Middle-market PE firms prepare for a shift
The public markets’ downturn and subsequent volatility, along with rising interest rates and the possibility of a recession, are leading middle-market sponsors to begin changing their approach to dealmaking after 2021’s good times. Investors say those factors are creating opportunities to scale platform companies—especially those in a fragmented market—through add-on acquisitions, in which sponsors buy smaller businesses to add them to the platform companies they already own.
As the public markets have dipped from last year’s highs, private market valuations have begun to recalibrate, opening the door to more, smaller deals targeting companies at lower valuations, they said.
“Add-ons are typically smaller acquisitions made at lower valuations; there is arguably less of a valuation disconnect between buyer and seller expectations for smaller companies than there are for larger companies which are more likely to be viewed as platforms,” said Zia Uddin, president and co-portfolio manager at Monroe Capital.
Nitin Gupta, a managing partner at middle-market PE investor Flexstone Partners, said the current environment is expected to push sellers to readjust their expectations for valuations, in particular smaller, founder-owned businesses, allowing sponsors to add new acquisitions to their platform companies.
“We can buy smaller companies at more accretive multiples, and it allows us to lower our offer price,” Gupta said. “Post-acquisition synergy multiples can be very attractive in buy and build strategies: Sellers will eventually readjust their expectations for valuation, but to date valuations in private markets have not come down much.”
He said he also expects large buyout funds will increasingly look to the middle market for add-on deals, creating more exit opportunities for middle-market PE sponsors. His firm has carried out three exits since the first quarter to sponsors or strategic buyers.
PE looks to snap up venture-backed startups
The private markets’ value recalibration has extended to some venture-backed startups, which have seen valuations fall and exit opportunities dwindle. As a result, PE firms are targeting high-growth companies held in VC portfolios and look to acquire them at lower prices.
“PEs have always been interested in buying up venture-backed companies, however, the interest is probably a bit higher now than usual because everything is on sale,” said David Spreng, chief executive and chief investment officer at Runway Growth Capital. “On a (valuation) multiple basis, a lot of companies are essentially half price.”
Many investors are holding on to their best assets and doubling down on their stakes in those top performers. But not every venture-backed company has such luck. For some startups, if they can’t raise additional capital from investors to extend the liquidity runway, the VCs that control these companies are likely to market these businesses for sale.
“These investors may want to take what they can get now, potentially settling for an okay instead of a great return,” Spreng said. “You’re seeing a lot of that happening right now.”
Venture-backed exit value in the US stood at $48.8 billion in the first half of 2022 compared with $777.4 billion in the same period in 2021, according to PitchBook data. The steep drop came amid stock market turmoil, the worst quarter for new listings in 13 years and tougher conditions for SPAC mergers.
Cash flow management comes to the fore
Sponsors in the last several months have been focusing more on managing their existing portfolio company’s cash flow, a contrast from last year, when more resources were spent on conducting due diligence for new acquisitions. The shift is another way sponsors are positioning their portfolio companies for future headwinds, said Sean Mooney, founder and chief executive at BluWave, a business network that connects sponsors and companies with third-party service providers.
“The PE industry foresaw the coming storm, and they have been talking about a coming recession for the last six months,” he said.
They have undertaken activities including hiring specialized consulting firms to design product pricing strategies to keep up with inflation, recruiting procurement specialists to help make strategic purchases of goods and bring down input costs, and enlisting other professionals to make operations more efficient.
PE firms are also bringing in interim CFOs specialized in managing a company’s liquidity, he said.
Value creation-related PE activities—which encompass the undertakings mentioned above—rose to 74% in the first half of 2022, up from 65% H1 2021, according to the BluWave Activity Index. Due diligence fell to 26% in H1 2022 as compared to 35% in the year-earlier period, reflecting a slowdown in new M&A activity, the data shows.
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