July 18, 2017
Interviewed by: Privcap
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Dealmaker Roundup Q2 2017

Deal market veterans discuss the tepid private equity deal volume of the second quarter of 2017, the importance of the Staples take-private, healthcare deals and the fate of interest deductibility.

Deal market veterans discuss the tepid private equity deal volume of the second quarter of 2017, the importance of the Staples take-private, healthcare deals and the fate of interest deductibility.

Dealmaker Roundup Q2 2017

David Snow, Privcap:

Hello and welcome to Dealmaker Roundup. I’m David Snow, CEO of Privcap. Today, we’re joined by Ryan Flanders of Preqin and Michael Fanelli of RSM. Gentlemen, welcome to Privcap today. Thanks for being here.

Today, we’re talking about private equity deal activity in the second quarter of 2017. I’d love to hear your views. Michael, your practice is working with lots of private equity firms doing deals, primarily in the middle market. And of course, Ryan, Preqin is a major chronicler of the data in private equity in the private capital asset classes.

So, let’s begin. Has there been a dead-cat bounce in the private equity deal market? What I mean is typically in the first quarter of a year, there is a bit of a dip in deal activity for a number of reasons, but then, there’s typically a comeback in the second quarter. But, in the second quarter of 2017, it looks like there hasn’t been as much of a bounce back, so I’m wondering what’s going on. Certainly, there’s a steady stream of middle-market deals getting done, but as far as the volume of overall deal activity, it’s not quite there.

Michael Fanelli, RSM:

Within our practice, we saw essentially the same exact trend from a numbers perspective. I think the interesting thing is, when we went into March and April—when we’re in the pre-acquisition mode, so we’re doing the due diligence before the deals actually close, so I have a bit of insight into that. March and April were a lot slower than what we were expecting it to be, which would fall into those Q2 deal closes. So, while we did see the bounce after Q1, to your point, it was much less.

When we talked to our private equity firm clients, it was really one of those situations where all the sellers they were talking to just were not ready to sell. They were not ready to sign a Letter of Intent or an Indication of Interest or otherwise. The bankers were doing the same thing; the bankers we talked to had a huge pipeline, but they weren’t ready to put it out in the market yet.

Contrary to that, moving into work that we’re doing in Q2, which would likely close in Q3, we’re seeing a significant uptick. So, it’s kind of interesting. Right after May, June and now into July—the pipeline for July has been really strong—[they have been] potentially our three highest-volume months ever. So, I’m going to assume and hope that the Q3 private equity deal counts are going to be up compared to the prior year.

Ryan Flanders, Preqin:

Given dry powder and the multiples where they were prior, do you expect to see the multiples trade even higher? Are these portfolio companies going to be selling at an even higher premium?

Fanelli: Yes. From the private equity firms we speak to, we don’t think it’s going to go exponentially higher, but we also don’t see any reason for it to go down. On the contrary.

Again, even if the interest rates increase a little bit just because of everything within the regulatory environment, we just don’t see that impacting things too much. Just because, again, supply and demand.

Snow: Mike, you alluded to the fact that your firm has been exceptionally busy recently, which is a leading indicator for potentially a pop in finalized deals. What will it take to get that “pop” to happen—for this pent-up demand to do deals and to take advantage of the M&A market—in the second half of this year?

Fanelli: There’s a lot of things that are driving uncertainty. If we can remove some of that uncertainty over the next six months, you would almost have to see an increase in deal volume within the second half of 2017 and really into 2018.

One of the interesting things, which is probably a good thing, is that a lot of the traditional bank lenders and non-bank lenders don’t seem to be stretching it too much either right now. The multiples are at a reasonable level (the debt multiples, that is). It’s not covenant light or zero covenants.

Flanders: I would agree that there’s been a slight loosening of covenants here and there, but it’s not prevalent throughout the market, and you can even take it from the equity side. You’re still continuing to see pretty high equity contributions in these transactions as well. So, people are still holding to their guns in terms of diligence and being very thoughtful in where they’re putting their money in the market. Which I think bodes well for the…private equity class as a whole.

Snow: Of course, one scenario that would see us putting a lot more of the dry powder to work would be dealmakers throwing caution to the wind, which is sort of what happened in the lead-up to 2008. You had a loosening of underwriting and standards; you had people piling companies on with debt and making very heavy projections about how fast these companies could grow that did not come to fruition.

It’s becoming a bit of a broken record here, but for yet another quarter, we have a new record, which is the most dry powder ever—now on the sidelines of private equity. With, let’s call it, a dead-cat bounce of a Q2 recovery, that doesn’t seem to be saying that this dry powder is getting put to work at a rate that would justify the incredible amounts of fundraising happening elsewhere in the market.

Flanders: The dry-powder figure has been something that’s been oft discussed over the last, I would say, 24 months. The amount of capital coming into the market, combined with potentially a bit of a slowdown in deal flow—although we hear that Q3 and 4 could potentially be better, it’s certainly concerning. I think the institutional investor continues to put money into the class. Dry powder continues to pile up. That worries some, in terms of putting the capital to work within the private equity space.

Snow: Of course, the private equity firms that are raising the most capital are the largest private equity firms: groups like Apollo and Black Stone. The kinds of deals that get done out of these very large funds tend to be large deals. So, public-toprivate types of deals are a signature type of deal that gets done by these larger firms. We haven’t seen a lot of those. But, in Q2, there was a notable announced deal, which is the announced takeprivate of Staples.

I would love to hear your analysis about why that’s interesting. Mike, what does this tell us about what might be about to happen in the market?

Fanelli: With the larger private equity firms having that much dry powder, they’re going to have to do some of these. But a lot of these deals are not for the faint of heart, because they’re typically going from public to private for a reason. That reason is typically because shareholder value has been on the decline and they can transform their business outside of the public eye.

I think Staples is a perfect example of that. They are in a mode where they’ve had… I think it’s three to five years of consistent declining sales. They’re in a scenario of store closures, just like everything else in retail. But they still have a business there.

The challenge I have with it is, who are they going to sell it to? It’s probably not going to go public again. Maybe they will, but I would doubt it. So, is it another private equity firm that’s bigger than them that would take it on? I’m not certain about that. Is it a Wal-Mart play? Target? Amazon? The interesting thing is going to be, after they actually do transform that business, what’s the exit strategy?

Flanders: The specialist approach from a Sycamorist is certainly a play that makes a lot of sense. Being able to make those operational changes and make those closures outside of the public eye is beneficial for them.

Fanelli: The interesting thing about that is, without that operational expertise, there’s significant execution risk doing those types of deals. So, a lot of them—it’s not a typical leverage buyout where you’re buying the company, you can get them into additional channels and you can improve the margins a little bit, then sell it three to five years later. There’s going to be some significant business transformation that’s going to happen at something like Staples.

Snow: Let’s talk about the relative surge in healthcare deals done by private equity firms. Although, overall, deal activity has not been surging as much as in prior years, healthcare seems to be a bright spot.

Flanders: The aging population within the U.S. is certainly something that continues to be a driver within that healthcare space. I think, when you’re talking about the potential growth in healthcare, it outweighs the indecision within Washington.

Snow: Three of the top 10 deals of the second quarter were healthcare deals. There was a medical device company, and two pharmaceutical companies.

Michael, what do you see in your practice at RSM as far as interest in healthcare and what’s driving those kinds of transactions?

Fanelli: We’re all seeing a lot of rollup strategy within specific physician practices, such as dermatology, etc. We’re not seeing as much in the hospital space; we’re not seeing much where there’s reimbursement risk space. But we are seeing medical devices, we are seeing the pharma and we are seeing the specialty practices where you can have a little niche regional practice, and then continue to add on throughout the country to get some of the synergies there.

Ryan, you’re in charge of a quickly growing asset class, which is private debt. You’re in charge of that for Preqin. There’s a huge issue in debt, of course, which is the possibility of the change to interest rate deduction, with the new White House Administration. What are people saying about that? How might it affect private equity deal flow if the change does go through?

Flanders: I don’t think that either group thinks it’s going to be incredibly detrimental to the space. Or it’s going to grow things from an equity side if the deduction is removed. But, it’s just really…trying to get some finality on what’s going to happen. Finality and predictability…[are] good for dealmaking within the private equity space and the debt side of the transaction as well.

Fanelli: We had a full discussion on regulatory matters, tax matters, etc., with one of our larger private equity clients. When we talk about the potential removal of the interest deduction, I don’t want to say [they’re] freaking out about it, but they are not too keen on it whatsoever. It would significantly change the returns within the fund, obviously.

I don’t think the interest-tax deduction or the interest deduction from a cashflow perspective within private equity in and of itself will make a difference. Unless they did that and nothing else.

Flanders: Right. [It will have a] huge impact if it’s that and nothing else.

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