When does one realize when the ice is melting around them? Generally when it’s too late. Trend shifts and paradigm shifts are usually analyzed and considered after they have taken hold. As most industries mature common characteristics are evident. There are more market entrants, less differentiation, and price and deal pressures to gain business at reduced favorable economics. Today’s alternative asset allocation class of private equity is in such a paradigm shift. Attractiveness of the business model with its 2/20 compensation especially during a period of economic growth between 2002 and 2007 aided growth in an industry that has gained many entrants. Additionally smaller buy out shops, boutique investment banks, diligence specialists and a variety of consultants and service providers to the private equity space have emerged.

Market Statistics

Current 2014 industry performance statistics in PE are pointing to stronger M&A activity in the middle market but with some troubling signals:
  • Historic debt availability and pricing to the middle market is adding fuel to the valuation frenzy.
  • The wild card of corporate acquirers in this role is unknown. While they are often cited as the reason for high valuations, there are some PE firms winning auctions at these high valuations. This yields sub 15% IRR and companies in need of operational assistance and strategy at levels most PE firms have not had to deal with historically. Many companies in market are undermanaged and grew slowly or inconsistently between 2009 and 2014. This would be consistent with the US GDP numbers and overall economic growth and performance.
Perhaps the 40,000 foot conclusion is that PE like all industries can absorb new entrants and have a competitive market place providing the economy is strong. Historic data will probably show robust M&A in public and private classes is correlated to periods of overall economic strength. This is similar in some aspects to the ongoing housing crisis (an example of an oversupply of questionably valuated assets limits the ability for a market to improve); a market with excess of ready capital to invest is chasing inflated or underwater deals.

Value creation through strategy and execution at the company is how average companies are going to become better and how companies are found at reasonable and acceptable valuation multiples. PE is about value creation and restarting a new chapter in ownership. Slow growers of the last five years that have management issues in niche scalable industries are an opportunity for "value investment" level multiples. The question is who will validate the thesis and sweat the management details from the operating point of view in the market today?

Firms with industry focus and specialization can utilize their internal resources to source, validate and pre-diligence most deals and perhaps from prior deals and industry depth know of executives in transition or imminent transition. An inch wide and mile deep in a few specific areas could better serve smaller PE firms in this market. If a firm does not have such a strategy or internal operational talent then working with consultants specializing in PE business development can help in this transformation of strategy with better execution and resource use. Business development for PE cannot work with limited resources and as the last priority role of partners to source deals. Other options have become expensive, buy-side banks and independent sponsors, or with less certainty (associates and junior partners more experienced and with a preference for deal structure and execution).

Such thesis and investment focused firms (along with the generalist firms) utilize the newer role of the industry expert-board advisor executive. This person is typically unpaid and works with the PE firm to ask the questions at management meetings and educate the PE firm on the industry, opportunity, operational issues and the add ons and exit issues. All PE firms are using this resource now due to the glut of under employed executives in transition. The end game of an auction process can become 'who found the best executive to bring to the management meeting to show off to the intermediariary and/or the target company?' While this does enhance deal possibilities from a knowledge point of view and does divide up work to some extent, is it the newest low cost approach to diligence and deal flow?

Operating Partners

The other function is the Operating Partner. This person plays a role of executive mentor, 40000 foot eyes above a certain company in need of skills on a temporary basis and does a large degree of the post-closing implementation of strategy for the first 100 days with management where needed. Once past that area, the operator goes to other firms to perform a similar function but also becomes involved in deal teams, origination and tool kit developer and implementer. Not all PE firms have the luxury of this group. It should not be confused with the less focused industry expert model. It’s a surrogate which rarely will provide the same success. Development of full time, PE firm integrated Operating Partners is vital going forward especially for firms with industry focus. With a focus area, the repetition in related industries and situations develops a strong bench in the firm and a competence to go after the harder more trouble companies. This is where deal flow will thrive while supply and demand of deals and dollars as the balance of such supply and demand work themselves out.

This paradigm shift is playing out in business development strategy, diligence, deal execution, 100 day planning and exit strategy ideation. Business development at the PE firm needs to be embraced through its culture and have the same consistency as the companies they own.

Parting Thoughts

  • M&A is more robust with valuations along historical trends when the macro economy is healthy and growing. Supply and demand of deals and capital align better.
  • In the absence of that alignment and balance the valuations are too high, the debt is currently fuel for it and weaker companies become the segment of focus for deals in the value investor range of 4.5-6.5X cash flow.
  • PE firms will need consistent deal flow and diligence talent internally to validate actionable (yet challenging) deals in a more rapid and ongoing way.
  • PE firms will need to stretch the 2% management fee across many areas to run the business more efficiently today. Business development resources and efforts with PE fund culture and investment needs will converge into the requirement to have business development and execution strategy experts.