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WilliamsMarston’s Jon Marston on the evolving lifecycle of private equity investment

Covid may have accelerated the evolution, but changes to diligence, value creation and exit strategies were already afoot, says WilliamsMarston partner Jon Marston.

Jon Marston
Jon Marston, WilliamsMarston

The week of March 15 marked the anniversary of local and state government lockdowns at the onset of the covid pandemic. A lot has certainly changed since; how would you characterize the impact in the C-Suite and on the processes that shape the PE investment lifecycle?

Private equity, by its very nature, has always adapted. Historically, one of PE’s big selling points to business owners and the C-suite was the ability to pursue ambitious transformations to enable long-term growth, rather than be subject to the relatively short-term focus of the public markets. In many cases, covid required that – ambitious transformations. So, in hindsight, the industry was uniquely suited for the challenges posed by the pandemic.

That being said, while covid may have accelerated private equity’s evolution, in many cases it wasn’t necessarily the cause for change; it just left sponsors with no other option than to adapt more quickly to shifts already occurring.

What changes have you observed in due diligence processes at this point?

In many sectors, asset values had come down, so buyers and sellers were a bit closer, which drove deal activity. But given a still-uncertain backdrop – post-covid, as the new administration finds its footing, and ongoing digital transformation – prospective buyers are now taking deep dives into the drivers of 2020 performance and how it translates to future performance. They either want to understand what went wrong and how a company is going to fix it, or what went right and how sustainable that will be.

Diligence, as a result, is scrutinizing changes in end markets and sales channels, assessing supply chains, and re-evaluating cost structures to identify potential upsides or risks to growth. Tax changes, of course, are an additional consideration. Beyond just those issues driven by the CARES Act, other more subtle factors can’t be overlooked. There can be nuanced tax implications posed by covid-driven changes to capital structures, net operating loss attributes, or even whether the workforce has relocated to other jurisdictions.

Because the ground has shifted, it’s about getting back to basics. There’s certainly a renewed focus on what data is being provided and what it is telling us. Then, you have to translate that into a go-forward model. So diligence today is looking at a wider range of upside and downside scenarios, which means it takes longer and involves more collaboration across the diligence effort.

Moving onto the actual deals, how has the shift to a ‘hybrid’ working environment impacted integration strategies and approaches to the first 100 days of ownership?

Successful integration starts with great communication. To a certain degree, we can collaborate more easily now through widely adopted video-conference tools, but there is still the ongoing demand for in-person contact to build strong relationships. That’s happening a lot less in many sectors. So, while integration or first-100 days-planning may be more efficient, there are certain intangibles that risk falling through the cracks.

Prospective buyers are now taking deep dives into the drivers of 2020 performance and how it translates to future performance.

Additionally, you could previously put an integration or 100-day plan in place that was drawn upon a fairly consistent set of assumptions. Now we see managers more often taking a phased, or hybrid approach because uncertainties require delayed decision-making. Management teams want to see how things play out before fully committing, whether that is to do with real estate requirements, go to market strategy or other investments.

Finally, there’s a heavy focus on systems and technology; everybody is engaging with customers, employees and vendors electronically, so cybersecurity continues to be critically important.

How have managers adapted their approaches to value creation in light of new factors?

As it relates to longer-term value creation, business models continue to change quickly and operations professionals have had to adapt. In many cases during the pandemic, sponsors were able to help their companies navigate through the uncertainty by adjusting strategies or using their platforms to share best practices, not to mention providing capital to either weather the disruption or be opportunistic in pursuit of market share. Now the focus is on understanding what changes prompted by covid will endure in the long run, and what will revert to ‘normal.’ Again, it goes back to PE’s ability to adapt.

It’s also been a dynamic landscape for exits, particularly in light of the SPAC boom. What impact has this had on approaches to exits and exit strategies generally?

On SPACs, specifically, blank-check companies have effectively opened up the public markets to companies that previously wouldn’t have pursued a full scale process. And there are certainly some advantages over a traditional IPO. For instance, companies can retain flexible deal terms; most SPACs also have experienced managers who can add value; and there is less volatility and a shorter runway to exit, versus a full process which can take 12 to 18 months or longer. However, as it relates to most regulatory matters, the same rules still apply.

At the same time, the stock market has armed strategic buyers to be aggressive, while PE and VC funds are sitting on $2 trillion of dry powder. So, again, fund managers are going to be opportunistic and sometimes employ a dual-track approach to explore different exits. Given these trends, though, there is real value in being “public ready” as it relates to financial accounting and reporting, audits and governance.

Finally, how do you think the new US administration will impact private equity, and where and when do you expect to see the greatest impact on demand for your services as a result?

The American Jobs Plan, as it’s currently proposed, would see around $2.2 trillion of investment over the next 10 years, channelled toward infrastructure, employment, and research and development. Private equity funds and portfolio companies are going to be shifting strategies as a result, targeting sectors positioned to enjoy a tailwind.

Parallel to the infrastructure bill, the administration also outlined changes to the tax code that would hike the corporate income tax rate, impose a minimum tax on large companies that report high profits but have little taxable income, and boost enforcement against avoidance strategies more generally. What is missing is any change to capital gains tax and carried interest, which for now is a silver lining for sponsors.

In terms of demand for our business, though, change generally is a catalyst for consultation. CFOs, in particular, are faced with so many challenges – both operational and regulatory in nature – so they count on our experience and expertise around these newer challenges that they may encounter once in a career, but we’re dealing with every day.