Over a year on from the first lockdown, Savannah Group has reflected on what has been an extraordinary year in the Private Equity sector with the volume of requests for pre and post-acquisition support mirroring the ebb and flow of deal-making and all the challenges that has brought with it.
SUPPLY AND DEMAND
After the market paused in the first half of the year, there was a rush of activity in H2 2020 into Q1 of 2021 as pent-up demand drove transaction levels from deals that had been delayed or were rushing to close before the end of the tax year and avoid possible CGT changes. The volume of requests we received for Chairs, Executive Chairs, CEOs and CFOs trebled from Q3 to Q4 and remained high into the New Year, matching the increase in transaction levels.
Given the market volatility and wider economic impact, you might have expected company valuations to have dropped from what were already high levels but, as Bernard Dale, Partner at Connection Capital puts it, “Over the last 10 years, prices have been steadily increasing and, over the last two years, have plateaued.” Despite the impact of the pandemic, Richard Parsons, Lead Private Equity Partner at Deloitte Corporate Finance adds, “There continues to be a mismatch between supply and demand driving the valuations of good businesses,” so investors are therefore expected to pay full price for assets.
Whilst valuations for ‘Covid resilient’ businesses have remained high and the volume of quality businesses has dropped the “wall of capital that exists is creating pressure on investors to deploy funds,” says Sanjay Patel, Investment Director at IW Capital.
These dynamics are creating real challenges for investors in a crowded mid-market where, as Jason Lawford at Duke Street puts it,
“Investors are walking a tightrope between wanting non-cyclical, Covid-robust businesses but not wanting to overpay!”
‘Covid resilient’ sectors such as Healthcare, Pharma, B2B Technology, Support Services and Compliance for example continue to trade at high multiples.
According to Maria Wagner, Investment Director at Beringea, “B2C ecom businesses have benefitted tremendously and seen a sharp acceleration in their growth” whilst those in the Healthtech, Edtech and Work from home tech space have seen valuations boom as a direct result of Covid.
Clearly, Travel & Hospitality on the whole has had a very tough time, but there are hidden gems in sub-sectors such as ‘Staycations’ and food delivery where people in the UK have been desperate to get a break or treat themselves to a takeaway. Equally, garden centres may appear to be a great investment but as Chris Price at Mobeus says, “You don’t buy garden furniture every year or even every 5 years,” so that bubble will likely burst. Jason Lawford at Duke Street says, “The challenge right now is knowing whether Covid has created a blip in performance or whether it has caused a longer-lasting shift in the earnings potential of the business,” even with Covid-adjusted EBITDAs.
Rooting out these gems and being sure of what you’re buying has forced investors to redouble their efforts on Due Diligence. Sanjay Patel, Investment Director at IW Capital told us, “We are looking at more historical data than we might have before as well as undertaking a detailed analysis of the pipeline. We have to be more rigorous than ever.” This is echoed by Tristan Nagler, Managing Director at Aurelius, “We look at historical earnings and undisturbed earnings in FY18, 19 and 20 to get a broader picture of what may come in FY21 and 22.”
Some investors are forced to employ more creative deal-making structures to ensure they can deploy funds but also mitigate risk. Chris Price at Mobeus Equity told us that “in sectors which are more challenging… deferred consideration is common. Buying 51% rather than 100% sometimes.” Another investor said that “deals are becoming more creative in terms of earn outs to justify the multiples.”
In lockdown, a further hindrance to deal-making has been the need to transact almost entirely via Teams or Zoom. Bernard Dale at Connection Capital says that before the pandemic his team “hadn’t completed a deal where they hadn’t met the seller at least a couple of times and would always want to go and see the premises.” This has proved problematic with international deals in particular and one acquisitive portfolio CFO admitted that “not being able to meet the sellers has been a real miss and as a substitute we have been asking for more management information.”
Where investors haven’t been able to get comfortable with the team or the information provided there has certainly been a greater willingness to walk away from something that feels too risky or over-priced. According to Gavin Hood, Corporate Finance Partner at Deloitte, where businesses are taken to market with overly aggressive processes or presentation of performance, they are not attracting the same attention from the PE market “as investors need to get comfortable with what normalised trading would look like which takes time and additional scrutiny.”
This has been particularly true in founder-led businesses which have been rushed to the market to avoid the possible increase in Corporate Gains Tax. Chris Price at Mobeus remarks, “We have seen a lot of businesses coming to market that were not ready to be sold.” This has resulted in deals breaking down as investors walk away, unwilling to be held to ransom and flex their investment strategy beyond breaking point.
LOOKING TO THE FUTURE
One year into this crisis, the question now is how long can investors hold their ground and stay strong in the face of ever-increasing pressure to deploy funds whilst valuations remain frothy? The effects of Covid are clearly some way from being over and market conditions are unlikely to change for the remainder of the year. This means that strong businesses with good management teams will continue to attract high levels of interest in a crowded investor landscape and subsequently we can expect to see high valuations and a paucity of good assets for some time to come. All the while dry powder is continuing to burn a hole in investors’ pockets whose mettle will be tested even further.
Deal making and valuations will remain a significant challenge for investors, but healthy deal-flow has returned to the market as investors get comfortable with the new reality of more comprehensive and sometimes innovative approaches to valuing a business. Despite these challenges, we expect to see a busy deal market this year with valuations remaining high for Covid-resilient businesses and demand for pre-deal Chair, CEO and CFO hires undiminished.