Private Equity: Q&A with Jasper Van Heesch

Q&A with Jasper Van Heesch

In The Real Economy’s latest topical survey, Private Equity (PE) came out as an incredibly popular funding option for the middle market. 47% of our panel of middle market business leaders expect to use PE as a funding option over the next 12 months.

One of the main reasons why private equity is currently such a highly sought-after funding option is due to the knock-on effects of the considerable economic turmoil of the last 12 months. Debt has become a lot more expensive, with many options taken off the table all together. On top of this, a build up over the past two years has left PE dry powder (the capital that has been allocated to be deployed) at an almost record high.

A private equity investment is an attractive option for many businesses in the middle market, especially for those looking for growth and added resilience, as it comes with a strategic partnership, one with experience and strategic knowledge of how to enter new markets, make acquisitions and help navigate the tumultuous economic environment.

Director and Private Equity Senior Analyst, Jasper Van Heesch, discusses the PE landscape, why businesses are looking to raise capital and how it will be deployed.

 It’s clear from our survey results that middle market businesses are seeking additional finance. What does that tell us about how important fund raising and alternative funding streams are to the protection of those in the middle market?

Having capital, or having access to capital, provides businesses with a certain amount of protection. But it also opens up opportunities.

In the current economic climate, businesses are under pressure on multiple fronts, and protection for their organisations will be a priority for leadership. Over the past 12 months businesses will have been dealing with lost or struggling clients, increased costs, cash traps in accounts receivable and potentially excess inventories, all meaning that companies need to protect their liquidity position. Having the security provided by a supply of capital to call on when needed is crucial.

But in these times of, shall we say ‘moderate crisis’, it’s important that organisations innovate and having access to capital facilitates those opportunities. For example, looking internally, investment in research and development, such as training and new operational equipment to increase productivity and competitiveness, can be a huge opportunity for the middle market, and the UK more generally.

Within the G7 the UK is behind the US and France in terms of productivity, and just ahead of Japan and Canada. It is therefore very encouraging that 44% of the respondents to the survey were looking to use capital on training and development. It was second only to energy cost investments, at 46%, but that is understandable in the current energy cost environment.

From an external perspective, capital allows businesses to grow rapidly and shore up their strategic and competitive position. The capital can be used to make acquisitions or grow organically, for example by entering new markets, expanding capabilities or entrenching themselves in their current attractive markets.

The issue for businesses at the moment in terms of accessing capital, however, is that the supply of capital available from banks has slowed, and the funding that is available is expensive. Companies are therefore turning to alternatives like private equity and debt instruments, such as asset based lending and private lending.

Direct lending by private debt funds in particular has become an important funding source for the middle market since it first emerged after the Financial Crisis. What’s interesting about this is that it typically has a higher risk appetite compared to banks. That usually comes at the cost of higher interest rates than banks, but it also offers greater flexibility on the terms offered to companies, e.g. bullet repayments at the end of the loan rather than payments due from the outset. At the end of 2022 there was a direct lending dry powder pool of $146bn globally, which can be deployed quickly – a significant amount.

 47% of the middle market have indicated that they expect to use private equity finance in the next 12 months. Is that a surprising figure to you?

Not surprising at all. And that’s for two reasons.

Firstly, in addition to the debt supply and cost dynamics, other equity capital sources have been under huge pressure. IPO’s have all but shut down, there were just 45 in 2022 on the London Stock Exchange, down 62% from 2021 and a massive fall of 90% in proceeds. Venture Capital (VC) funding has come under a lot of pressure too, with UK-based VC deal volumes down 39% in Q1 2023 vs Q1 2021, down to 415 transactions according to data from PitchBook Data Inc.

The second reason is because there’s a significant amount of private equity dry powder to be deployed, $1.2tr globally. So, while other sources have retracted, PE has remained an open market.

It’s important to bear in mind though, that to draw PE in companies need to have a compelling investment story, looking at both upside growth and optimisation opportunities and managing the downside with the appropriate risk mitigation interventions and strategies in place.

 With the continued economic instability many may have expected more businesses to scale back investments, but that does not seem to be the case. What does that tell us?

44% of our survey respondents have stated they plan to access finance for capital investments, which is really positive, but not something that I am surprised at seeing.

51% of the over 400 survey respondents are PE backed, and they will be focusing on making capital investments to improve the strength of the business and tee them up for future growth. PE funds, and the management teams they back, recognise that they need to create a compelling investment story for the party that they will sell to, so they will invest where necessary.

PE backed firms also plan multiple strategic interventions. In fact, results show us that these firms were more likely than non-PE backed firms to be making these moves, for example internationalising or acquiring other businesses.

The reason that PE firms use growth via acquisition is because it is a key value creation mechanism. In fact, three in every four acquisitions made in the private equity space are made by private equity backed businesses – this type of deal is called an ‘add on’.

These businesses are making these acquisitions for two reasons. Firstly, for strategic reasons e.g. to enter new markets, and secondly to utilise a valuation increase mechanism called a ‘multiple arbitrage’.

The arbitrage is a tactic used by PE which recognises that a larger business typically sells for a higher price-to-EBITDA multiple than a smaller one that is otherwise identical. This is a function of the larger risk and lower momentum that characterises smaller firms. The arbitrage occurs where the multiple that the combined business is able to command becomes at least that of the acquiring company’s. The effect is that the acquired entity is worth more simply because of the acquisition.

To illustrate, a small business of £5m EBITDA might attract a price multiple of 5, giving it a value of £25m. If an identical, but larger, business of £50m EBITDA and attracting a multiple of 7, and therefore with a value of £350m, acquires that smaller company, the combined EBITDA of £55m would then attract a multiple of at least 7. That then gives the combination a valuation of £385m, versus the £375m of the two business if they weren’t combined.

In this uncertain climate, there are opportunities available for those looking for them.

What is your view on how the funding landscape is going to change and evolve over the coming year and beyond?

The PE dry powder pool is significant. The funds holding that capital need to continue to invest at a constant cadence or risk not being able to deploy the committed capital in the typically finite time they have agreed with their backers. Additionally, the weaker economy equates to lower entry points and as S&P Global put it, ‘the seeds of private equity’s best vintages are often planted in trying times’. We can therefore expect that appetite for PE will be sustained.

From a debt perspective, interest rates will not return to the low rates experienced in 2020-2021. We expect the Bank of England to push up their rate from 4.25% to 4.5% on 11 May, with the longer-term projection according to Bloomberg to be down somewhat but still elevated at 3.1% in Q2 2025. In other words, these ‘high’ interest rates will become the new normal.

These rates will impact amount of debt that companies can viably carry, which in turn will impact the attractiveness of some investments. However, businesses whose investment story is not predicated solely on the low cost of debt but rather on a growth journey that involves strategies like add-on acquisitions, internationalisation, the energy transition or digital transformation will be able to attract capital from PE.