This Q&A was published as part of PitchBook's 2021 Annual U.S. PE Breakdown Report sponsored by Baker Tilly.
The private equity landscape has faced numerous changes over the course of the last year and continues to evolve. Bill Chapman and Brian Francese provide PitchBook with their insight on trends in dealmaking, exits and fundraising that are defining the industry.
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Certainly 2021 was another interesting and challenging year in the private equity space. Numerous dynamics changed over the course of the year. In some respects, the PE landscape that we saw in January, February, and March looks nothing like the current landscape.
Nine months ago, speed was a differentiator on the buyer side. Now, dealmaking cannot necessarily move that fast since everybody is backed up with the high volume of deal flow. That's not just on the accounting and finance side. We also see this trend with attorneys, environmental engineers, and all the professionals involved, as well as the Department of Justice (DOJ) in cases where you have to file a Hart-Scott-Rodino.
We’re also seeing companies utilize backup plans more than they did in the past. Companies are trying to predict the next unforeseeable event. More than ever, companies are trying to be ready for anything.
Additionally, investors are being more thorough and broader in what they are looking for from their diligence teams. We're seeing more investors expressing that they want to see everything now. In addition to a company’s quality of earnings report and the tax due diligence, they want to see IT, HR, commercial, and operational due diligence.
Finally, while analytics have always been a big part of due diligence, we’re seeing operational risk becoming more and more important. A company claiming that they have a customer concentration simply isn’t sufficient anymore. That's just too thin. It’s not a thorough analysis of the risk profile of the business. Buyers don’t just want to see the earnings. They also are interested in the free cash flow and the risk profile, because that will indicate how sustainable those earnings will be. That's the kind of ask that we are receiving more frequently now.
We've seen companies’ free cash flow becoming an increasingly important measure during the deals process. In a lot of cases, simply looking at EBITDA as a pricing metric just doesn’t cut it anymore.
A story can always be told to make numbers sing and dance, but you really can't fool cash. We've seen EBITDA metrics skyrocket and free cash flows plunge 45 degrees into the dirt within the same company. But in a situation like that, you've got to find out what's really going on. PE funds are looking a little more closely into economic earnings, and they're walking away from deals that aren't generating the level of free cash flow that they initially expected.
Time is the biggest enemy of a deal closing. So, when PE investors speak with management about their cash flow forecast, how quickly management can answer those questions with supporting data that they're comfortable with—assumptions that can be validated by the quality of earnings or independent third-party data—is becoming more important. This is especially true as PE firms’ diligence procedures are looking more closely than ever at data and expecting management to explain the reasons for ebbs and flows in the historical cash flows and the financial model. It’s more critical than ever.
To begin, it is important to note that in this case, we’re talking about high growth of economic earnings, not high growth of revenues.
With this in mind (and this of course is nothing new), PE funds are taking advantage of their operational partners to build on any existing synergies. If a company’s workflow is in a tangle, so to speak, their PE firm can offer the assistance of industrial engineers from their staff to help untangle the business. Perhaps they have existing professionals who can help with inventory management, or purchasing, or bookkeeping. In some cases, building on those synergies is enough to squeeze another half-percent out of their free cash flow.
Due diligence—specifically operational due diligence—can help identify those synergies ahead of time. As we tell our clients, the due-diligence process (or, in our case, the quality of earnings) not only helps validate an investment thesis, but it helps provide critical data to prepare a post-transaction plan.
That’s a value strategy that PE investors are using to get that edge. Specifically, they are starting to use statistics and analytics to look for synergies and more efficient ways to spend their money. We expect these trends to continue in a major way in 2022.
The sheer volume of deals that came to market accelerated in 2021. If you expected it to slow down after the election, like many of us did, you couldn’t have been more wrong. We are seeing continued activity now, not so much for fear of higher taxes as we go into 2022, but because in addition to a lot of money still chasing deals, business owners are concerned about the potential of another unforeseen major event.
Bankers are still asking us to do sell-sides right now. Not because they want to try taking a company to market before year-end 2021, but because they're going to take it out in the first quarter of 2022.
Additionally, exits in the public space just “hockey sticked” this year. Considering the requirements to go public and do an audit process, that was an eye-opening experience for a lot of finance teams within the companies themselves.