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Saturday, Apr 13, 2024

State of the sector: Hot trends in private equity for 2024

By Damon Houterman
Baker Tilly

In today’s challenging economy, private equity firms are struggling to find qualified talent with experience in managing not only finance and accounting but also operations. This historic problem has only worsened in recent years, with many professionals retiring and fewer people graduating with accounting degrees. Also, many individuals left the financial profession during the pandemic to pursue other aspirations. It’s created a void that firms are striving to fill.

This topic served as the backbone of a recent Q&A with Baker Tilly industry leader Damon Houterman as he examined the state of private equity in 2024.

Which 2023 PE trends do you anticipate will make the most impact in 2024?

Rising interest rates have been one of the biggest factors influencing PE deals, and we expect the current high-interest environment to continue for an extended period.

As a result, we’re seeing more structure around a deal, with more earnouts and seller notes. Sellers have been rolling more equity into a deal structure, which has tended to have less debt than in previous years, and buyers are thus more likely to retrade deals.

Before, PE firms focused less on earnings and more on working capital and debt items, as those two areas had a greater impact on the net purchase price. Earnings were important, but buyers wouldn’t necessarily retrade based on a discrepancy that turned up in due diligence. That isn’t the case anymore. Consequently, sellers are more likely to adopt sell-side preparation to preserve value.

A more recent development involves entrepreneurs and family-owned businesses.

Typically, when interest rates start to climb, these types of businesses wait for the market to turn in their favor, so the bid-ask spread on deals can be fairly wide, based on the expectation that the spread would decrease with changing interest rates. Since the end of Q3, we’ve seen capitulation from private and family-owned sellers. The bid-ask spread has tightened to the point wherein PE firms have opportunities to negotiate for purchase and to close deals.

Given current economic pressures and slowdowns in exits combined with rising costs of capital, what mitigating tactics do you see PE fund managers deploying with their portfolio companies?

In 2023, PE firms focused on enhancing the values of current investments. They enhanced the technology base, upgraded their talent base, and focused on the metrics associated with key performance indicators.

To illustrate this point, in a more active merger and acquisition (M&A) environment, we spend most of our time — often 70% or more — talking with investment professionals versus operating professionals. Today, we spend at least 70% of our time talking to operating professionals who want to enhance the performance of currently held businesses.

Supporting this effort, PE firms are starting to investigate and adopt technologies based on AI (artificial intelligence) and machine learning (ML). Overall, the sector is curious about the new technology, and some players are implementing systems or processes related to AI. It remains to be seen what the adoption rate will be — and whether the payoff for the investment ultimately matches the hype.

Of the concerns that your colleagues and PE clients worked on in 2023, which do you think are still underdiscussed or underrated, and why?

Due diligence is taking longer, and sellers are finding the process more tedious than in years past. Think about the periods that companies review when evaluating a potential acquisition — typically, two years and a stub. For most businesses, those were turbulent times, with many factors — positive and negative — affecting companies’ financial performance. PE firms need to sift through the noise to uncover that baseline business they can count on in 2024, 2025, and beyond. Due diligence now requires a lot more work than it did in pre-pandemic and recovery years, so there’s a level-setting of expectations going on.

Also, with the increase in retrading, we’re seeing more conversations with the previous owners of portfolio companies. Because the acquisition process can be difficult, these individuals aren’t always the best salespeople for the PE firms that bought their businesses, and these increasingly common conversations add another layer of complexity to the process.

One key area that has been underdiscussed is the prevalence of cyberattacks and contemporaneous cyber work within the current portfolio. In quiet conversations, operating partners will admit to breaches — whether it’s ransomware, malware, phishing, spoofing, or any other derivative cyberattack.

In our experience, many firms lack a thoughtful, portfolio wide policy on concurrent security evaluation and testing. Failure to establish a foundational cybersecurity policy is pure folly, particularly given the increased exposure of migrating to cloud-based processes and systems.

With the current geopolitical unrest, the most effective way for foreign actors to attack a country is by destabilizing confidence in the commerce system. Cyberattacks will only increase, jeopardizing not only the portfolio company and its performance but also the fund’s performance and investor confidence.

What interests you most in the current PE landscape, and why? Which concerns do you think are overblown?

We’re very interested in seeing how PE firms use AI and ML — specifically, whether the technology will deliver, disrupt or distract PE buyers.

Will it deliver sustainable, tangible results equal to the hype that’s in the marketplace? Will it disrupt business models, potentially creating new models or cannibalizing existing models? Will it distract firms by attracting huge inflows of capital to technology with an elusive or indiscernible investment thesis? Consider the example of robotic process automation, which was a hot topic for quite a while, yet we still don’t know whether the technology has delivered the results investors hoped for.

Regarding overblown concerns, we believe the PE sector is more resilient than credited. People are saying that PE is oversaturated and can’t survive in this environment, but we disagree. Firms have reoriented their focus and are waiting for the right timing. Historically, PE outperforms public equities during crises and recovers more quickly. Funds launched in this tepid environment could have similar results to those launched during the global financial crisis (GFC), which outperformed funds preceding the GFC.

Damon Houterman is a partner in Baker Tilly’s transaction advisory practice. Learn more about how Baker Tilly can assist with your private equity needs here or contact Damon at [email protected].

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