This Q&A was published as part of PitchBook’s 2021 Annual U.S. PE Middle Market Report sponsored by Baker Tilly.
Last year the U.S. private equity middle market recorded its busiest year ever, topping $600 billion in deals. However, the future holds many challenges for the dealmaking environment among this growth. In PitchBook’s latest report, Baker Tilly Partners Brian Francese and Frank Walker discuss key trends, challenges and differentiators PE players should keep in mind given the evolving status of the pandemic.
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Certainly, 2021 was a high-water mark in terms of the number and value of deals across all markets, including the middle market. Deals increased across the spectrum—PE, strategics, and SPAC transactions. Deal volume was up more than 50% over the five-year average by some measures. Some of this deal volume related to pent-up demand, after deals dried up at the beginning of the COVID-19 pandemic. Many middle market deals resulted in a rush to close before year-end because of concerns over possible federal tax policy changes on capital gains.
The middle market includes a class of companies that are attractive assets for buyers. Many are founder-led firms that have been around for 50 to 60 years, have experienced significant growth in recent years, and can reasonably be seen as growth engines for a better-resourced owner. So, you have a convergence of demographics—owners acknowledging it is a good time to exit and well-resourced buyers executing on deals.
One thing that has not changed is that clients are often surprised by how long a transaction takes to close. Because so many deals hit the market at the same time last year, it became more difficult to secure qualified assistance from advisors such as accountants, transaction attorneys, and investment bankers. Sellers that didn’t close in 2021 are thinking about what their horizon might be and are taking a more clinical view on how to prepare to come to market. So, speed has become more of a concern for our clients. While the window is very much open for deals to get done at attractive valuations, when you look at all the potential headwinds—political uncertainties, fiscal and monetary policy, and concerns about the overall equity markets—there is a fear that the window will shut.
On the buy-side, our clients’ valuation expectations have begrudgingly changed. Although there was a good supply of sellers, demand was just as robust, particularly for quality assets. Prices and multiples for quality businesses are much higher than they were pre-pandemic. Even PE funds that would, historically, pay somewhere between seven and nine times their earnings are commonly paying much higher multiples. A lot of money is chasing the same opportunities, and that should always be a concern over the long term.
The SPAC market was still hot in early 2021, but it has started to cool for various reasons. One is the level of effort it takes to be a public company, not to mention the increased regulatory scrutiny SPACs are facing. Still, a significant number of SPACs have yet to complete an acquisition, but we should expect to see more completed SPAC deals in 2022.
As some deals are priced to perfection, buyers can’t financially engineer their way into acceptable returns. To mitigate higher valuations, sponsors are very disciplined about what they’re pursuing, ensuring they have a clear edge in a particular industry to make an acquisition successful. Sponsors are also increasing due diligence, focusing not only on financials but also on operations. They’re going to earn the return by growing and improving the business, making their operating partners and value-creation teams much more central to the transaction. In the middle market, these changes often manifest in areas such as business systems, digital transformation, financial planning and analysis, and procurement, as well as areas where operating leverage can be realized.
On the sell-side, while there’s competition for quality companies, some of our clients are surprised that more buyers aren’t interested in their businesses. But if a buyer does not see a profitable angle for a particular business, it is quick to pass. What we do see is sellers being surprised by unexpected buyers. A seller may expect that its buyer will be a company looking for a strategic add-on or perhaps a main competitor. Because so many new PE players are in the market, however, we have seen deals where a PE investor, not previously known in a particular market, will buy the number one and number two players in a niche market because it had a thesis about how they were going to enter the market.
We assisted clients with a number of nine-figure transactions last year. All of these clients had been considering a deal for some time but finally decided to pull the trigger. In most of these deals, the seller was willing to roll a portion of its equity into the new business, as it had high conviction on the new owner’s ability to grow the business, which is good to see.
Many middle market businesses are differentiated by their ability to run operations under a single roof or benefit from the presence of the founder. As the forced adoption of remote work ensued, some businesses did better than others navigating the new world. A lot of middle market companies may be less vertically integrated and more reliant on external suppliers than larger companies; we have certainly seen more pervasive supply chain issues, compared with larger companies. Perhaps the biggest challenge for middle market businesses, however, is the rising cost of labor coupled with an inability to fully pass on that cost to their customers.
The concerns of 2021—the uncertainty of the pandemic and potential tax policy changes—are still with us in 2022. Think of the amount of money disbursed by the federal government, which has helped to fuel inflation. Ongoing issues with global supply chains are also fueling inflation. Expanded unemployment benefits likely have kept people out of the workforce, and other dynamics caused some to decide on early retirement, contributing to the talent shortage affecting all sectors of the economy.
All that being said, we try to keep our clients balanced. It is best to focus on continuing to run a good business and be deliberate about preparing to go to market.
The speed of change and the separation of fad from the future. All-encompassing change is everywhere—for example, digital technologies and artificial intelligence (AI), environmental, social and governance (ESG), information security, hybrid working, supply chains and, of course, digital currencies. The velocity of this change today makes it difficult to distinguish between the future and the flavor of the day. There is an incredible amount of brainpower in PE, and its investment returns are why the asset class continues to attract capital. There probably isn’t much that PE firms aren’t aware of regarding the challenges they may face—high valuations, credit market changes, and the typical topics discussed.
A big differentiator we hear about more frequently from our clients is soft skills, usually either criticism or praise of a particular PE firm in terms of matching personality and values, as well as overall relatability with the founders. So, despite all the change, one thing remains the same—the people.