Key Insights from Leading PE Partners, 2018
April 17, 2018
After a record-setting 2017, in terms of both deal value and number of transactions, the US PE middle market is off to a mixed start this year. We spoke with senior partners from four leading PE companies to gain insight to what they see ahead, and to what they’re doing to continue to compete.
Included in the interview:
Walter Florence, Partner,
Frontenac
Richard Lawson, CEO & Co-Founder,
HGGC
Bill Spell, Founder & President,
Spell Capital Partners
Marc Utay, Managing Partner,
Clarion Capital Partners
Here’s what they had to say:
Where do you see the opportunities for Private Equity today?
Marc: Well, it’s a very interesting market to invest in. On one hand, it’s a market where technology and the implementation and use of technology is really at a scale that we’ve seldom seen in our investing history. This creates an ability not to just invest in technology businesses, but to invest in how technology can either empower businesses or fundamentally change the way companies do business. If it’s a consumer business for instance, how consumers want to do business with brands is evolving quickly. So on the one hand, it’s a time of unbelievable opportunity. As the world changes, the consumer changes, businesses change, and people who can take advantage of that change can create businesses of scale in a time frame that would have been almost unimaginable 50 years ago.
The flip side, though, is that this is also one of the scariest times in which to invest because existing business models can be changed by those very same factors that create the opportunity. Therefore, when you look at the kinds of businesses that historically private equity firms might invest in, they have far more risk embedded in them because the world is changing faster than ever. The business attributes that used to provide a degree of downside risk protection, like a brand name, might no longer do so. This dynamic creates both an opportunity and a challenge.
Rich: At HGGC, we continue to find attractive investment opportunities in technology and information services, business services and industrial services. We believe that the majority of traditional end markets are being fundamentally disrupted by emerging technologies, and we look for companies that are using technology to re-define the industries where they operate, such as automotive, grocery, retail, healthcare and insurance. There are tremendous investment opportunities to be had if you can successfully identify these businesses and find unique angles to differentiate your firm in their sale processes, particularly in the middle market where value-add initiatives can really fuel growth.
Bill: It’s a very competitive marketplace. Our strategy has been to specialize and stake out a niche in the PE marketplace. At Spell Capital, our focus is lower-middle market industrial manufacturing buyouts. For us this has been very beneficial and rewarding. A second opportunity is that as technology has advanced and evolved, it has provided for productivity gains. The consequences of this is enhanced cash flows at our various portfolio companies, so that’s good. Thirty years ago, when we started Spell Capital, there was just a handful of financing sources, both senior lenders as well as mezzanine. Today there’s a plethora of financing sources to consummate transactions. That’s a great development. Finally, I would say that the maturing of the market, in terms of deal-flow sources and financial intermediaries really creates opportunities to see a lot of different deals and situations, which allows to effectively specialize and execute a strategy.
Walter: My partners and I believe the opportunities in the lower middle market (LMM), which we define as revenues less than $100m, continue to be an attractive area for investment. The data supports it. LMM funds make up approximately 15% of available U.S. private equity dollars but upwards of 95% of U.S. all companies, and PE ownership is still less than 5% of all LMM companies. We’ve built our firm not only to access these opportunities but to manage the challenges and risks that come with investing in this segment of the market. Private equity as a macro assets class continues to be the leader relative to delivering consistent returns over time, and I think there’s a number of different strategies that work.
What would you say are your greatest challenges, short term, long term?
Rich: The biggest short-term challenge is fierce competition for assets driving up purchase prices. The market environment has changed drastically over the last few years, and today there is a proliferation of non-bank lenders that have enabled PE firms to effectively borrow well in excess of traditional debt limits. To get away with it, many private equity firms are becoming very creative with using ‘juiced’ EBITDA metrics, such as pro-forma EBITDA, run-rate EBITDA, cash EBITDA, or a combination of them. These avenues have allowed GPs to borrow in excess of six times leverage. Combine that leverage with an enormous amount of dry powder that exists today in the private equity asset class and the prices of assets are being pushed toward pre-Global Financial Crisis levels. At some point, industry participants have to take a step back and pressure test how PE firms are going to generate attractive returns in a marketplace where investors are forced into underwriting single-digit IRRs to win deals.
“...on the one hand, it’s a time of unbelievable opportunity. The flip side, though, is that this is also one of the scariest times in which to invest because existing business models can be changed by those very same factors that create the opportunity.”
Mark Utay
A long-term challenge faced by almost every PE firm today is how to attract and retain top talent. There is a real generational shift occurring, wherein the people that pioneered and bootstrapped the PE industry are moving on in their careers and are looking for top investment professionals to assume leadership roles. Many of these PE firms have also just raised funds two or three times larger than their predecessors, as well as new auxiliary products, and need to fill seats. It will be interesting to see how this generational shift unfolds as new leadership teams form and these new groups begin to think about how to retain key individuals. Retention is something that we talk about on a daily basis, and we constantly ask ourselves, “How do we build a ‘firm’ and not a ‘fund’?” I think we have been very successful in growing our people internally, building a culture of accountability and focusing on partnership investing.
Walter: There is no question that competition, higher prices, and shorter time intervals to complete due diligence are real challenges in today’s market. Longer term, I see those challenges remaining. There’s no question that competition, prices, shorter intervals to do due diligence are the challenges that I think everybody talks about and are front and center on our minds. I’ve been in the industry for 20-plus years, and there’s always been competition, and there’s always been too much money chasing too few deals. I don’t anticipate that will change, so the question is “how do you build resources and assets to compete in the PE environment?”
As long as I’ve been in the industry, I think everybody looks at it and says, “There’s too much money chasing too few deals.” I think there’s points of intensity and lack of intensity around that, but I think that’s a long-term trend in the industry. And everybody looks back and says, “We had it great 10 years ago. It’s harder today.” And while that may be true, I think it would be wrong to think it wasn’t competitive five or 10 years ago. The firms that are doing well have embraced the challenges and established market differentiation and resources that address those challenges.
Bill: I think for the short term, it’s a very competitive marketplace for finding good investment opportunities. Valuations are very high. And because of the number of intermediaries who are representing sellers, and the number of PE firms in the market, it’s driving valuations to historically high levels. So I think that’s a concern. The other short-term issue for us, since we specialize in industrial manufacturing transactions, is the challenge of finding skilled labor at our various portfolio companies. It’s a very tight labor market. The lack of dependable skilled blue-collar workers will represent a challenge in the future as the economy grows – especially in the more rural areas of the country.
Long-term, I guess the challenge is that as private equity has become a legitimate alternative asset class – the amount of capital is really almost unlimited. There’s a lot of folks getting into private equity and I don’t think there’s enough really good opportunities at reasonable prices to sustain an acceptable risk adjusted rate of return. So there’s going to be some fall-out in the future as some firms are unable to deliver the kind of returns required to remain viable.
“The market environment has changed drastically over the last few years, and today there is a proliferation of non-bank lenders that have enabled PE firms to effectively borrow well in excess of traditional debt limits.”
Richard Lawson
Marc: So the greatest challenge in the short term is just how expensive the market is. When you look at both the private equity market and the public markets, it’s not an insightful observation to say that, “We are at the peak of a bull market”. It doesn’t mean it can’t go higher. It doesn’t mean that it’s going to correct tomorrow. But it does mean that if you look at investing, as private equity does, over a three to five year time period, you have to take into account the fact that you may be selling in a market that has purchase multiples that are lower than they are today.
So the challenge that you have is a macro challenge. It may not be specific to every deal, but on average, investments made in today’s public markets, if you look at a five year forward rate of return, are unlikely to be that attractive. If you look at all of the markets over the last 80 years and rank them by how expensive they are using PE ratios and then take the top (most expensive) 10% and look at what the rate of return has been over the next five years, it’s typically been zero. And in two thirds of the outcomes, you actually would have lost money. This analysis should be sobering for anybody investing in the markets today, that there’s a two thirds chance that overall the market will be lower five years from now than it is today.
Similarly, in private equity we believe the same dynamic exists. The average deal done in this environment which is sold three to five years from now has a decent chance that it will undergo multiple compression, i.e. it will sell for a lower earnings multiple than the one you bought it at. That’s very daunting math. So the challenge, if you think about it, is how do you invest in an environment like this one? For instance, the idea of just finding a very good company, paying a very full price, it performs fine, you pay down debt, and then you sell it at the same multiple, and that creates an okay rate of return. The math will not work, however, if you end up selling at a lower multiple than what you paid on the way in. The challenge is to find true organic growth at a reasonable price because it is the growth in earnings that will allow you to maintain enterprise value, and it’s the growth rate that will allow you to maintain multiple. But if you don’t have growth, you may not maintain either.
The long term challenge, I think, is no different than it’s ever been. Sometimes we’re in expensive markets. Sometimes we’re in less expensive markets. Every once in a while, we’re in a cheap market (but hopefully one that wasn’t created by an economic collapse). You just have to be able and willing to invest through all parts of the cycle. Albeit from our standpoint, you’re going to be more likely to make more investments in markets you find more reasonable, and less investments in markets that you find more expensive. But I don’t think the long term challenge in private equity is really different. There’s a lot of competition. Generally the competition is pretty smart and well resourced, so you need to create a competitive advantage for yourself in terms of industry knowledge or strategic vision that allows you to differentiate yourself from the firms around you. But that’s really as it’s always been.
How do you think the Tax Cuts and Jobs Act is going to affect mergers and acquisitions for PE firms?
Bill: Well clearly we’ve already seen it. Valuations are going to increase and it’s going to accelerate an already frothy market. The Tax Cuts and Jobs Act is going to drive valuations higher in the future because the free cash-flow component of these companies will increase and it’s going to allow private equity buyers to pay more. The second effect is that it’s going to incent folks who were otherwise not sellers to reconsider exiting their business. You’re going to see an increasing number of businesses hit the market in the next couple of years. So, I believe that is a positive consequence. And for existing portfolio companies, the enhanced cash flows are going to be very helpful and allow owners to take those cashflow savings that otherwise would have been paid in taxes and invest that in capital equipment, infrastructure improvements, and to invest in their businesses.
“The firms that are doing well have embraced the challenges and established market differentiation and resources that address those challenges.”
Walter Florence
Rich: Historically, strategic / corporate acquirers have not been overly aggressive or nimble when competing for assets in the middle market private equity arena. If you think about how the changes in the Tax Cuts and Jobs Act will impact this dynamic, the reality is that strategics / corporates will have fewer taxes and incrementally more cash. I believe that this will allow these acquirers to be far more competitive for assets that many traditional private equity firms have been winning in recent years.
Marc: First, it’s a little early to tell. I’m not convinced we understand all the implications yet. Near term, I don’t believe that the cut in the tax rate will affect us dramatically. An awful lot of our deals are asset deals where we get a step up in tax basis, and therefore we’re not a taxpayer in the short term. And so I think there’s a modest benefit from the lower tax rate on corporate income, but not a massive difference for us. I think in the short run, the deductibility of interest will not be an issue. But over the long run, particularly when the rule changes five years from now and the deductibility limit is measured against EBIT rather than EBITDA, I think you could begin to see some interest that people pay be non-deductible, particularly if we’re in a higher interest rate environment at that time. That would clearly affect returns and multiples, so that’s not a good thing.
The second area where it’s clear that it will have a very negative impact where there are companies that aren’t doing well at that time. So, they started out with a capital structure that made sense and all the interest was deductible, but their earnings declined and they get themselves into trouble, they are actually going to accelerate the financial problems because they’re no longer going to get a tax shield. If interest stays the same and the amount of earnings go down, then you reach that percentage cap much quicker.
Walter: The most immediate impact has been a spike in billable hours for lawyers and accountants! I mean, one, they tried
to simplify it, and I think it’s made things complex as opposed to simpler. And the funny thing is, the immediate reaction is we have 10 meetings and 10 emails, lawyers and accountants who have gone through the legislation and are trying to understand it, and I just find it funny. All kidding aside, I am not sure how it impacts the overall industry, but I can say, it will have very minimal impact on our portfolio and our strategy. In some instances, it appears more favorable to structure new deals as c-corps where previously we might have opted for LLC.
We noticed that there were a number of conferences that were starting to use the tax cuts as the main subjects. So it’s been interesting with interviewing so many of the PE principals on where they see it’s going, so thank you for that.
Marc: You may find that the answer is very different for large funds versus small funds, right? Because we don’t use as much leverage. Not nearly the same amount of leverage as the mega funds do. And for the mega funds, they’re typically buying C-Corps rather than getting a tax step-up, so they’re more likely to be taxpayers day one. So it’s more important to them than for us.
What tactics does your firm use for increased visibility and improved deal flow?
Marc: First and foremost, we are organized by industry group. What we seek to do is rather than react to deals that we’re shown by Wall Street, we create investment theses in our industry verticals where we believe that the macro trends support a terrific organic growth rate. And then the challenge for us is to find the right opportunity with the right company, at the right price, given that we think the macro trends are in our favor. The way that we do that is, having identified the trends within our industries, we then build our network in a particular industry sub vertical.
So we go out into the world. We don’t wait for an investment bank to send us the book. We do our industry research. We build our network in our industry vertical. Then we use our network to introduce us to companies in the areas that we’re interested in. We meet competitors, we meet customers, and we meet suppliers. We gain a rich and nuanced view of the ecosystem within which all of these companies operate. This allows us to develop strong points of view as to who’s likely to win on the ground, not in a Wall Street analyst sense, but commercially, who’s winning in the marketplace.
And in the course of building our network, we meet a lot of companies. If you think about it, meeting those companies may not be something that’s going to lead immediately to a deal. Just because we have a common friend who thought it would be great if we met each other, it doesn’t mean they’re ready to sell their company or take in some equity capital. But we get to know them. We refer to this as planting a seed and we start to build the relationship. As we build the relationship, at some point there will be a life event which could be that they’re ready to retire and don’t have kids in the business, they need to do some estate planning, or maybe it’s that their largest competitor is now for sale and they’d love to buy them, but they need a partner to go do it.
What we hope is, at that point, they have gotten to know us well enough, even if they talk to other people, we are their preferred partner for the transaction that comes out of that life event. And so the intent or the strategy of our business is to plant enough seeds over a long enough period of time that it only takes a couple of them to pop in any one year and to turn into a deal.
We have found that this is the best way for us to not only find deals at prices that we find attractive, but candidly also to get to know our potential partners quite well, and know whether or not it’s going to be a good partnership between us and them. And that’s an incredibly important distinction because the market for auctioning businesses does not give you enough time to really get to know who you’re going into partnership with.
In the average auction you get a book that’s modestly informative. Then, you put in a first round bid. They open a data room. You go out to a management presentation. Maybe you have a dinner the night before and then a four-hour management presentation. After that, all your interaction with the company is typically through submitting questions in writing to the investment bank. You never really spend a lot of time with the company again, until you’ve been awarded the deal.
The challenge is, if you think as we do, that in a business sense you’re getting married, you’re doing so before you get to know the person very well. So the way that we invest gives us an ability to get to know the people, and know that we and they are well suited to each other. There could be wonderful people who you shouldn’t marry, and there can be wonderful management teams that are terrific people, but we shouldn’t be in business with them. And our process allows us to separate those two. When it works well, which it has quite often for us, we might do a negotiated deal. Or, more often, there’s likely to be a process, but at some point because of the existing relationship, we’re effectively given a last look and an ability to do the deal.
Bill: As a consequence of Spell Capital being in the business for over 30 years, we have over 5,000 unique deal-flow contacts in our database. We’re in regular contact with those sources and many of these sources provide us proprietary deal-flow. Second, based on our track record in certain industries -- plastics, capital equipment, various metal fabricating -- we usually get one of the first calls if there is a seller in those specific industry sectors. And finally, one of our managing directors was the recent president of our local ACG chapter. We also participate in various industry conferences, and with 12 investment professionals at the firm we’re networking constantly. The result is we’ve become a well-known player in private equity buyouts.
Walter: This is a timely question for us, but it is important to understand it in the context of our strategy. We go to market with our executive-centric approach called CEO1ST to identify, acquire, and build market leading companies through transformational acquisitions and operational excellence. We look for interesting deals, but people and ideas are just as important to our sourcing process. To help drive that effort on a daily basis, last year we hired a Director of Business Development, Teri Gjestvang. With her help we upgraded our CRM tools and improved our internal processes around recruiting and research, enabling our firm to execute the CEO1ST strategy in a more streamlined and effective way.
“The Tax Cuts and Jobs Act is going to drive valuations higher in the future because the free cash-flow component of these companies will increase and it’s going to allow private equity buyers to pay more.”
Bill Spell
I think it’s important to look at that in the context of our strategy. We go to market through this Executive Center CEO1ST approach, and that’s really a sourcing, an underwriting, and a value creation strategy. And to do that effectively, what we’ve made the decision on is we need to build more process and more resources in the sourcing arena. And so we’ve added to our team in the last year a new position, a director of business development. And that has really helped us more than we anticipated by giving us process, discipline, and consistency of looking for people, ideas, and deals, and smoothed out some of the peaks and valleys that are natural in the day-to-day lives of investment professionals. I think it’s a strategy and a model that others have pursued. We’d like to think ours is tailored more to the needs of our strategy, but fundamentally I think you see the industry’s been investing more in business development over the last couple years because of the importance of competing effectively in today’s market and seeing all the opportunities.
Many PE firms, of course, have a executive operational teams, but it just seems like your CEO1ST program is more process driven and more structured than most.
Walter: We are process and structure driven, because if you’re going invest resources you want to try to build a sustainable advantage that delivers consistent results over time. And we believe that comes from great process and execution, as opposed to one-off opportunities where you can afford to be opportunistic. We’re all for being opportunistic and getting lucky, but I think to execute well in this competitive environment, I think you have to have a sustained effort against it.
Rich: In just over a decade, we have built an organization that is responsible for employing over 62,000 people across the globe, which is perhaps only possible here in America. I believe a large part of our success can be attributed to our approach of treating everyone in our ecosystem like a client. Our ecosystem includes our Limited Partners, lenders, banks, brokers and intermediaries who provide us with the ability to find and sell companies. As an example, our Investor Relations team held over 200 meetings and phone calls with LPs in 2017, which was a year where we were not fundraising! It is just a fundamentally different approach to how you build your firm and its brand. Because of this, among other practices, many of our LPs have labeled our style as “old-school private equity.”
Often we find that private equity firms are loose confederations of independent contractors, where everyone holds their relationships close to the vest and try and claim attribution for deals. Rather than succumb to this model, we decided to institutionalize our Business Development function from day one to build a better mouse trap. No one partner at HGGC owns a relationship, whether it is a big bank, a middle market bank or broker. We have a dedicated in-house group that is responsible for all deal flow and has helped us evaluate over 4,000 deals. This practice is something that you cannot just decide to institutionalize one day—you have to do it at the outset of a firm for it have a good chance of success. It makes a big difference when you treat your ecosystem participants as clients by visiting them on a regular basis and holding proactive discussions around potential business opportunities.
You referred to “old school PE.” Does this structure that you have, is it unique?
Rich: We think it is an ethos that not all firms have at their core today, and the practice is not a secret. Back during private equity’s infancy, most control buyout deals were done in partnership with existing sellers, regardless if the sellers were other private equity firms, management teams or founders of the businesses. Nine times out of ten, these selling groups would reinvest a signifi-cant amount of money to be a minority investor in the deal going forward. That is simply not the case anymore. Many institutional private equity firms today want to own 100% of a business and bring in their operating teams with strict operating principles. They have their own opinion on how a business should be run, and they are going to push their agendas forward. We have chosen to take the artistic route as opposed to this ‘assembly line’ approach.
Nearly a third of the invested capital in our deals is reinvestment by the sellers who sold us control of their businesses. When your seller is as much a buyer as a seller because they are reinvesting meaningfully in the deal, that is true partnership investing. We have taken this “old-school private equity” approach to not only partner with management teams and founders, but other sponsors as well.
We just bought IDERA from TA Associates, where they were a significant re-investor in the deal, just like we did seven years ago during a billion-dollar partnership deal with Vista Equity Partners, which was a 51/49% equity split. Think about that, seven years ago we were partnering in doing a billion-dollar “old-school private equity” partnership deal, and here we are today doing the same thing. We are still one of the largest investors in our private equity funds, staying disciplined when evaluating deals and finding unique opportunities to partner with sellers who still see the opportunity for value creation with the right financial partner—like HGGC.
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