April 13, 2018
Interviewed by: Privcap
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Dealmaker Roundup | Q1 2018 Review

In this episode of “Dealmaker Roundup,” Jesse Fahy of Preqin and Michael Fanelli of RSM US LLP discuss the return of mega-deals in Q1 2018, as well as the “Golden Era” for add-ons.

In this episode of “Dealmaker Roundup,” Jesse Fahy of Preqin and Michael Fanelli of RSM US LLP discuss the return of mega-deals in Q1 2018, as well as the “Golden Era” for add-ons.

Dealmaker Roundup | Q1 2018 Review

David Snow, Privcap:
Hello, and welcome to Dealmaker Roundup. I’m David Snow from Privcap and today we’re joined by Jesse Fahy of Preqin and Michael Fanelli of RSM. Gentlemen, welcome to Privcap today, thanks for being here.

Unison: Thanks for having us.

Snow: So let’s talk about private equity deal activity. We have the numbers in from the first quarter of 2018. Jesse, I’d love to get your take as you’re sort of the numbers keeper at Preqin. But interestingly in the first quarter, the number of private equity deals worth more than a billion dollars, so called megadeals, was up in a big way. There were 24 private equity backed megadeals in the first quarter.

Jesse Fahy, Preqin:
Yeah, I mean, obviously you’ve both been waiting to see these kind of large deals come to fruition. We’ve been seeing dry powder kind of tick up year after year. We’re seeing record levels of dry powder. We’ve surpassed the one trillion dollar threshold, so clearly there’s a lot of capital put to work, and it’s exciting to see it finally moving out kind of off the strength of these billion dollar let’s say megadeals.

We’ve actually seen the strongest first quarter in terms of deal volume that we’ve had since the Great Recession, actually. Also we’re seeing this common to various industries, so it’s not that it’s just one industry seeing all this capital, it’s really being spread around nicely.

Snow: Mike, from your firm, RSM, what are you seeing as far as deal activity?

Michael Fanelli, RSM:
It continues to be hot. I don’t want to sound like a broken record but it just continues to be hot. We’ve just been waiting to see these large cap deals happen though. We’ve been talking about dry powder both at PE and cash on the large cap balance sheets. I think we saw a lot of activity at the end of last year, but it didn’t come to fruition in terms of closed deals or announced deals

Snow: I wonder if the U.S. tax reform, the tax cuts, made an impact on, I guess, the willingness of parties to close deals.

Fanelli: I mean even in our middle market business index, which is the tier below the deals we’re talking about right now. The CEO sentiment’s really high, probably at the highest it’s been in the last couple years. I think a lot of that is due to tax reform, a lot of it is due to expected lower regulation, let’s say. I think finally CEOs and shareholders are saying, “Yeah, this is the time. Let’s put our capital to work.” There’s a little bit of pent up supply as we’ve always said and now there’s finally willingness on the seller’s side, too, to come together.

Fahy: If we look at 2017 kind of Q1 to Q3, we kind of were on pace for a record year post-recession. Then Q4 we saw that kind of taper off as there’s some questions arose over, A, what the tax code would end up looking like and would it actually come through.

Fanelli: Yeah, uncertainty is the one thing that kind of can kill all deals or all movement forward. Once some of the uncertainty was removed, you’ll see a big path forward.

Snow: Do people continue to express worry about the valuations that they’re seeing? Or are private equity firms finding a way to grow the companies in which they invest to the point where maybe they’re less worried about the valuations that they’re paying?

Fanelli: I think they’re still worried. I think they’re still worried about valuations, I think. On the large cap side, organic growth has been good but not great, and so probably some of the pent up demand in terms of larger cap deals is partially because they are seeing that a little bit of a slower growth than expected and to get some of the growth, they’re buying it.

So they’re buying either tangential companies or complementary companies to increase that growth. We see that all the time in the middle market space, as well, where part of the buy and build add-on strategy, that we’ll talk about later is for multiple arbitrage to lower that total valuation paid for, for the totality of the platform company.

Fahy: Preqin performs a fund manager survey every year, and in that survey one of the questions they ask, what is the biggest challenge you see facing private equity industry. Two-thirds of respondents replied that valuation was the single biggest challenge they see facing the industry.

Snow: Of course, as valuations continue to rise, private equity exits continue to fall. I think the Q1 numbers show that exits have fallen yet again from private equity portfolios/ You’d think that in a world of frothy, irrational valuations, people would be trying to sell everything that’s not nailed to the floor. And yet private equity firms are, for the most part, seems like net buyers of companies.

Fahy: Yeah, for the first straight quarter, exits have been down and this is over a multi-year trend, so it’s definitely not a great exit market.

Interestingly, as exits are moving down, one thing that has been rising up is sale to GP, so GPs are willing to trade with each other, we just don’t see the more traditional exit opps happening.

Snow: Let’s talk about the fact that we are in one of the biggest deal booms there has been in the history of private equity. But it’s important to characterize what kind of deals are getting done. By and large, these are add-on acquisitions so in the first quarter of 2018, there were 357 platform acquisitions by private equity firms, but there were 436 add-on acquisitions. So it seems like we’re in a golden era of add-ons.

Fanelli: It’s a little bit of a supply issue of good quality, true middle market businesses available for sale. I don’t think there are enough of them for the global private equity marketplace to invest in and to capitalize on.

The other interesting thing is for a fair amount of industries, not all industries, there is a significant amount of fragmentation throughout these industries, especially with the higher valuations. These private equity firms are coming in buying a nice platform company and backing the existing management team, or bringing in a new limited management team, and then saying, okay, the growth prospects for this are 5% per year, that’s good not great.

But we’re in a significantly, highly fragmented industry and if we can do 20 add-ons in five years very aggressively and put in a true merger innovation plan in place, and the platform might have cost me 10 to 12X, but the add-ons are going to cost me 6X, we get the multiple arbitrage, less worry about the valuation side that we talked about earlier, and then overall good exit at the end of the day.

Snow: Because it’s one thing to do an acquisition, that’s kind of the fun part. The hard part is actually getting these different companies to merge and to operate together in an efficient way, and to realize efficiencies. What tends to gum up the works from your perspective when trying to make that happen?

Fanelli: It’s one of the biggest challenges. It’s the thing that nobody talks about. We keep on talking about add-on acquisitions, which inherently is a merger integration process, post-closing now, if it’s a 200 million dollar company, a 10 million dollar company, maybe it’s a little bit easier, just because the 10 million dollar company basically just does whatever the 200 million dollar company says. But if it’s a slightly higher size of an add-on or multiple of those 10 to 20 million dollar add-ons to that 200 million dollar platform company, it’s a huge challenge.

We always look at it from a kind of three legs of the stool. There’s the people, the processes, and the technology. Those are kind of three of the main points of an integration plan post-closing. And we see one or all of them go poorly post-closing of an add-on or a merger integration plan.

Snow: Of course, many private equity firms now attempt to distinguish themselves as having that operating expertise to help integrate platform companies with the add-ons. I’m going to guess that some of that is genuine, and they have genuinely capable people who can do these integrations, or at least lead them.

Then there’s probably other private equity firms not to be named, that say they are good at this and yet need a lot of help probably from a service provider, such as yourself.

Fanelli: The professionals at the private equity firm, highly intelligent, highly experienced, they can do the work partially themselves, as well, but they don’t have the arms and legs, they’re very lean.

What they end up doing is they end up bringing operating executives into the deals post-closing, sometimes even pre-closing. And those sometimes are part-time individuals, sometimes full-time individuals.

Fanelli: We see this auction situation on a weekly basis. You know, so take price out of the aspect. I would say there’s kind of three things. One is if it’s an add-on, so they’re bringing their platform company to the table and say we’re all in this together, talk to the platform executive management team to see how they are to work with us, this is one big family, etc., etc.

The other way is bringing in an operating executive to truly help the business increase their top line, or increase their operating margins in a way that they would not have been able to do on their own.

The other thing that’s been interesting is I had one call in the past couple of weeks that said, “Valuation is important to us, but not the most important. Speed and certainty to close is the most important.” If you can close within 60 days and with certainty doing enough work before the letter of intent exclusivity period, that’s what’s going to be the most important to us. Obviously, you got to pay a fair price, but you can beat out somebody who’s paying a higher price in that instance.

Snow: We’re mostly talking about buyout deals in the U.S. private equity buyout market. But you spent a lot of time, Jesse, with the venture capital market. What’s going on there? What’s notable?

Fahy: I’d say the venture capital market’s actually kind of mirroring the buyout market whereas we just see a continuing scaling of the size of these funds and the deals that are happening.

Snow: We’re seeing the rise of some very large venture capital funds. Venture capital funds are supposed to or at least historically be going after by definition smaller companies because they’re earlier in their stage of life or even just start ups or seed stage companies. But we’re seeing these billion dollar plus venture capital funds, which are actually going after fairly mature technology enabled companies, correct?

Fahy: Yes. Some people call it the SoftBank effect. Obviously when you raise a 100 billion dollar fund, you’re going to throw things out of, a little haywire, so we’re seeing all these name brand firms raise kind of the largest funds in their history. Sequoia has raised multi-billion dollar funds, NEA has gone into it. We’re seeing more and more people scale up so they can kind of compete with these huge bite sizes.

Snow: Right and it’s worth noting that in the run up to the peak  of the dot-com era in 2000, the venture capital market was filled with very large venture capital funds raised by firms that had historically raised much smaller funds. And so on the one hand maybe they’re responding to market dynamics, on the other hand maybe we’re headed toward collapse of the bubble.

Fahy: Now you just jinxed it.

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