By Shaharyar Ahmed
“Everybody has a plan until they get punched in the mouth.”
It’s Mike Tyson’s iconic quote that became applicable to just about every industry in 2020. If covid was the figurative right hook, private equity was the industry that seemed to be taking it in the ribs more than others – owing to its abundance of instantly outdated plans (of the value creation, exit and fundraising varieties, for example). The punch, however, proved far from a knockout; although PE’s plans were upended, 2020 became the year the industry proved its ability to pivot.
So, what have we learned? That private equity can persevere and even flourish through economic curves. And the only thing we can really count on this new year is certain uncertainty. However, that doesn’t mean there aren’t beacons in the fog – clear signs of the transaction trends emerging across the PE industry in 2021. Here are three of those trends:
De-risking of the deal: This year will continue to see flexible, de-risked deal structures. These structures – earnouts, sellers’ notes, conservative leverage, valuation ratchets, greater downside protection/preferred equity/convertible debt – not only bridge valuation gaps between buyers and sellers, but also serve to mitigate risk given market uncertainty. Of course, there are still risks, even to these de-risked deals. Earnouts, for example, can be an impediment to successful and accelerated post-merger integration and synergy realization. Convertibles and other excessively creative deal variants can be dilutive to management and expensive for buyers, muddying exit plans for sellers. To hedge against those risks and prevent companies from becoming hostage to overly engineered deals and tortured capital structures, sponsors should follow the golden rule of deal making: keep it simple, keep it short. (One year of earnout is better than two, which is better than three.)
Roll-it-up, carve-it-out, tuck-it-in: The bite-size deal is king and will reign supreme through the remainder of this year as sponsors encourage management teams to engage in platform plays, growing their existing business inorganically. The de-risked elements of the bolt-on include an intimate familiarity with, and confidence in, existing management teams and operating models. The accelerated pace of these deals can also be attributed to their availability: large businesses will continue to seek additional liquidity by offloading non-strategic, non-core assets in an uncertain market, making such deals ripe for the picking. But just because they’ve been bitten-off doesn’t mean they’re easily chewed and swallowed. Rushed deal times meant to prevent the seller from running a full-scale sale process will lead to diligence mistakes. Experienced buyers must mitigate against the inevitable misses with mobilized management teams, a full finance team infrastructure and trusted third-party service providers.
Where accelerated diligence can cause front-end headaches for the ill-prepared, back-end issues can cause valuation problems for those uninitiated in the yeoman’s work of integration. Sponsors must double-down on post-merger integration plans and teams, otherwise they will never be able to realize the full exit potential of these Frankenstein companies at exit.
Spotlight the special: Special Purpose Acquisition Companies (SPACs) will continue their unusual ascent. These companies – publicly listed firms with a two-year window to merge with a private company as a pathway to public trading – had a record year in 2020. Their perceived advantages in terms of the structural benefits and flexibility they offer to both sponsors and targets make them an easy sell in a period of certain uncertainty. But it doesn’t always make them a profitable investment – at least not for all. While SPAC economics are favorable to sponsors and pre-IPO investors, their dilution and cash costs significantly reduce the returns of those who invest concurrent to the merger and hold it for some time post-merger.
Sophisticated sponsors can avoid return inequity with carefully drafted and meticulously executed value creation plans, which drive enough value through ongoing involvement with the post-merger company to fill the hole created by SPAC’s dilution. In addition, sponsors should plan for more hands-on involvement during integration (and for performance improvement purposes) to offset management’s inexperience, especially given the complexity of operating as a publicly listed company.
In addition to these three trends, there are broader market tendencies that will play into the 2021 landscape as well: the accelerated close times and amplified valuations of the most covid-resilient sectors and business models (technology-related things like SaaS, cloud, remote work, B2B digitization). And the sectors that have fared less favorably through the pandemic (lodging, real estate, etc.) where seller valuation expectations outpace recovery, will continue to lead to dampened deal activity. There’s also the continued, expected consolidation of larger Sponsors within the industry, and the ongoing maturation and inevitable dominance of large tech investors.
All of these macro-market narratives will inform the pace and risk-appetite of deal activity, but it is the handful of risk-mitigating deal structures that will most define that state of 2021 transaction activity. What will separate the winners and losers? It may well be their willingness to see (and plan against) the risks inherent in even these de-risked deals.
By Shaharyar Ahmed, Director, Accordion, the private equity-focused financial consulting and technology firm.