private equity fund manager looks up at buildings in a city

This Q&A was published as part of Pitchbook Q2 2021 US PE Middle Market Report sponsored by Baker Tilly.

Private equity dealmaking in the U.S. continues an unprecedented run supported by considerable capital availability and continued economic recovery. Mike Milani and Brian Francese provided PitchBook with their insight on trends private equity fund managers and their respective portfolio companies are seeing and how these trends can be leveraged in preparation for a deal.

Key trends discussed:

  • Challenges presented by accelerated timelines to close deals
  • The increasing amount of deals in the software and healthcare industries
  • Sustainability and stability of a seller's supply chain
  • Talent shortages facing privately held companies
  • Commonly overlooked items when preparing for a sale

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High values in the market, willing strategic and financial buyers, and a friendly lending environment are some of the factors driving PE, corporate, and private company sellers to head for the exit. PE is highly incented to sell into a seller’s market, as it leads to premium pricing. In addition, both strategic and financial buyers are competing to structure deals with for-sale businesses that are performing at or above pre-COVID-19 pandemic levels.

Sellers of privately owned companies are also considering the following:

  • Some owners no longer want to bear the effort and risks of their business.
  • Some owners who spent time working remotely enjoyed their flexible schedules and time with family and friends, i.e., the “vacation home effect.”
  • Many owners near retirement are concerned about the potential for higher corporate, personal income, capital gains, and dividend taxes.
  • The wealth accumulated in private companies is illiquid, and many owners have determined that the after-tax proceeds from a sale will last for an extended period of time.
  • Owners are wary of the next crisis and how it could affect their companies.

From the perspective of private company owners, everything was on hold for several months after March 2020, but now may be the time to sell.

Business owners have become more flexible because of the urgency to complete transactions this year. Many private company owners are hiring interim CFOs, quality of earnings providers, real estate appraisal companies, environmental consultants, or financial consulting firms as they  prepare for an accelerated sale process and expedited buyer due diligence. In addition, business owners are signaling to buyers their willingness to roll over equity, provide seller financing, consider earnouts, and provide a longer than usual leadership transition period, post-closing.

We’ve certainly seen it on the behavioral health side. Many PE platforms are chasing behavioral health businesses. It’s an opportune time to sell those businesses, unfortunately, because there are more people in crisis.

For the most part, software companies floated through COVID-19 with little change. Their employees were  already working remotely, and the companies were set up to get on with business with little interruption. COVID-19 encouraged many businesses to automate financial and operational systems, implement software, or work with consulting firms, such as Baker Tilly, to improve  processes. That process-improvement mindset is continuing and will not change for the foreseeable future, as there is a wealth of old economy left in our modern economy.

In an M&A transaction, we are seeing much more due diligence around the stability and sustainability of the seller’s supply chain. Buyers are digging in to figure out what—if any—disruption occurred, how that was resolved, how gross profit margins were affected, and whether a business was able to pass those costs to customers. This scrutiny doesn’t necessarily add to the due diligence process or delay the close of a sale unless an issue is uncovered that has not yet been addressed.

There is a huge nationwide talent shortage of top and middle management in privately held companies. PE portfolio companies can lure top managers with money, equity, and work-location flexibility in ways many privately held companies cannot.

Private companies can address this problem by going out and hiring management from competitors, training from within, or hiring consultants, such as Baker Tilly, to augment the management team.

With so many new and existing regulations, guidelines, and rules, it is nearly impossible to stay on top of it all unless you have somebody on your team who can devote time to monitoring changes in the regulatory world, or they work with a firm such as Baker Tilly to help navigate the ever-changing regulatory environment. Owners need to make sure their businesses are “big picture” regulatory compliant, in accordance with HR, OSHA, EPA, and other federal, state, and local agencies. Staying connected to relevant industry and trade associations is the easiest way to stay informed; also, consider talking with your competition about the regulatory issues they have faced.

Here are some key items buyers are looking for that sellers need to consider in an M&A process:

  • Commitment of shareholders and management team
  • Quality of financial and operational information
  • Realistic valuation, deal timeline, and transaction structure expectations
  • Management’s ability to run the business while working through the sales process
  • Management’s ability to present well/sell to potential buyers
  • Coordination between the seller and buyer(s) and all their respective advisors
  • General transparency of not only positive business outlooks but also potential adverse outlooks

A company needs a good top management team, with depth and breadth of talent, so the buyer can be confident in what they are buying. If you are a buyer, you want to make sure that you are looking at current run rates of revenue and profitability, and that trailing 12-month EBITDA isn’t just a large rebound from COVID-19.

In addition, buyers look for infrastructure stability and sustainability across IT, finance and accounting, and customer pricing systems. Many private business owners of successful growing businesses are blissfully unaware that their underlying systems are less comprehensive than what buyers expect.

Sellers and management must sell the future of the business to buyers. Acquirers conduct due diligence on the present and how management has navigated the past; they will also assess how current management can run the business strategically and tactically in the future, under new ownership.

Most owners run successful businesses with quality management. The question is, how do you hand off a company that’s operating under a certain culture to a new buyer that may have a different way of running the business? Will the existing management team fit into and adapt to that new paradigm, or have they hit their performance limits and will they stick with what they know?

Michael Milani
Executive Managing Director, Principal
Brian P. Francese
Partner, CPA
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