managers may have identified and focused on a few components of the major pillars of value creation—such as sales growth, overhead reduction, gross margin improvement—today, their strategies are more targeted, interrelated, transformative, and synergistic.

For example, they are looking at optimizing their products, services, and geographic segmentation strategies, as well as transforming their business processes in areas such as finance, customer service, procurement, inventory management, and payroll. These kinds of strategies require experience and a deep understanding of an acquisition’s sector and unique attributes. The performance improvement and value creation that private equity is going to need to employ in their portfolios is going to be critical to achieve the rates of return LPs have come to expect. The most sophisticated buyers in this market are scenario planning further into the future to make sure that the deals they complete today still look good three, five, maybe even 10 years from now.

What silver linings could exist should a recession occur?

Private equity is one of the most adaptive and creative asset classes in the market today, and a recession could make for a very interesting marketplace. When public markets sway, investors turn to the stability of alternative assets, and private equity has trillions of dollars in dry powder to deploy, in good times or bad. In a recessionary environment, EBITDA and multiples typically come down, and leveraged loan and high-yield bond defaults are likely to rise.

I suspect a lot of assets will shake loose. We’ll see a shift in the types of deals that have been done; more reasonable valuation terms should motivate private equity and hedge funds to deploy capital en masse. Plans for distressed investing, which saw a spike at the beginning of the pandemic and have been steadily declining since, but should see a resurgence of interest. Wherever the economy ends up a year from now— recovering, stagnant, or in full-on recession—private equity usually positions itself to make the most of evolving market opportunities.