When readying to make their next big investment, all private equity firms face the same set of challenges. Here’s Martec’s Rick Claar on what those challenges are, and how they can be overcome with deep market research.
Allison Reck: What do you see as some of the most pressing issues that private equity is dealing with today?
Rick Claar: One of the biggest problemsprivate equity faces today is the competition among themselves. There are thousands of PE firms out there with billions of dollars to spend. Both the numbers of PE firms and dry powder continue to grow, but there is still a relatively similar amount of companies that may be available for sale. Everyone claims that they don’t want to be in an auction process because it generally drives the multiple up higher. As the price tag goes up, the intensity goes up.
With so many funds participating, firms don’t want to raise capital and then not make a deal for three plus years. They would most likely be looked upon as inferior or not able to employ capital. It becomes harder to make deals, but they have to make them, so they’re putting the capital—that’s been contributed—to work.
AR: Is this competition localized within PE or is it coming from any other angles as well?
RC: Strategic companies present a similar problem to private equity. If a private equity firm is buying a collection of companies that may or may not be related to each other, they may not be able to capture as many synergies as a strategic company will. If a strategic buys a company and they already have a similar business, there’s a good chance they can cut a lot more costs than a private equity firm can, and this allows strategics to change the game in their favor.
I’ve seen several recent example where PE is really interested in a deal, but then a strategic company comes in and can actually pay more initially because they’re going to be able to cut out more costs in the future.
AR: On the opposite end of the spectrum, the world of private equity moves at light-speed when it comes to closing a deal. Is there a way to mitigate this process?
RC: PE wants to see as many deals as they can handle but they need to have the right size firm from an overhead and expenses perspective to make it work. If a middle market, or lower-middle market firm is trying to take a look at 1,000+ deals a year, maybe they seriously consider 100 of those. Then 10 out of those 100 deals might go through in a year. That’s an extraordinary amount of effort and manpower to look at this number of deals, and they don’t have much time to do it. So PE always has to make a quick decision and that problem is not likely to change.
To offset these extremely tight time frames, many firms will send a business development team on the road to find those companies that fit their target category. They’re starting these valuable relationships years in advance so that when—and if—these companies go to sale, they’re not going to auction. That’s playing the long game as a way to cut out the competition, but it’s certainly a lengthy process to build those relationships.
Sometimes it’s not always the highest bid that wins. For example, say a company for sale wants to keep its management team or keep a minority or even a majority of the equity. Or they want to grow the company and they think a relationship with this particular private equity firm will help them in that growth. The winning firm might not be the one who had the highest bid, it might be the company with which they’re most comfortable.
AR: How do you see PE firms trying to counteract these competitive problems?
RC: One of the things that private equity has done to combat the fact that there are so many other firms out there trying to make deals is to diversify themselves. They’ll target a certain industry or a company of a certain size. Maybe they target growth companies or turnaround companies. Each private equity company does try to present themselves as unique from everyone else, even though there are thousands of firms out there. That’s another distinct issue that PE faces: how to present themselves as being differentiated or unique in a way that makes sense to them and, more importantly, to the industry and potential targets.
Some firms are industry agnostic and they might be looking for a variety of seemingly disparate companies that all have a common need or a problem that requires an expert solution. For example, companies that might be struggling or coming out of bankruptcy would be targets for (and benefit from) a PE firm that specializes in operational expertise.
AR: Other than these various forms of competition, what other problems are private equity firms facing?
RC:Certainly carried interest is one topic that has been around for a while now within PE circles. This is the way that PE firms/General Partners are taxed based upon their funds gains. Right now, private equity’s gains—its income that it will see from buying and selling companies—is treated as an investment, as a capital gains tax as opposed to an income tax. That can extrapolate to a significant savings of over 15%. If all of a sudden you’re making 15% less, that can change the entire investments program.
Another thing to watch out for is the ratio of debt to equity employed to make an acquisition. Before the bubble burst in ‘08, equity employed for a PE firm to acquire a company was likely below 30%. In that example, a private equity firm would put equity down—let’s say 25% down, and finance the balance (75% through debt) from the banks—to acquire a company. Then, when they exit and sell the company, and pay off the banks, the firm can make a lot more upside money. There’s been some revisions to that process and an update to different funding requirements and market conditions. Now, PE firms may be putting 40-60% equity down and financing 40%-60% through the bank. If there are any further changes in regulation or competition from strategics (who can employ more capital and require less debt), that could be something that could really turn the industry upside down.
AR: What about the offshore impact on the domestic market?
RC: Certainly, this is something to watch. Many of our lower/ middle market PE firm clients are acquiring companies that are really only playing in the US or Canada, but that is not to say they will not be impacted by trade issues or trade wars. And it is not at all uniform in that some companies may benefit from protection and others may be disadvantaged if a significant portion of their raw materials or parts are imports. This is a macro trend that everyone will continue to watch, as there may be a particular industry that can be better positioned because it has less of an offshore impact. Finding those “best fit” industries (and therefore targets within) will continue to be a focus of PE firms that like to invest into macro trends.
AR: How can expert research and market due diligence help a private equity firm to make the right deal?
RC: In some cases, doing diligence or pre-diligence will bring a firm up to speed and can provide a really good initial opinion of that target company. That can be helpful in ultimately winning a bid. There’s so much money out there, and there are so many firms, and there’s so much competition, once you’re in that competitive mode or you’re in the auction process, is wheremarket due diligence can help make that firm smarter. If they really want the business, they’d be more confident bidding higher if they have certain pieces of diligence on the positive side, or at least have discounted the downside risk. On the flip side, if it’s overall negative commercial diligence, maybe they exit the process sooner and don’t waste time and money continuing down the path.
AR: How are private equity firms using due diligence to gain an advantage over their competitors?
RC: PE firms are trying to obtain more customer insights on the target, whereas before maybe they’d do that themselves after they closed the deal or right at the end of the process. Now, they want market research to conduct more customer interviewing just to see how the company they’re trying to buy is positioned with their customer base and versus competition. Obviously, this type of work needs to be done in a careful and thoughtful way, because in the vast majority of cases the acquisition process is not known by customers and sensitivities at the company and PE firm are at a heightened level.
Many companies that perform due diligence narrow their focus too much on the financials and management and may be missing important pieces such as market, customer, or competitor intelligence. Martec’s holistic approach to diligence can marry all of our commercial intelligence with the numbers to put the financial details into the right context.
Rick Claar is a partner at Martec. He has over 30 years of experience bridging the gap between pure market research, data collection, and management consulting. He’s been providing due diligence and expert market research to private equity firms for more than 15 years.
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