Private equity - Seeking opportunity in a scarce environment
This article was first published in CVCA Central in June 2018
The market for private equity firms has never been as competitive as it is today. Not only are the opportunities in the market increasingly scarce, but the amounts of capital to deploy have never been so high. Traditional private equity firms are competing against more and more firms as well as their customary limited partners, such as pension funds and family offices, who are seeking higher returns through co-investing and direct investing. As a result, private firms often have to expand their scope, strategy and/or risk profile in order to meet the return expectations of their investors.
Expanding the deal type
Most traditional private equity firms are control investors, seeking to own a majority equity position, with previous ownership or management retaining a minority position to align interests in growth. As market opportunities become more infrequent, private equity firms are looking at alternative deal types to deploy capital in quality businesses. Where a strong business is looking for a partner to execute on a growth plan, but is not willing to give up control, private equity firms are turning to minority equity positions as viable options, while structuring transactions where appropriate controls are put in place to protect their position.
Some private equity firms have also deployed non-equity structures that allow them to participate in a company’s growth while not diluting the existing ownership group. These mezzanine or structured product investment strategies can provide a private equity firm with a more targeted return profile while aligning upside to those that are executing it, i.e. management and existing ownership.
Buy and build strategies are certainly not new to private equity participants. The usual strategy, however, would involve the acquisition of a platform investment, followed by a series of add-ons that increase scale, diversify the revenue mix, expand products and services etc. all with the goal of increasing the exit multiple to drive a higher return on capital. With platform investments becoming more limited due to this increasing competition, some private equity firms are using alternative strategies such as buying multiple smaller businesses at the outset to create the platform or identifying a management team within smaller companies that will be leveraged to grow through acquisitions.
This expansion of deal type requires private equity firms to think outside the box and assess opportunities in a completely different way. This often requires a new skillset from within the firm to support and manage these investment structures. Private equity firms’ advisors also need to adapt their approach to these different deal types to best support them in identifying any risks in the assessment phase and subsequently manage and mitigate risks during the investment phase to create value prior to the investment exit.
Expanding the geographic target
Limited partners have traditionally mandated their private equity general partners to invest in specific geographic markets, often as a result of identifying and allocating capital to different private equity general partners in these different markets.
Often platform companies making add-on acquisitions in these markets have been the only method for private equity firms to participate in jurisdictions outside their core market. With businesses becoming more global in nature and local markets being so much more challenging, private equity firms are looking at expanded geographies in which to invest to be able to meet their investor return requirements.
Generally, this involves the private equity firm requesting from its investors a change in its mandate to be able to invest in these new jurisdictions. When these changes occur, private equity firms will tend to focus on geographies with similar markets, i.e. Canada, the U.S., the UK and Western Europe as an example. In Canada, few private equity firms have a true global investment mandate, a space predominantly occupied by the very large asset managers where their fund sizes require them to have a global view to remain competitive and sustain the levels of return expected from their investors.
The risks of operating in different markets offer both opportunities and challenges. Private equity firms that operate across multiple jurisdictions require both the internal infrastructure and external advisors that can support them accordingly, which requires a more substantial financial and human commitment.
Expanding (or contracting) the sector focus
Standing out in a crowded private equity market can be a challenge when competing for quality deals. Some private equity firms have expanded their sector focus to be able to identify a wider number of companies for their portfolio, while some have done the opposite. They have narrowed their focus to become very deep in one or only a small number of targeted sectors.
The expansion of sector focus is often done through the hiring of talent with relevant direct experience to support new sectors. Some private equity firms have also used operating partners to lead their ventures into new sectors. Backing talent is a key focus of private equity and partnering with key operating partners that have the background to create value in a new sector can significantly reduce the risk of entering into these new industry areas and can increase the firm’s credibility to attract new opportunities.
The narrowing of sector focus is typically more relevant to business owners looking at a partner or divestment where retaining their legacy is a major factor. This narrowing becomes even more relevant when the business owners are asked to retain an equity stake going forward. With growing eminence in an industry, some private equity firms are not only getting access to proprietary deal flow but are also better placed to act like a strategic acquirer with the ability to look at synergies across a portfolio of companies operating in a common sector.
Increasing the risk appetite
Certain risks have often been off limits for traditional private equity firms such as customer or supplier concentration, technology and management succession risks. While structuring was often used to assist in mitigating risks, some of these risks had traditionally been too significant for private equity firms to manage and mitigate.
With the changing environment, whereby technology is impacting every aspect of our lives and is a key driver in business change, technology risk is now an area which some private equity firms are getting much more comfortable with. Some firms are even going one step further by seeking technology-driven companies operating in more traditional industries that can be disrupters and agents of change.
Technology-driven investment requires the management of an additional layer of risk and ensuring the investment process deals with not only the traditional diligence items but is also underpinned by deep understanding of how technological change is going to further develop over the investment timeline.
All of these areas involve private equity firms taking on additional risk to meet the requirements of their investors and their expected returns. This requires the full buy in and commitment of a private equity firm’s limited partners. Engaging them early and often is key to success. With additional risk taken, limited partners will expect private equity firms to increase or expand upon their risk management processes and ensure their advisors are equipped to support them accordingly.