By Jim Childs
Although the IPO market has made a comeback of late, the private equity market continues to gain share, with the US seeing a continued rise of PE-backed companies. These companies enjoy significant access to capital and operating expertise compared to non-PE backed private ones, which has pushed the private sector to be more sophisticated and competitive.
With an expanding private equity sector (the number of PE-backed companies has risen from roughly 1,000 in 2000 to almost 8,000 in 2019), companies also have more options than ever before to access private capital across debt, minority or majority equity investments, which could enable mid-market companies to tap into the value of a private equity partnership without fully divesting.
First, the trend has created an appealing environment for potential sellers. Private equity fund managers are forced to put funds to work in investments or risk the viability of the firm itself, since insufficiently invested funds are not able to generate positive returns in future periods. The race to commit capital becomes ever more competitive as the industry for private funds expands. In other words, private-fund demand for companies has grown exponentially. The supply of companies, on the other hand, is essentially constant.
The impact stretches beyond companies considering a sale to private equity. It has also led more broadly to a changing operating environment for mid-market companies. The estimated market value of PE-owned firms has exceeded the public market capitalization of global companies since about 2007, according to McKinsey’s Global Private Markets Review 2021. PE owners take an aggressive approach to value creation, and they use sophisticated tools and processes to drive growth and profitability. With a large share of PE-backed firms in the marketplace, the performance baseline for day-to-day operations has escalated across most industries.
Here are five areas that illustrate the benefits that PE-backed private companies are seeing:
Governance advantages: Private equity owners often use more advanced governance as a process to institute discipline and accountability throughout the operating structure of their holdings. One of the key methods of achieving this is through a board of directors. The board typically includes outsiders who bring experience to the business from across the industry and across operating disciplines, from supply chain management to accounting practices.
An edge on strategic planning: Using an operating partner model or skills from the board of directors, private equity investors have pushed many industries to a new level of strategic planning. PE-backed firms use a repeatable process for establishing or updating company strategy, outpacing the approaches of smaller operations. They also excel at vertical integration, including pairing complementary companies within their portfolios.
Incentives: Compensation packages are an important tool for securing management talent in a competitive market, and the structure of PE investments can work favorably in the design of executive-level compensation. PE-backed firms often create pay structures for key personnel, including equity awards that monetize when the PE firm exits the investment.
Aggressive investment in technology: Armed with clear data on the return on investment of expensive technology outlays, PE-backed companies are likely to spend more on technology. This kind of investment can pay off quickly in the smaller, fragmented markets that middle-market companies often serve.
An acquisition mindset and skillset: Buy-and-build has proven to be a successful approach across many industries as companies capture synergies and the economics of scale. Because the PE industry is rooted in transactions, PE-backed firms are at a huge advantage taking this strategy to their markets.
Partnership advantages are here to stay
The megatrend toward private equity has already changed the business landscape permanently. Today’s sellers care as much about partnership advantages as they do about price—an indicator of what a powerful force the right PE partnership can be. With private equity operating partners, boards, and top-tier management talent, PE-backed companies have major strategic advantages.
That’s not to say that PE is the only way. There are many non-PE backed private businesses that are succeeding. However, PE ownership is raising the intensity and quality in a number of aspects of the private sector.
This megatrend has also generated broader options for mid-market companies. In the market for capital, companies now have access to various options for majority and minority equity investments, and private debt options have proliferated. Mid-market companies should consider the range of options carefully, as they could tap into the partnership benefits of PE investors without being limited to a complete sale of their businesses.
Jim Childs is head of Citizens M&A Advisory. For more, go to citizensbank.com/insights.