Despite inflation, middle market firms have options to position themselves well for profitable deals

Structures haven’t seemed to change much yet, but as we look further out and after speaking to our private equity clients, they are seeing banks providing less leverage as a multiple of EBITDA. What we’re hearing is a quarter to half turn less leverage and that may change as interest rates continue to rise. As senior debt gets more expensive, something has to fill that funding gap, so potentially that could be putting more equity in, requiring/increasing an equity rollover from a seller, or asking for a seller note. So far, we have not seen larger earn-outs come back into play—the deals we’ve closed lately have had limited earn-out components, but that could be something private equity firms could utilize to maintain total transaction value as they look at debt as a more expensive component of a deal’s capital stack.

We’ve seen our clients do several things. Obviously, they’ve implemented price increases that are either larger than what some may be used to and/or more frequent than in the past. Some clients have implemented across-the-board price increases, and others are specifically focusing on certain customers buying certain products/services. Our clients are looking at what will make the largest gross margin difference strategically; it’s not simply a flat percent increase across the board. Companies are being more surgical in how they look at their customers and product/service margins to determine what makes the most sense.

Another approach we’ve seen our clients take is changing the minimum order/shipping quantities on products. In the past, the company may have shipped “less than a truckload” of product to a customer; now, they might require a minimum of a full truckload to manage shipping costs better.

Some clients are taking a second look at their suppliers. If a company is buying something from overseas, it might be looking for an alternate U.S. supplier. Or, if the company was already buying domestically, they may be looking for an even closer supplier to reduce the total delivered cost.

Also, the C-suite at our clients is more intentional in leveraging company data and looking at it differently to see what’s driving up costs and then trying to be prescriptive in addressing those issues.

Buyers will not initially be able to put as much bank debt on a deal as they have in the past with less leverage available and higher interest rates. To maintain equity returns, private equity funds could use a combination of seller financing, high seller equity rollovers, earnouts, and debt recapitalizations (for example, 2.5 years into the investment hold period) to lower the total amount of fund equity committed at closing. More importantly, sponsors will be focused on companies where there are a number of financial and operational changes that can be implemented and sustained to drive revenue growth and improve EBITDA and EBITDA margins.

Not every company needs to pivot to navigate this complex environment meaningfully, but the ones that have a C-suite and management team with the right skill sets in place will utilize data to find efficiencies or take a hard look at products/services that aren’t achieving revenue growth or gross margin targets. In addition, companies can implement automation (co-bots) and optimize their IT systems to improve procurement, scheduling, labor mix, shipping costs and customer service.

When you look at deal flow this year and transactions that have closed, the actual number of transactions and the total dollar amount are down compared to 2021. However, 2021 was an unusual year based on the deals that were delayed from going to market in 2020 due to COVID-19 and business owners that were concerned that tax rates were going to change. In addition, a number of private business owners had grown weary of supply chain issues, labor shortages and raw material price increases, and so pushed up their plans for retiring, transitioning out or selling their business.

From a hold time perspective, it doesn’t appear anything has changed yet. Depending on what happens for the next 6 to 12 months, private equity funds may hold their portfolio companies a little longer than they thought, depending on how those portfolio companies perform during and after the technical recession. In addition, when funds look to sell a portfolio company, they have to consider who the financial and strategic buyers could be. Most funds will look at public market valuations and comparable transaction data to see where EBITDA multiples could be at the time the deal is brought to market. Finally, the amount of leverage available and interest rates could impact the timing of when to sell. We could see something similar to 2008-2010, where private equity held on to portfolio companies a little bit longer than initially anticipated.

Regarding exit strategies, we anticipate seeing a continued downtick in public market exits compared to 2021, but corporate divestiture exits and middle market sponsor portfolio exits we foresee being more mainstream.

Private equity firms are still looking for quality deals, and it seems like they’re back to how they operated in 2019. The expectation is that there will be a number of transactions going to market late in 2022 that will close in early 2023 – and the private equity appetite for these appears to be oddly unaffected by inflation and recession fears. What is surprising is the very limited number of distressed private portfolio companies – this is likely due to the laser focus on financial performance since early 2020.