Private equity firms will be back in action over the next year - here's what investors should expect
Marianne Ayala/Insider
- Private equity deals have been down about a quarter over the past year, but they're rebounding.
- Private companies looking for funding or an exit now will have a wealth of options.
- In addition to big competition for deals, PE firms will also face challenges gauging their quality.
- See more stories on Insider's business page.
Last April, as the US confronted a historic pandemic, Alex Schneider, cofounder of private-equity firm Clover Capital Partners and adjunct lecturer of innovation and entrepreneurship at the Kellogg School, watched as the private-equity industry pressed pause on deals.
During the past year, deals were down about a quarter (though the average size of deals increased).
But now, it is safe to say that the pause is over. "There's a lot of deal-making happening right now, and there's a lot of money out there to do it," Schneider said.
Sellers who would've gone to market in a normal year but held off are now back in. The US election is over, the markets proved resilient, and vaccines have buoyed hopes of economic recovery. Companies' values are high, interest rates are low, and PE funds are ready to invest.
"Other than a few weeks' uncertainty at the end of March and early April 2020, there was substantial liquidity to keep credit markets alive," Schneider said. "Prior to the pandemic, there had been a lot of wealth created and limited places to invest."
Which is why Schneider predicts that the next year will be a busy one for these investors.
"Dry powder" and tax planning are fueling buyouts
One reason why the industry has rebounded so quickly is that many PE firms were in strong shape heading into 2020 - and there was a pause on deploying that capital in early stages of the pandemic.
The longest bull market in the US ended in March 2020, Schneider said, leaving PE firms with large reserves to safeguard against an inevitable market downturn. In 2019, so-called "dry powder" totalled $2.5 billion and grew to $2.9 billion in 2020, Bain reported.
As a result, PE firms are now primed to spend on buyouts. And due to President Biden's proposed changes to the capital-gains tax, there will likely be more assets to acquire. Currently, owners who sell their businesses this year should have their capital gains taxed at 20%. The current administration's proposal would double that for households making more than $1 million annually. This provides sellers with a strong incentive to close deals in 2021 rather than waiting for later.
"There's still demand to put capital to work through traditional PE funds," Schneider said. "There's going to be a bit of an urgency to deploy some of that capital here in short frame. I definitely would see multiples increasing and higher prices, which I think ultimately benefits sellers. We saw this in 2012 before the capital-gains rates changed from 15% to 20%."
Competition is heating up
Still, for PE funds looking to invest, deals may not necessarily be easy to come by - and competition for the best companies will be fierce. Private companies looking for funding or an exit now have a range of options including corporations, sophisticated family offices, and Special Purpose Acquisition Companies (SPACS).
"Corporate M&A is starting to pick up again largely because many large companies adapted during the pandemic and restructured - cutting costs and hoarding cash. Many are in a favorable position now to attack market share and innovation through acquisitions," Schneider said. "That's particularly true in the food industry, where companies like Kraft, Modolez, General Mills, and Unilever performed well through the pandemic and now have funds to invest."
Some sophisticated family offices are also staffing up, hiring their own investment professionals to source and execute deals directly, rather than investing in larger "blind-pool" funds. This allows them to reduce the amount of fees they pay for deploying capital. Multigenerational family offices also tend to have a longer investment horizon than the typical three- to five-year hold of a private-equity fund. This longer horizon is often an attractive feature to sellers as well.
SPACS, which the SEC calls "blank check companies," go public as shell companies without commercial operations. Their only assets are investments and IPO proceeds, which they later leverage to purchase a company. The Wall Street Journal likens them to "big pools of cash listed on an exchange."
"SPACS go public and then they look for a company to acquire," Schneider said. "This puts them into competition with a lot of larger private-equity firms. There's a ton of interest from institutional investors in this strategy right now, even if the market may be overheated at the moment."
While all of these have existed for decades, they have returned to vogue as companies seek financing options that have a greater deal of liquidity than typical private-equity investments can offer.
Atypical metrics, uncertain recoveries
In addition to fierce competition for deals, PE firms will also face significant challenges gauging the quality of these deals.
With many businesses having endured a highly atypical year, firms are having to find new ways to accurately scrutinize companies' health. Add to that the difficulty in gauging when certain sectors will fully rebound, and some deals may not be as easy to close as they were in the past.
"PE firms are analyzing year-over-2019, because 2020 was so different," Schneider said. "The metric that they're looking at is, how do we compare to the last year of pre-pandemic, and will that be accurate?"
One challenge for firms looking to invest: ongoing global supply-chain challenges, both in terms of materials and labor.
The pandemic has of course wreaked havoc on international supply chains for materials. Lead times have grown substantially, in particular with the global microchip shortage upending the production of machines for factory automation and automobile production. This has left plenty of otherwise promising companies with a lot of demand they cannot execute on.
Ditto for labor. "There's a need for labor in the market right now, particularly in manufacturing, retail, and the service industry," Schneider said. "The demand is there for workers, but companies are struggling to hire."
There is some optimism from business owners that as legacy COVID-19 unemployment programs trail off, the available supply of labor will bounce back, but it will take some time before labor supply and demand reaches equilibrium.
The biggest question for buyers and lenders is how well a company managed risk at a time when the priority went from value creation to value preservation. Those that got through the last year unscathed are going to make attractive targets.
"For a lot of business owners, the past 12 to 18 months have been the most challenging of their career," Schneider said. "They've experienced how events outside of their control could have a very meaningful impact on their business. As a result, many are more open to a sale or financial partner as a way to diversify their own risk. The second half of this year should see a wave of private-equity deals."