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Key trends that PE fund managers and their portfolio companies are paying attention to post COVID-19

This Q&A was published as part of PitchBook Q2 2021 US PE Breakdown sponsored by Baker Tilly.

What are some of the key trends that PE fund managers and their portfolio companies are paying attention to coming out of the COVID-19 pandemic period?

Five things are looming larger this year:

  • Workforce—attracting and retaining top talent
  • Sourcing of raw materials
  • Changing dynamics of business ownership
  • Environmental, social, and governance (ESG) criteria
  • Possible federal tax code changes

There is a shortage of labor, which can be attributed to a combination of factors, including workplace health and safety concerns, extended unemployment benefits, and lack of childcare and eldercare options. In addition to the operational challenges that the talent shortage presents, businesses have seen a deterioration in profitability as many companies are paying higher wages to stay competitive and have higher costs associated with recruiting and overtime pay for the existing workforce. Another concerning trend is employee morale. Burnout is prevalent across companies regardless of industry or size. Rewarding and retaining top talent is a critical risk right now for many companies.

Investors looking at manufacturing companies are paying more attention to the sourcing of raw materials. Investors are aware of how manufacturers and other businesses were affected in the early months of the pandemic as their supply of raw materials or finished goods dried up when shipping from and into countries was put on hold. The diversification of supply chains—not only at the supplier level, but also at the country/geography level—has become even more important.

Another dynamic coming out of the pandemic concerns baby boomer generation business owners who are ready to sell or transition ownership to the next generation. It is not uncommon for generational transitions in ownership to lead to changes in overall business strategies, including taking on investors, whether that be at a minority or a majority level. This “rush to the exits” of sorts is leading to more competition among PE investors and deals with higher valuations that are closing faster than before.

While ESG criteria are generally not part of official financial reporting, we are beginning to see LPs inquire more frequently about the ESG positions of PE funds   as they look to commit capital. On the flip side, we are also seeing sellers ask PE funds about their current  ESG position. Considering the amount of buy-side competition in the market, sellers may be faced with multiple offers, and ESG positions may be a differentiator. PE is taking notice of the ESG conversation, and operating companies need to be aware investors are beginning to make ESG  part of their due diligence process, whether that be at the platform level or at the bolt-on level.

PE investors are aware that the Biden administration has proposed changes to the federal tax code, including taxing capital gains for wealthier taxpayers at ordinary rates. This may provide more incentive to pursue and close deals in 2021 if changes to the capital gains tax rate are not made retroactive.

Has there been an increase in carveouts by larger companies?

We have seen an uptick in carveouts by large public and private companies over the past year, along with an increased interest in these deals by PE firms. We are experiencing a vibrant market of buyers with vast amounts of capital in the marketplace chasing deals.

With strong demand and high valuations, many sellers are choosing to  monetize  certain assets and realize  value for shareholders. These carveout transactions provide buyers with strategic assets that can serve as platform or bolt-on transactions. In the early months of the pandemic, companies may have pursued a carveout to focus on core-business assets and shed non-core or underperforming business segments as they prepared to shelter the pending storm. In a September 2020 update to the Department of Justice’s (DOJ) Merger Remedies Manual, the DOJ called PE investors the “preferred” purchaser of divestiture assets in some instances  because the PE investor’s flexible investment strategy, commitment to the divestiture, and willingness to invest more when necessary were key to the success of a divesture.

It’s important to note a carveout isn’t limited to a company seeking to sell a non-core part of their business. A company may ultimately decide to divest its core business if it believes that industry or service is experiencing a permanent decline.

Is there a stronger incentive to close deals before the end of 2021?

Companies may be more likely to exit because of concerns over possible federal tax code changes and overall competitiveness in the marketplace. There are more deals closing, involving more funds and fund sponsors, with higher valuations and shorter timeframes to carry out due diligence before closing. The speed to close may lead to an increase in bad deals. Deals are closing in 60 days, and when deals are done that quickly, due diligence may not be as thorough.

Investors don’t want to hold off on deals because, on the buy side, they see acquisitions as a way to grow. Even though valuations remain high, investors are aggressive as they seek top-line growth. With that said, investors are concerned about a possible valuation bubble.

Traditional economic indicators such as unemployment or national debt seem to not matter as much in the moment. Investors who are consolidating businesses  and concerned about a bubble need a clear view of their horizon.

How has due diligence changed because of the pandemic?

Investors didn’t have as much in-person contact with a target company’s management team and employees over the last year, causing a significant change in due  diligence. Company culture is a key ingredient in the success or failure of M&A. The past 18 months have proven difficult to engage with companies and evaluate factors  such as employee morale, culture, and quality of workforce. But not all things have been bad—there are benefits in working remotely. Now, many firms are evaluating how to operate remotely while still incorporating more second- and third-level employees in their evaluation of potential acquisitions.

Financial due diligence looked different over the past year in this largely remote environment. We believe the due-diligence process going forward may include a mix of recent trends and the “way it was done before.” So, while efficiencies realized through Zoom meetings will continue, the benefits of on-site diligence (such as meeting with executive teams, evaluating culture, or observing operations) will remain important.

Post-close, what are the areas of focus that you’re seeing most frequently regarding performance optimization at portfolio companies?

As PE firms look for appropriate portfolio acquisitions, we have seen an increased focus on firms understanding a target company’s ability to not only speak about, but to demonstrate, data maturity. Data maturity is a shift from a backward-looking, tactical approach regarding data to a forward-looking strategic approach. An organization that gets better at harnessing its data will see transformation in its people, processes, and overall business results. Advanced data analytics can support both PE investors and portfolio companies through every stage of a transaction’s lifecycle.

Additionally, finding the right talent has posed and ongoing challenge before and through the pandemic.  The remote environment many companies shifted to over the past year has made the issue more acute. Post-close, making sure key positions at portfolio companies are filled with the right people will be crucial for long-term success.

One of the keys to M&A success is the new management team post-close. Quality, highly capable CFOs are in high demand in certain industries with the flurry of activity over the past 12 months. The ability to identify and hire high-performing leaders is an important focus area for investors and executive teams.

Ken Fleming
Brian P. Francese
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