By Matthew Roberson, Director, and Craig Bowden, Senior Vice President, SC&H Capital
The SC&H Capital team recently attended the Association for Corporate Growth’s (ACG) 2018 M&A East conference in Philadelphia, where more than 1,300 dealmakers gathered to compare notes and source deals. We spent two full days meeting with middle market private equity groups (“PEGs”) and have aggregated our notes from these discussions for you.
Deal Activity is Up
Nearly all the firms we met with and have spoken with in recent weeks have noted that deal flow from investment bankers is up in 2018, with the consensus figure pegging this increase at 20-25% over 2017, which itself was a banner year. Figures from Pitchbook through the third quarter of 2018 would point to a fifth consecutive year of both increased deal value and transactions with private equity buyers.
While deal volume is up, the quality of deals in 2018 has been mixed. We heard from several firms that their pass rate (% of deals where they do not submit an indication of interest) has increased in 2018. Many PEGs cite an increased level of selectivity for deals to pursue, but a willingness to pursue aggressively once an ideal opportunity has been selected.
On the flip side, quite a few PEGs have also noted an improvement in deal quality post-Labor Day, suggesting that some of the higher quality opportunities were held during the typical summer slow-down.
A couple of possible theories for the uptick would be quality businesses who have more recently grown into viable private equity candidates. Another is that C-Corporations are more willing to consider sale processes in 2018 given the significant and favorable corporate tax rate change for sellers.
Private Equity Continues to Feel Pressure to Put Capital to Use
PEGs continue to lock in great returns as they exit their older investments in this market, and have used those returns to raise their next, often larger, funds. Even with active deployment of capital from these new funds, the industry-wide amount of capital committed but not yet deployed (“dry powder”) continues to rise (currently at +$1 trillion).
As the level of dry powder grows, private equity buyers are feeling increased pressure to make investments, but many have found it to be a challenge with high valuations and increased buyer competition. One private equity group with whom we spoke cited an inability to close a single platform investment in 2018, compared with their historical average of 4-5 investments per year.
Strategic Competition Has Increased
We continue to hear from private equity buyers that they are being priced out and/or beat out by strategic buyers or financial buyers with strategic angles (e.g. family offices who have relevant industry expertise and rolodexes). Data from Thomson Reuters suggests that this is a real trend, with overall global M&A up to 64% in the first half of 2018, while private equity M&A is up (“merely”) 46%, or a 9.5% decline in the share of overall M&A from 2017. Private equity buyers are learning that it no longer works to just have money, given its abundance in the market.
Private Equity is Pursuing Differentiation Angles
Industry specialization and situation-specific investing among middle market private equity buyers is not new but is clearly on the rise. We see this as a direct response to falling “win percentages” on bids, as well as an effort to copy winning approaches from other firms. The specialization has taken a number of forms, with a few sampled here:
- Operating executive: pairing with an experienced operating executive in a specific industry to add strategic value and deleverage risk (potentially increasing the valuation upfront);
- Increased focus on add-ons to platform investments: recent data from Pitchbook noted that add-ons in 2018 have accounted for nearly two-thirds of buyouts, and 2018 is on track to be the fourth consecutive year of 2,000+ add-on transactions;
- Independent sponsor: executives without a dedicated fund source a deal first, and then (hopefully) build the rest of the capital team before closing;
- Investment thesis approach: PEGs have grown their business development functions to concentrate on building deal flow targeting very specific industry verticals (e.g. dermatology practices, branded snack foods, etc.)
Direct Outreach vs Represented Deals Debate
Many PEGs are directly reaching out to potential sellers to generate what buyers call “proprietary deal flow” or deals where competition is low or non-existent and the selling business owners are not represented by financial advisors. The goal for PEGs is to make an acquisition with more buyer-favorable valuation and deal terms.
However, a large number of PEGs indicated that they risk-grade deals without investment bank representation as higher risk, and often avoid these situations. These PEGs cite benefits to having an established investment bank such as (i) greater comfort in a committed seller, (ii) banker-established, reasonable revaluation expectations, and (iii) due diligence preparation. These benefits decrease the risk of wasted time and money to PEGs who must be judicious with investing their resources.
What does this mean for business owners?
In short, buyers remain bullish on the market and opportunities, and deal flow continues to be strong as we stretch into the fifth year of a sellers’ market. We believe that seller-favorable conditions (including valuations) are likely to remain strong through 2019, though we are keeping an eye on a few M&A headwinds, including rising interest rates, public stock market volatility, and political uncertainty with tariffs and international trade disagreements.
We believe that companies with strategic differentiation in their own markets will be in high demand from both strategic and financial buyers. Sellers will continue to have strong negotiating leverage with buyers in a very competitive M&A market, with both strategic and financial buyers competing on both valuation and strategic value. Sellers should also be aware of the evolving dynamics of the buyer universe and the most recent competitive valuation and terms in M&A deals before getting too far with any single buyer.