Private Equity Firms Shifting Focus to Deal Sourcing

by: Atta Tarki,  Ken Kanara, Gustav Brown  & Steven Haug

 

Key Highlights: ECA Partners recently conducted a second survey of private equity investors and executives to understand how the COVID-19 emergency and consequent economic downturn are affecting investment decisions in the private equity sector. Our previous survey, conducted in April, found that most PE firms were shifting focus to controlling costs at their portfolio companies, while some were exploring opportunities for medium- and long-term growth.  

The second survey, conducted in May, generally supports these conclusions, but also finds a shift among PE professionals from controlling costs to sourcing new deals and growing revenues at their portfolio companies. At the same time, the survey also finds that PE professionals expect a longer period of recovery than they did in April.  

Selected findings include: 

  • 42% of PE professionals expect to spend more time on deal sourcing than they were before the COVID-19 downturn, up from 27% in the first survey – a major shift in strategic priorities 
  • 54% plan to spend more time growing revenues at their portfolio companies, up from 49% in the first survey – a moderate shift in strategic priorities  
  • PE professionals believe revenues will return to pre-COVID levels in 2021, with a median response of Q2, whereas in the first survey a majority predicted Q4 2020 or Q1 2021 

 

Introduction: Private equity in the US accounts for more than $1 trillion in value and employs approximately 9 million Americans, with more $600m in wages earned in 2018. It has been one of the main drivers – and beneficiaries – of economic expansion since 2009. Like other sectors of the economy, however, PE-owned companies have been deeply affected by domestic closures and other restrictions enacted in response to the COVID-19 outbreak, as well as from the disruptions to the global supply chain, ongoing declines in global trade, fast-rising unemployment and general loss of consumer confidence that define the current economic climate.  

Our surveys pose a series of questions to PE investors and executives on the following themes: (1) how the COVID-19 emergency has changed their strategic priorities; (2) how they plan to spend uninvested capital; and (3) when they expect company revenues to return to pre-COVID-19 levels. The second survey is comprised of more than 75 respondents from various corners of private equity: tenured committed funds, family offices and fundless sponsors, ranging from small ($0-100m assets under management) to very large (more than $10b assets under management). 

The April survey found that PE professionals were focusing less on active investing and more on maximizing value at current holdings – both by controlling costs and finding new avenues for organic revenue growth. The second survey largely confirms these findings, but also shows a notable shift from controlling costs at portfolio companies to sourcing new deals and growing revenues at existing portfolio companies.  

At the same timerespondents have grown more pessimistic when it comes to the downturn’s duration: in the first survey, respondents felt that the PE sector would rebound by the end of 2020 or first half of 2021; one month later, few respondents feel that the crisis will end before 2021, and may last until the third quarter of that year 

Taken together, these findings suggest that PE investors understand that there is likely no quick fix for the economy, and so are beginning to focus more on “offensive actions” that set them up for long-term success 

 

Time Allocation 

We began by asking PE executives to compare (a) how they plan to spend their time over the next 90 days to (b) how they allocated time during the recent period of economic growth. Most respondents (82%) told us that they plan to spend more time managing costs at their portfolio companies. This is a slight drop from last month, when over 88% of respondents told us that they planned to spend more time managing costs. A plurality of respondents (48%) also plan to spend more time on revenue growth initiatives. This is relatively unchanged from last month, when 45% of PE professionals reported the same. In addition, large pluralities of respondents plan to spend less time on fundraising (43%) and closing deals (46%). This trend has carried over from last month.  

The most striking finding relates to time PE professionals expect to spend sourcing deals. In April, 49% said they expected to spend less time sourcing deals, compared with 27% who said they expected to spend more. In May, however, these numbers reversed, with 31% expecting to spend less time sourcing deals and 42% expecting to spend more time doing so.  

 

 

These findings show that, in relative terms, PE investors are continuing to shift strategic focus from mergers, acquisitions and divestments to ensuring that their existing holdings are able to successfully weather the storm. However, the shift toward sourcing deals is inarguably significant, and likely points to the fact that many companies are currently undervalued – making them attractive targets for investment.  

 

Uninvested Capital  

The second set of questions focuses on how PE firms plan to allocate uninvested capital. Overall, new investments remain the top destination (46%) for uninvested capital. This is down from last month when 54% of invested capital was earmarked for new investments. Notably, this is a further retreat from pre-COVID-19 numbers (60%). Inorganic growth initiatives (26%) remain largely unchanged relative to both April and pre-COVID (26%). On the other hand, PE professionals continue to invest more capital in organic growth initiatives across their portfolio (30%, as compared to 21% in April and 12% pre-COVID) 

 

 

State of the Economy 

We asked respondents questions relating to the macroeconomic health of the PE sector and market as a whole. First, we asked them to predict when portfolio company revenues should return to their pre-COVID-19 levels.  

In April, most respondents felt that revenues would return to pre-COVID levels by the fourth quarter of 2020 or first quarter of 2021 (mean)This month, the mean response shifted from the first to the second quarter of 2021. Notably, more than 12% expect revenues not to return until after 2022, up from 8% last month 

On the surface, this suggests a somewhat more pessimistic view of the economy, but it may also reflect new information on the virus itself and the growing expectation that a vaccine will not be available in mass quantities until early 2021, if not longer.  

 

 

Respondents were also asked how much they expect the Dow Jones Industrial Average to gain or decline between now and the end of 2020. In April, respondents predicted a 10% jump; in May, however, the prediction declined to a loss of 4%. Still, this may reflect gains already made in the past month as much as bleaker prospects for the market. 

 

 

Hiring 

In May, we started asking PE professionals about their hiring priorities – namely, how much time they plan to spend on talent over the next 30 days (compared to the preceding 30 days). Unsurprisingly, we found that PE professionals plan to focus most of their attention on independent consultants and interim talent to meet their needs (rather than filling permanent roles). This reflects the prioritization of cost management over longer-term growthsomething we expect to shift slowly as a lengthy recovery takes shape 

 

 

Portfolio Sales 

Respondents were also asked whether the COVID-19 downturn has led them to delay the sale of any portfolio companies. PE professionals were split, with 53% saying they have delayed at least some sales and 47% saying they have not. Roughly half reported delays are expected to last fewer than 12 months, and half are expected to last longer.  

 

 

Demographics  

The survey offers a snapshot of private equity in the United States. Respondents hail from tenured committed funds (66%), family offices (12%), fundless sponsors (14%) and other vehicles for private equity investments (8%).  

Respondents also range in terms of assets under management (AUM). Representatives from funds under $100m AUM account for 36% of respondents, while those in the $100-500m AUM range account for 30%. Another 8% of respondents come from funds in the $500m-1b AUM range, while 18% come from funds in the $1b-10b AUM range and 8% from funds with more than $10b AUM.  

Respondents also represent a range of private equity activities, from fund-level investments (77%) and portfolio operations (61%) to portfolio company management (10%). 

 

 

Conclusion: The second iteration of the survey largely upholds our findings from April, when we said “it is clear that private equity investors are making a fundamental shift away from aggressive investment strategies toward a more defensive stance that places more emphasis on value creation at existing portfolio companies…at the same time, though PE investors are scaling back their deal-making activities, they are by no means curtailing them altogether.”  

However, we have found some significant changes in attitudes among PE professionals. To beginPE professionals plan to spend significantly more time sourcing new deals than they expected to in April. Their appetite for new investments also appears to have returned to pre-COVID levels. At the same time, PE professionals are more pessimistic about economic recovery and now believe the downturn will last significantly longer than originally expected.   

At first glance, these findings seem at odds with one another, but it may simply be that, without a quick fix in sight, PE professionals can’t just wait for better conditions to arrive. Conversely, it may also be that they sense we have reached the bottom and that many companies with solid fundamentals are available now at a heavily discounted price. Regardless, the turn towards active deal sourcing and continued movement toward investing in portfolio companies promises to have a positive effect on the sector as a whole, as well as the overall economy.  

Published On: May 22nd, 2020|Categories: Uncategorized|

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