By now we’re all familiar with the refrain: 2008 is going to be a difficult year. Anecdotally there are rumblings of lenders becoming less generous, deals taking that little bit longer to complete, and private equity firms taking more time over their due diligence. Early figures indicate deal volumes may indeed be slowing down as people adopt a ‘wait and see’ approach.
Let’s make no mistake: 2008 will be tougher than for many years, and if lenders do become more risk-averse, as would seem likely, buyers may struggle to do deals. Debt providers are certainly going to be less gung-ho about lending beyond their comfort zone, and sellers wanting to exit in anticipation of a sustained downturn may have to settle for less. Those that can afford to ride out the current uncertainty and are confident of higher prices in a year’s time may choose instead to wait. If so, there could be fewer businesses for sale and scarcity will lead to higher prices. Supply and demand may yet even out: deal volumes and values may, in fact, carry on with scarcely a blip. But a wise investor will definitely be more selective in their investment decisions.
A flight to quality is inevitable, and any business that isn’t perceived as having the potential to become a leader in its market may struggle to find a buyer. A challenging economic environment will also hit portfolio companies hard, particularly in cyclical sectors where spend is perceived as discretionary, such as retail and leisure. Private equity houses invested in those industries may find themselves having to devote extra time and money to existing investments, rather than looking for new transactions. Investors are likely to become increasingly hands-on – after all, it’s their money on the line – so private equity firms will be under increasing pressure to keep investing and generating returns, be it through acquisitions, exits, refinancings, add-ons or additional investment in portfolio companies.
But before we all get too disheartened, it’s worth pointing out that even when market conditions are tough there are still opportunities aplenty – it’s just a question of knowing how to maximise them. It boils down to two things: firstly, knowing what you’re good at and sticking to it; and secondly – and this one is harder to achieve – already having a good reputation and track record in place.
2008 could be a year when smart private equity firms start to steal a march on their rivals. Yes, they will probably need to work harder but having a clear investment focus, and sticking to it, will pay dividends down the track. Firms will have to be even cannier at extracting value from portfolio companies, rather than relying on a well-timed exit to deliver returns. Private equity funds with a proven track record in business transformation will be at a distinct advantage as management teams and vendors, not to mention lenders, will be keener to transact with them.
In the mid-market, where debt is rarely syndicated, private equity firms with a good credit history and a strong relationship with their debt provider should still be able to finance deals.
More than ever before, successful mid-market firms will need to keep a clear head and maintain their investment discipline. By investing only where you have expertise and a proven track record, not to mention an existing network of relationships, private equity firms can continue to thrive – both in relative and absolute terms. Having a clear focus in terms of deal type, territory, size and sector gives a private equity firm the edge when it comes to deal origination. Firms operating at the £500m-plus end of the market may be tempted to invest instead in five £100m businesses as a way of spreading their risk in an uncertain environment. But if their skills are best applied to larger businesses, that strategy could simply be a way of minimising their returns over five separate transactions, thereby wasting five times the amount of executive time and effort.
Likewise, if a firm is used to backing sub-£100m businesses, and high quality investment opportunities of the type it is used to are hard to come by, there is no point in it pooling its resources and investing in one larger business.
Companies operating in the mid-market generally require a different approach from those at the larger end. They tend to need, and welcome, hands-on support. They generally expect to build a rapport with their private equity backers well before completion, and place great value on the advice and guidance that an experienced backer with an understanding of their business and their markets can give them. Taking a company from turnover of £20m a year to £100m a year through a buy-and-build strategy and creating a sustainable leader in a niche market is a skill that comes with experience. In the mid-market, a private equity backer has to know how to add value, and the best way is to keep doing deals of a similar size and type, in a sector and territory that you understand.
2008 may yet prove to be a turning point after the bull run of the early 2000s, but the future is still bright.