March 15, 2022

M&A in the Middle - A Private Equity Lesson

By Bill Myers, Vice President, Sales - Private Equity

Why are private equity (PE) firms interested in acquiring US middle-market companies?

Because they always have been! But why now especially? The US mid-market is a prime hunting-ground for assets you can grow quickly to achieve a swift exit. So when interest rates are low and debt is easy to come by, PE firms will swoop. According to PitchBook, PE accounted for a record 20% of global M&A activity in 2021, of which the US mid-market activity made up 27.5%.

Other factors are kicking in too. There’s a lot more scrutiny of deals now, for both security and antitrust reasons. That means fewer corporate mega-mergers, and when those do happen there are more divestitures and spin-offs. So PE is picking off these tasty opportunities.

In addition, PE firms are sitting on a mountain of dry powder, feeding a trend of funding acquisitions through direct lending. We saw this in action recently in one of the largest buyouts ever: a consortium of PE firms acquiring a family-owned medical-supply company.

What are the main areas of concern for PE firms?

Economic weather is always an issue – which at present means things like the changing monetary policy, shifting regulatory priorities, a greater focus on environmental, social and governance (ESG) risks, tax reform, inflation, supply chain challenges and labor shortages (the “Big Quit”). According to our December 2021 survey of 600 global dealmakers, the top deal-breaking risks this year are likely to be ESG factors and inflation.

Then you have the risks down at deal level. A white-hot market, scarce assets, frantic competition. Due diligence in the Americas is being raced through – an average 19% faster than last year, according to Datasite Insight. And this is with a reduced workforce. Efficiencies simply must be found, such as through technology like ours.

Now, factor in sky-high valuations. These make it tough for PE firms to create an investment thesis with robust ROI. One solution has been to focus on roll-up strategies, while another has been to dodge competitive auctions in favor of one-on-one acquisitions.

Consequently, in this part of the market, more buyers are preferring to take the wheel on due diligence. Instead of having the seller call the shots, buyers are finding it more efficient to set up and manage their own data room and have sellers upload documents into that. Our dedicated buy-side platform has been instrumental here.

Why are PE firms getting anxious about ESG risks?

We’re seeing ESG transform from check-the-box compliance to a genuine source of value creation — or potential value loss. Our research shows that ESG issues now register as the highest priority for boards, and that nearly three-quarters of PE dealmakers expect to see more deals sink in the coming two years because of issues surrounding climate change. With the direction of travel so clear, it’s no wonder that businesses everywhere are feeling the heat.

Larger PE firms have already made ESG issues part of their due diligence processes. Mid-market firms can head off many risks by doing the same  and we are increasingly seeing that become a core part of their strategy and value proposition to investors . Another good practice is to address any ESG issues in portfolio companies prior to selling, to make those businesses more attractive.

Above all, the motto is “buyer beware”. An asset with hard-to-fix ESG problems could start losing value from the day of purchase. And PE firms know it. We saw unprecedented levels of deal scrutiny in 2021, with due diligence teams reviewing 34% more materials on average  than in 2020. 

Meanwhile, there are new openings, especially in the energy and power sector. Our research shows that green energy initiatives will represent the biggest M&A opportunity in the sector over the next five years. We’re also seeing global investors place bets on clean tech, with a primary focus on agriculture, food, and mobility — these being the biggest carbon emitters. The 41% surge in technology, media, and telecom (TMT) projects in 2021 wasn’t just about remote working — a big chunk of it was clean tech.

What’s going on elsewhere in M&A that might influence PE activity?

The US has a housing shortage to overcome, so both home prices and the home building market are shooting through the roof. That’s resulted in much PE activity in the real estate space, and also in infrastructure.

We’ve seen record PE activity in the past year, especially in TMT. How does the industry sustain this without burning out?  

Inevitably, there are limits to dealmaking capacity. In our survey of 400 dealmakers, close to 90% told us that they were now being more selective in choosing deals to pursue. Even allowing for this selectivity, a busy year lies ahead. We expect PE firms to find efficiency gains through technology and external specialist support.

One example of this is the rapid adoption of our previously mentioned buy-side platform, Datasite Acquire. This lets buyers run an easily repeatable process while consolidating checklists and all other workflow items in one place. Now that they don’t have to muddle through a new seller’s data room for every new deal, they can save huge amounts of time, while getting specialist buy-side support.

There are efficiency gains to be found on the sell side too, via technologies such as artificial intelligence and machine learning. These help not just with high transaction volumes, but also with automating the most time-hungry parts of M&A, such as asset marketing, deal preparation, and due diligence itself. It translates into more completed deals for the same — or less — effort.

And, of course, PE would be nowhere without funds. Technology such as Datasite Outreach can help with the whole process of investor engagement, keeping track of prospects, progress, and potential obstacles. Along the way, it creates better transparency for stakeholders so that fundraising hits fewer snags. In short, every cog in the deal machine can now move faster and more smoothly.

For more insights, download the 2021 Annual US Middle Market Private Equity report.

2021 Annual US PE Middle Market Report

US PE middle market tops $600B in 2021, but inflation looms.

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