ARTICLE
25 October 2024

A&M Value Creation In Private Equity Report

Private Equity (PE) firms are sensing a potential recovery in the M&A market, with deal values rising 42% in Q2 2024 compared to the previous year, although the number of transactions fell by 7.4%.
United States Corporate/Commercial Law

Foreword

Private Equity (PE) firms may have gotten a whiff of recovery from the stifling dealmaking market of recent years as M&A activity showed signs of recovery in the second quarter of 2024. Deal value surged 42 percent in the second quarter compared with the same period last year, despite a 7.4 percent decline in the number of transactions.

It's a hopeful sign, but the industry is not out of the woods quite yet. Portfolio companies continue to grapple with the effects of higher interest rates, inflation and post-Covid supply chain disruptions, while a valuation mismatch between buyers and sellers is largely keeping PE exits on hold. As a result, distributions to limited partners (LPs) dropped to a record low, hampering the fundraising that flows during typical markets.

Now, with the U.S. Federal Reserve starting to cut interest rates and inflation mostly declining, the industry is starting to reflect a bit more optimism. According to S&P Global Market Intelligence, the U.S. PE market is expected to recover quicker than Europe's and other global markets as investors put their record dry-powder capital to work.

So what have PE investors been doing to sustain returns while they buy time for better market conditions?

To answer this question, we surveyed 50 PE investors, operating partners and C-suite portfolio company managers across North America to understand how their investment and value creation strategies have evolved in response to the tougher environment, as well as how they are preparing for a new cycle. In this report, we explore the key findings from the survey, including the growing emphasis on large-scale operational transformation within portfolio companies and the integration of generative AI in value creation.

We hope these insights will prove useful to PE leaders as they navigate the challenges ahead and position themselves for the future.

Introduction

The PE sector both in the U.S. and globally finds itself in a frustratingly lethargic environment in which high interest rates and longer exit horizons have sharply stifled deals and dented returns. Following the post-Covid boom in 2021, PE M&A activity has finally picked up and is pacing about 12 percent ahead of estimates from a year ago, according to Pitchbook.

In actual volume and deal counts, however, the first six months of 2024 still lag 2023. Year-over-year deal volume and deal activity at the half-year mark declined approximately 8 percent and 17 percent respectively when compared to 2023. North American volumes are aligned with global activity, which slipped about 22 percent during the same time period.

Megafunds, which command $5 billion or more of assets under management (AUM) and comprise more than half of the fundraising market, have been hit hardest by these conditions, recording single-digit or even negative returns after 40 quarters of double-digit profits.

Mid-market funds — those between $100 million and $5 billion AUM — have been more insulated from the current climate given their focus on smaller deals, which are more easily accomplished and give them more opportunities to improve company valuations than Megafunds, whose assets tend to be optimized already and are of larger scale. They have also fared better in terms of fundraising. In the first half of 2024, they raised an aggregate value of about $80.8 billion, representing 52 percent of all PE capital raised so far this year.

Exit activity has been depressed as buyers and sellers battle over valuations, with exit activity in the U.S. down 34 percent since 2021. However, exit value has increased about 15 percent at 2024's midway mark compared to last year. This may reflect fund general partners dangling their prime assets in front of potential buyers to generate deals while holding onto less attractive portfolio companies for much longer.

It's the longer exit horizons that have weighed heavily on funds' returns. The historical hold times of three to five years has lengthened to an annual median exit hold time of about 7.1 years in 2023. In the current environment, funds are testing alternative deal structures, such as employee stock ownership plans — essentially a qualified retirement fund — that can offer tax deferral benefits with creative structuring. It's unique, but it indicates the lengths some managers will go to get returns.

The growing backlog of portfolio companies are forcing funds into uncomfortable positions. They must either squeeze more value from their assets and wait on a more favourable deal landscape or face the significant challenge of refinancing at much higher rates. The longer wait times are translating into limited distributions to limited partners, which in turn stifle fundraising on the back end of the cycle.

PE deal activity

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The Path Ahead

So how is the PE environment evolving from here? And what value creation strategies are being put in place as the industry heads toward this new cycle? We are optimistic that PE dealmaking will continue to improve as interest rates subside and borrowing costs ease. An improved outlook for the global economy in 2024 — with inflation slowing and growth returning to many economies — is also helpful.

In fact, we are already seeing some signs of life coming back to the market. The increase in M&A activity in the first half of 2024 stems largely from the return of big-ticket transactions. In the U.S., large deals including the $15.5 billion buyout of Truist Insurance Holdings by a group led by Clayton, Dubilier & Rice, Mubadala Investment and Stone Point Capital confirm that trend.

Additionally, we continue to see some funds actively pursuing transformative deals via smaller add-on acquisitions. While add-ons have been key to PE deal volumes remaining resilient in the last two years, executing these platform strategies has become more complicated.

One reason for that is the rise in interest rates, which is limiting financing for such transactions. Secondly, the longer timelines for completing M&A deals means that businesses are often being acquired halfway through the enlarged company's holding period, reducing the window for realizing synergies.

Consequently, funds are having to work harder on their buy-and-build strategies, putting emphasis on integrating platforms, making business models fit for digitalisation, incentivising management and undergoing meticulous exit planning.

Exit Readiness: The A&M Approach

The exit logjam in PE has deep implications for value creation and exit readiness plans. As discussed in our survey findings, funds are taking a more targeted approach to value creation, doubling down on interventions to generate top- and bottom-line growth at speed to insulate firms from the current headwinds. Data-based and AI techniques have become a critical pillar of such programs.

When it comes to exit preparation, we have also seen a few changes. PE funds and portfolio companies' management are being more proactive than before in financial loss — or disaster — prevention and exit preparation, with a view to maximizing transaction value in the tough dealmaking environment of today.

In our experience, a careful and well-thought-out exit preparation program should start at up to two years before the planned exit transaction date. Funds need to show demonstrated improvements to get full credit for valuation upon sale, especially in the current environment of longer holding periods, to increase the viability of a successful exit. The plan must include the creation of a consistent equity story to protect value, as well as the launch of some "quick win" initiatives to validate the value creation opportunity for potential bidders.

Generally speaking, buyers think they can always improve the performance from the former owner, and a robust equity story helps the seller kick-start the buyer value creation process and bridge the gap between any price expectations.

A Paradigm Shift

In this new cycle, we see PE firms increasingly pursuing new — and sometimes more radical — ways to create value at their portfolio companies, as revealed by our survey this year. Typically, our study found this involves the use of data-based techniques, including AI, to find opportunities for margin expansion and revenue growth.

This represents a significant paradigm shift for an industry that for years relied on multiple expansions and more traditional levers such as moderate and cautious cost cutting to achieve value on exit. While Megafunds tend to focus on carve-outs of large Fortune 500 corporations to secure assets, mid-market funds prefer buy-and-build models. What's new is that about 70 percent of all respondents were very likely to rely on organic growth for added value within their current portfolio companies versus just buy-and-build strategies.

Now, value creation interventions have a sharp focus on generating higher organic, profitable growth. Some of the levers being pulled to achieve that are market diversification, an increased focus on high, profitable service business growth, better pricing, improved customer experience and optimized processes — many of which are being executed with the help of cutting-edge data analytics and tested-and proved digital tools, including but not limited to AI.

In the next chapters, we will look further into the key findings of our survey to understand how these new approaches are taking shape.

To view the full article click here.

Originally published 18 October 2024

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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