Article
Key trends that PE fund managers and their portfolio companies are paying attention to post COVID-19
July 16, 2021 · Authored by Ken Fleming, Brian P. Francese
This Q&A was published as part of PitchBook Q2 2021 US PE Breakdown sponsored by Baker Tilly.
What are some of the key trends that PE fund managers and their portfolio companies are paying attention to coming out of the COVID-19 pandemic period?
Five things are looming larger this year:
- Workforce—attracting and retaining top talent
- Sourcing of raw materials
- Changing dynamics of business ownership
- Environmental, social, and governance (ESG) criteria
- Possible federal tax code changes
There is a shortage of labor, which can be attributed to a combination of factors, including workplace health and safety concerns, extended unemployment benefits, and lack of childcare and eldercare options. In addition to the operational challenges that the talent shortage presents, businesses have seen a deterioration in profitability as many companies are paying higher wages to stay competitive and have higher costs associated with recruiting and overtime pay for the existing workforce. Another concerning trend is employee morale. Burnout is prevalent across companies regardless of industry or size. Rewarding and retaining top talent is a critical risk right now for many companies.
Investors looking at manufacturing companies are paying more attention to the sourcing of raw materials. Investors are aware of how manufacturers and other businesses were affected in the early months of the pandemic as their supply of raw materials or finished goods dried up when shipping from and into countries was put on hold. The diversification of supply chains—not only at the supplier level, but also at the country/geography level—has become even more important.
Another dynamic coming out of the pandemic concerns baby boomer generation business owners who are ready to sell or transition ownership to the next generation. It is not uncommon for generational transitions in ownership to lead to changes in overall business strategies, including taking on investors, whether that be at a minority or a majority level. This “rush to the exits” of sorts is leading to more competition among PE investors and deals with higher valuations that are closing faster than before.
While ESG criteria are generally not part of official financial reporting, we are beginning to see LPs inquire more frequently about the ESG positions of PE funds as they look to commit capital. On the flip side, we are also seeing sellers ask PE funds about their current ESG position. Considering the amount of buy-side competition in the market, sellers may be faced with multiple offers, and ESG positions may be a differentiator. PE is taking notice of the ESG conversation, and operating companies need to be aware investors are beginning to make ESG part of their due diligence process, whether that be at the platform level or at the bolt-on level.
PE investors are aware that the Biden administration has proposed changes to the federal tax code, including taxing capital gains for wealthier taxpayers at ordinary rates. This may provide more incentive to pursue and close deals in 2021 if changes to the capital gains tax rate are not made retroactive.
Has there been an increase in carveouts by larger companies?
We have seen an uptick in carveouts by large public and private companies over the past year, along with an increased interest in these deals by PE firms. We are experiencing a vibrant market of buyers with vast amounts of capital in the marketplace chasing deals.
With strong demand and high valuations, many sellers are choosing to monetize certain assets and realize value for shareholders. These carveout transactions provide buyers with strategic assets that can serve as platform or bolt-on transactions. In the early months of the pandemic, companies may have pursued a carveout to focus on core-business assets and shed non-core or underperforming business segments as they prepared to shelter the pending storm. In a September 2020 update to the Department of Justice’s (DOJ) Merger Remedies Manual, the DOJ called PE investors the “preferred” purchaser of divestiture assets in some instances because the PE investor’s flexible investment strategy, commitment to the divestiture, and willingness to invest more when necessary were key to the success of a divesture.
It’s important to note a carveout isn’t limited to a company seeking to sell a non-core part of their business. A company may ultimately decide to divest its core business if it believes that industry or service is experiencing a permanent decline.
Is there a stronger incentive to close deals before the end of 2021?
Companies may be more likely to exit because of concerns over possible federal tax code changes and overall competitiveness in the marketplace. There are more deals closing, involving more funds and fund sponsors, with higher valuations and shorter timeframes to carry out due diligence before closing. The speed to close may lead to an increase in bad deals. Deals are closing in 60 days, and when deals are done that quickly, due diligence may not be as thorough.
Investors don’t want to hold off on deals because, on the buy side, they see acquisitions as a way to grow. Even though valuations remain high, investors are aggressive as they seek top-line growth. With that said, investors are concerned about a possible valuation bubble.
Traditional economic indicators such as unemployment or national debt seem to not matter as much in the moment. Investors who are consolidating businesses and concerned about a bubble need a clear view of their horizon.
