July 23, 2019
Interviewed by: David Snow
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Dealmaker Roundup: Q2 2019

Is valuation fatigue setting in? What does the tech IPO boom mean? Three private equity middle-market deal veterans from Harris Williams, Preqin and RSM discuss trends in the “unicorn” technology market and uptick in IPOs there, the seeming disconnect between buyers and sellers in the M&A market, and corporate culture clashes that occur when legacy companies buy younger, disruptive tech-oriented companies.

Is valuation fatigue setting in? What does the tech IPO boom mean? Three private equity middle-market deal veterans from Harris Williams, Preqin and RSM discuss trends in the “unicorn” technology market and uptick in IPOs there, the seeming disconnect between buyers and sellers in the M&A market, and corporate culture clashes that occur when legacy companies buy younger, disruptive tech-oriented companies.

TRANSCRIPT

Dealmaker Roundup: Q2 2019

Privcap: So let’s talk about what’s going on in the private equity deal market. We have now made it through the first half of 2019. One of the most notable trends in the deal market has been a few very high profile IPOs. Most of them venture backed. Many of them are described as unicorns, meaning a billion plus valuations. What does that mean for the private equity middle market, especially in the technology sector? What does that say about expectations around valuation? And sort of the mood that people are in to get deals done. Mike Wilkins from Harris Williams, you co-lead the technology practice for your firm, you’re advising clients about what to do in the technology space with regard to the the MNA market. What are you seeing?

Michael Wilkins, Harris Williams: Front and center is the continued momentum across the market and the appetite for deals in the space. And it’s not just sort of the private equity universe, but strategics as well. And I think that’s supported by a few different things. There’s unprecedented cash levels. I think that’s all stacked. It was something like a trillion and a half dollars amongst the s and p 500 and corporate cash reserves. And so, the corporates, the strategics are getting a ton of pressure to either put capital to work or give it back to shareholders. And then, in the PE world, the private equity buyers are routinely outbidding strategics and a part of that is just, they’re completely flushed with cash as well. I think there was close to $900 billion of new mid-market private equity created in the last, I think it’s 18 to 24 months and they’re not only flush with cash but they’re getting pressure from LPs co-invest as well. I will say that your comment about the IPOs that are happening out there, I’d say that relative to mid-market sponsors a little bit of a different market at least from where we sit, but the implications of these businesses going public and the valuations attached to them I think creates a little bit of hand wringing.

We’re starting to see a little bit  of valuation fatigue kick in where there’s a disconnect between seller expectations and what buyers are willing to pay for certain assets. And I think when you look back and you think, geez, we’re in the 10th year going into the 11th year of a bull market run, and now on top of already aggressive valuations, we’re seeing the public equity markets support aggressive valuations as well. It creates a little bit of consternation by some of the buyers about, geez, when is this going to slow down? And how do we deal with this disconnect between seller expectations and buyer realities? So a few thoughts there.

Privcap: Great, well I’d like to move on to hear what Michael Fanelli from RSM is seeing in the market, but before we go there, maybe let’s check in with Jesse Fahy from Preqin. As someone who follows statistics for the new market in private equity and venture capital, what can you tell that’s notable about activity in the tech sector in the first half of 2019?

Jesse Fahy, Preqin: Well, I mean the IPOs are definitely something that’s encouraging to see. It’s really been something everyone’s been waiting for. A kind of run on tech IPOs, these unicorns, these deca-corns. We can make up new terms because it’s just unprecedented how long these companies have been private and how much capital they’ve received. So seeing some of these investments finally start to unwind I think is a letting some people breathe a sigh of relief in the market. But actually 2019 has been kind of disappointing so far. Just looking in terms of overall deal activity both for traditional private equity and venture capital. Total deal activity is down, fairly significantly.  I think part of this is a little bit of fatigue as we’ve had some very strong years the last couple of years especially. But as I mentioned before, you know these firms are sitting on a trillion and a half of dry powder. Their LPs are expecting them to continue to produce, to invest and to drive IRR. So I think we could be in for a really strong H2 just off of the strength of some of these IPOs and also just how much capital is sitting on the sidelines.

Privcap: So Michael Fanelli from RSM, are you also seeing valuation fatigue? 

Michael Fanelli, RSM: Yeah, very similar to what Michael Wilkins had said as well. I mean I think the higher level of of IPO activity as of recent date, especially on Q two 2019 with the likes of Lyft and Pinterest and Uber etc., is very good for overall capital markets. I think two of the three at the very least are the current stock prices is higher than the IPO price, which is a good thing as well. Because sometimes you see kind of a a lowering in the first couple months subsequent to an IPO but it’s probably more correlated to overall venture capital returns, not as much to private equity. Funds continue to be raised, although potentially at a lesser rate in 2019 and the TMT industry specifically has experienced valuation fatigue. 

We’re seeing the same thing both when we’re advising buyers and sellers and we’re more on the buy side than the sell side. Probably 70% buy side 30% sell side. And there does seem to be a little bit of a disconnect currently between buyers and sellers. I think sellers are more focused on how hot the market has continued to remain for seven plus years, almost 10 years now. And buyers are getting to a point where they’re thinking, well, we’re seeing the IPO market, we’re seeing valuations in the public markets, we’re seeing what large private equity firms are paying for assets. However, we’re not sure we want to get in that game right now. And especially if people think there could be a potential slight downturn on the horizon.

Privcap: Follow-up question for Michael Wilkins of Harris Williams. Who is a candidate today, what types of companies are a candidate for an IPO? And in what circumstances are you finding that a seller’s thinking about like, well gee, as if if the buyers out there aren’t quite seeing my vision for the valuation of this company, maybe I’ll just try to go the IPO route and I’ll get a better valuation there.

Wilkins: These are or businesses that are well known consumer brands in many regards and if not, if they’re more enterprise focused, they’re businesses that have achieved a significant level of brand recognition and scale in the corporate market. And on the consumer side, as I was just mentioning, businesses like Pinterest, Uber, Chewy, Lyft, these are all businesses that have real brand cachet. They’ve grown to be significant in size and scale. And I think that they’ve often seen outsized growth relative to, call it maybe more mature peers that you know are playing kind of in the mid market. And so, I think that there are a lot of these, venture capital darlings, if you will, that are seeing kind of the exit opportunity in the support of the public markets and are excited and hopeful that this will continue. I know that our colleagues, it’s all very, continue to have unprecedented pipeline of potential IPO candidates that remain keen to get out into the market. 

Fanelli: The interesting thing that I always see that I always think with IPOs, especially the last few years is there’s a lot of them seem to have been tech focused or biotech focused and many of them operating at a loss and having potentially high cash burn rate. So big brands outsize top line growth and or general market penetration in whatever sector they’re in. But if you look at their price, you know their PE ratios is n/a because they don’t have the earnings to to calculate a PE ratio, which I think is always kind of interesting because a lot of times and you know in the mid market, upper middle market space, private equity space, you don’t see that as often. You do still see that, especially in TMT. However, we tend to see more profitable businesses going to scale from a lower middle market sponsor to an upper middle market sponsor for example. And coming from a startup type lens from the beginning. So I always think that’s kind of an interesting thing to look at, subsequent to an IPO, is how long does it take these companies to get to profitable level and does the market even care or are they so focused on the brand of the company and the top line revenue growth and/or production, even going back to like Tesla just starting to finally earn a profit.

Wilkins: Then just to build on that as well, I think that you’re absolutely right and also something that you’re seeing in kind of some of these tech IPOs today, especially in the Unicorns, that is a little bit odd is the growth is actually decelerating. So on top of not really having the profitability, the growth slowing down, which I think really taken effect in some of these companies like Lyft and Uber, where the enthusiasm is just hard to get behind them because if they’re not getting profitability and there’s no real clear roadmap of how they’re going to achieve that. I think some of these companies have been private for so long now. We’re looking at firms that are routinely staying private for 10 plus years. When we look kind of 10, 20 years ago, we’d have firms, private for three, four, five years before tapping public markets.

So I think some of this might actually be service to their employees where we have a lot of paper millionaires within their ranks, have been kind of a little bit antsy ready to go onto the new thing. And this gives them a kind of an avenue to get out from underneath. I think this is especially true if you look at Slack and Spotify. They kind of opted for the direct listing rather than a traditional IPO. So then I would say looking to raise any capital, cause Lord knows, a trillion and a half on dry powder private equity right now. They’ve had no problem getting funding up to this point. So this is kind of more just a way for their employees to get out and to get some of this cash recycled.

Fahy: I think if you look today, no one’s really talking about their IPO performance. I think people understand that these things kind of take time and not to overreact to the first few months of trading and kind of look for the long haul.  The distributions to LPs has been relatively strong for equity the last couple of years. So this is something that’s definitely going to help keep that cash flowing back to LPs. At least ones we spoke to have been relatively happy with their venture capital and private equity portfolio performances so far. I feel like kind of a broken record here, but literally every passing month we break the previous record for most number of funds and market. That’s kind of a figure that just keeps continuously pushing forward. If we kind of look right now, I think the fundraising market’s actually something that’s very interesting and that’s something of an inflection point year over year kind of fund closures have been trending down while the average fund size has been trending way up.

Right now we’re on pace in 2019. They’re seeing only one third of the total fund closures that we did in 2018 and only a fourth of what we saw close between 2015 and 2017. You’d actually have to go all the way back to 2013 to find a single quarter. We’re going to see at least 300 private equity funds close, but now we’ve been beneath that mark kind of the last two quarters running. Aggregate capital raise is also slowed down a little bit less aggressive pace due to larger average fund size. But at the halfway mark we’ve seen $221 billion raised by private equity funds, a little less than half the total amount raised last year and way behind the record $585 billion pace that we had in 2017. So I think it’s a little bit more of that fatigue I was mentioning earlier. However, the funds that are closing are all very sizable. The average fund size for those funds that have closed this year, sitting at just over $450 million, which would represent a full year record and the first time we’ve seen an average fund size north of $400 million since the global financial crisis. So while capital still being allocated, it’s really being funneled to the large managers who are kind of proven to raise new funds very efficiently. But for the thousands of other fund managers that have been trying to raise a fund, it’s looking increasingly grim that they be able to achieve the target they were looking for or even manage to close the fund at all. So I think we could really see some shake up in terms of current private equity managers.

Privcap: I believe the largest fundraise of 2019 to date has been Advent International raising, was it $17 billion? Of course, Advent International, very long tenured private equity firm, very well known and highly sought after by LPs probably did not have trouble reaching its target number. And to your point firms less well known, less time in the market, seemed to be victims of the fatigue that has set in a bit among investors.

Fahy: Yes. I really think that’s certainly reached the inflection point where we’ll see some fundraising just get abandoned and kind of clear up some of the noise in the market right now and kind of a reset where we’ll have the elite funds that have always been around will continue to raise capital, some promising new managers, but less kind of crowding of the space and kind of we’ll see how that takes us.

Wilkins: While I agree that we’ve seen sort of a slowdown in number of kind of new funds that are knocking at the door, it’s created some interesting diversity of new buyers that weren’t around just a few years ago. There’s been a whole host of guys that have spun out of the larger funds and created call it, $750 to two and a half billion dollar funds and are hungry to put that capital to work. I think in some respects it’s helped extend the market, this bull market that we’ve lived in and some of the valuations that we’ve seen play out because these guys are keen to obviously fill those portfolios and put that capital to work. So, as a sell side investment banker, we’re all too happy to see those guys.

Privcap: Excellent. Well let’s move on to another topic related to technology. It’s a bit squishier because it’s about culture, but as you all know, companies have been destroyed by a bad cultural dynamics and no amount of financial models were able to save them. I want to frame this as an interesting trend in the m and a market where companies that are from slightly different or completely different markets are merging or acquiring each other. Traditional companies acquiring software companies and sort of companies dipping into markets that they don’t typically, that they are not typically active in because they want to reposition themselves perhaps more as a technology leader. It strikes me that when this happens there’s the risk of culture clash where a team of people from a completely different market acquire a team of oftentimes younger people, technology oriented people and they don’t quite see eye to eye from a cultural perspective. Is that the case and what can you do to mitigate these kinds of problems? And maybe starting with a Mike Wilkins.

Wilkins: Yeah, I think it’s absolutely the case where, we’re seeing, larger whether it’s software incumbents or even holding companies that are acquiring, younger companies that fundamentally just have different DNA. And cultural inertia is a tough force to fight against. And so yeah, we’re unequivocally seeing that out in the market. That said, I think that buyers have become much more educated on retention. There are consultancies people are hiring now to help with the meshing of cultures. There are integration teams built out that have been sensitized asking the right questions and figuring out whether you know the business that their company is acquiring can be folded in or whether it needs to live autonomously. And I think that last point is an important one where I think there just a completely and fundamentally different way that people look at creating autonomy for the businesses that they’re acquiring and ensuring that the founder or the CEO that’s coming across with the business not only feels like they have a autonomy but they have some control over their team and how the team functions inside of these other organizations. So it doesn’t always work. But I’d say that firms have gotten a lot better at it and I expect that that’ll continue.

Fanelli: Yeah, I mean it’s funny that the numbers end up only being part of the story when it comes to something like that. Like there’s one aspect of it where if it’s a middle market private equity firm that owns a, call it $300 million business that’s doing a bunch of 10 to $20 million add-ons in a rollout stretch, we’re seeing a ton of that. That tends to seem to kind of work itself out because the business being acquired is so small, it’s inevitably improved by the provinces, procedures and culture by the platform company. However, in a more traditional, merger perspective, merger of equals or close to equals, we see this go downhill more often than not. And unfortunately, no, I don’t know what the numbers say. It can’t tell you what, what the culture fit is and how to best mitigate those potential issues.

I mean there’s actually a really interesting article in Harvard Business back in, I think it was the fall talking about Whole Foods and Amazon, which was actually very relatable to the middle market and talking about the potentially failed cultural compatibility. And especially when you have one culture that is very metrics driven, high profile, high touch, lots of processes, procedures, scorecards with a company that’s more loose and more gut feel more about sales and more about relationships. It’s just a hard situation to manage, quite frankly. And I think both management teams on both sides of the equation tend to be a little emotional with which one is better and how to best mesh the two together. So I would always just adjust external assistance, look for external help to try to bring in some independent third party intermediary, if you will, from an integration perspective. And also just trying to figure out, you know, that you might have to go somewhere in between. It might not only be the the larger business’s culture that runs the day. At the end of the day it could be a meshing of the two cultures that come together to form one cohesive culture.

Fahy: I think it’s when that expectations aren’t met or you begin to under produce that culture clash really starts to rear its head. And then just quickly circling back to the point Mike made about founders being much more cognizant of that, kind of trying to maintain control. I think, just to touch back quickly on the IPOS we were just speaking on, I think that’s something that’s much, much more prevalent today. And I think we’re seeing it, you see a lot more IPOs coming out with kind of these dual class structures, which essentially allow the founders to maintain a majority control their companies or close to it and essentially try to operate as close as they could, to as they did as a private company even though that they are kind of publicly traded now. And I think that’s an interesting new development that we’ll see how that kind of shakes out, especially with increased stress on government regulation and more kind of a spotlight on the CEOs and how they’re doing for the public good.

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