Private equity investors are awash in cash, with buyout funds sitting on a record $600 billion in uninvested capital, according to research firm Preqin.
That’s good for companies looking for buyers, capital or alternative financing deals.
“There probably hasn’t been a better time to exit your business in the last 20 years,” said Scott Paton, managing director and head of Financial Sponsors Group at SunTrust Robinson Humphrey. “If you’re thinking about how to grow your business, there hasn’t been a better time to access capital.”
In this frenzied environment, here are four developments in private equity (PE) that companies should watch for.
1. Valuations Remain Sky High
Valuations are high because of the huge amount of equity and debt capital available to provide leverage and produce positive returns.
For the first half of the year, acquisition multiples for corporate buyouts have remained elevated at about nine times EBITDA (earnings before interest, tax, depreciation and amortization), according to PitchBook.
What does this mean for middle-market companies? It should have founders thinking more about how to monetize their businesses. Not doing so could be a costly oversight in the current environment, Paton said.
Founders wake up every morning and think about their customers, their people, their operations and their competitors, Paton said. They often have little time left over to think strategically about monetizing their businesses and how changes in the marketplace might affect the values of those businesses.
Takeaway: Founders should evaluate whether the confluence of high valuations and the enormous amount of PE capital available makes this the right time to consider selling some or all of their business.
2. New PE Models Are Emerging
Given the huge amount of capital in search of deals, and the difficulty in finding appealing opportunities, PE investors are embracing creative deal structures.
While minority investors have always existed, some PE funds are providing the capital for a majority sale of a business, while allowing the founder to retain governance and control his or her company. Under this scenario, a founder could sell, say, 60 to 70 percent of the company, take money off the table, still control the company and attract a bigger, broader management team with unique skill sets.
Consider what this could mean: As a result of this capital infusion, a company that was the third or fourth largest in a fragmented market can suddenly buy up its competitors and significantly increase market share. Founders should be aware that if they pass on such opportunities, the competition may not.
“The fundamental question you have to ask yourself is whether this is the market I want to take advantage of,” Paton said. “And if I don’t, will my competitors take advantage of it, and what impact will that have on my business?”
Takeaway: If they’re not ready to exit, founders should consider the opportunity to monetize their firms over a long period, say 10 to 12 years, through these new PE funding models, as well as how their competitive dynamic might change if another player pursues this strategy.
3. What Happens In Washington May Not Matter
Tax reform, deregulation and other business-friendly government policies have been touted by the Trump administration since the presidential election, with much speculation about the impact on PE funds.
For all the headlines these topics have generated, more than half of middle-market dealmakers believe these policy promises will not affect PE’s ability to raise capital, according to a survey by ACG New York, the largest association of middle-market dealmaking professionals in New York.
A tax restructuring — such as a reduction in the corporate tax rate or a change in the deductibility of interest — might affect the economics of a deal or how a deal is optimally structured. Deregulation could relieve reporting burdens, but these charges will be absorbed by the private equity sector and are unlikely to materially affect how PE investors act, Paton said.
“A change in the corporate tax rate might drive up valuations a little bit, but valuations are already so high that people are having difficulty rationalizing the investments as they are,” he said. “It might throw a little gas on the fire, but when the fire is already burning white hot, the incremental temperature difference may be indistinguishable.”
Takeaway: News out of Washington creates a lot of noise but will likely have little impact on the proliferation of PE deals.
4. Everyone Is Thinking About A Downturn
According to Paton, every PE investor feels a downturn is overdue. Unlike 2007, when investors had heightened awareness that the mortgage market and housing prices were out of alignment, there are no material structural issues that point to a market drop.
The biggest current concern, geopolitical risk, is the least predictable. “As a result, we may be in for a longer period of recovery marked by lower but sustainable growth,” Paton said.
Given the current high valuations, PE wants to see companies readying for a potential downturn. That might mean that a software business starts shifting to a subscription sales model that provides recurring revenues, for example.
“PE investors want to see that companies have a greater focus on recurring revenues, particularly recurring sticky revenues, or that they are adding value to their customers that’s not easily replaceable even in a downturn,” Paton said.
Takeaway: Given that a downturn is on everyone’s mind, preparing for one should be on a company’s too — no matter how robust its business is today.