The private equity industry has evolved greatly over the years and firms are more involved in their portfolio companies than ever. Performance is no longer just based on returns on investment. Environmental, social and corporate governance along with diversity and inclusion have become key performance indicators, as part of the diligence process. Mergers & Acquisitions spoke with Dave Tayeh, head of private equity, North America at Investcorp about what will drive PE trends in 2021.

What role will private equity play in the economic recovery, particularly in the middle market?

Private equity will play an essential role in the recovery. I believe that our industry has an outsized ability to positively impact multiple aspects of the economy from the portfolio companies we invest in, to the value we generate for our limited partners, whose beneficiaries include pension plans and university endowments, among other institutional investors and family offices. The investment solutions that private equity offers are more critical today than ever before as low interest rates have made it very challenging for investors to meet their return objectives through traditional asset classes alone.

Private equity backed portfolio companies account for roughly eight million jobs in the United States. In the U.S. middle market, which Investcorp has been investing in for nearly 40 years, we believe that there is an even greater opportunity to create value and drive economic growth.

The middle market represents roughly a third of U.S. GDP. Mid-sized businesses typically lack the resources and expertise of larger scale entities. Private equity is ideally positioned to bridge this gap by serving as a strategic and capital partner to the millions of businesses and people we support. Middle-market companies also led job growth following the GFC, creating 2.1 million jobs, which outperformed both small businesses (less than $10 million in revenues) and larger companies (more than $1 billion in revenues).

This crisis has driven profound changes in how GPs fulfill a broader purpose for their constituents and make a positive impact on society. This year, we have seen an acceleration in the importance of ESG and a greater emphasis on increasing opportunities for underserved demographics. The recovery is expected to be uneven and private equity must step up to the challenge to ensure that it is inclusive.

At Investcorp, we believe that asset managers have a responsibility to enrich the lives of future generations. This cuts across all areas from returns to sustainability, diversity and economic opportunity. In private equity, value is not created by simply buying a company but by accelerating growth and improving performance. This includes ESG and D&I as they’re key performance indicators that we screen as part of our diligence process. We know that we’re not alone in this regard, which is why we focus on improving these KPIs post-investment. Not only is this the right thing to do but it has become a new standard for how firms are measured by their constituents. We expect this movement to continue and I believe it will ultimately create stronger businesses, more jobs and a more inclusive economy.

Which sectors do you believe offer the most attractive opportunities?

Attractive is a relative term as it depends on the level of risk you’re willing to accept. For example, there are many sectors that have been more severely impacted by the pandemic and which may appear to offer “attractive” buying opportunities now but that may also come with substantially more risk.

At Investcorp, we target sectors that we know well and where we have dedicated, specialized expertise that can provide a unique advantage for our portfolio companies. We have the strongest conviction in business services as it is typically cycle resilient. The sector generates consistent cash flows and benefits from several secular tailwinds, including the rise of services, digitization and the war for talent, among others. 

As part of our investment criteria, we’ve also identified nine megatrends that we believe will shape markets and society in the years to come. Many of these themes have been accelerated by the pandemic, such as tech disruption and health and wellness. But equally as important, we believe these trends will also be key growth drivers that position our portfolio companies to continue succeeding post-pandemic.

We have a long history of creating value in the six service industry verticals we focus on: tech-enablement, knowledge & professional, data & information, supply chain, B2B industrial and consumer services. Most of our portfolio companies have increased their market share and a number of them are on pace to deliver record results for 2020. We believe this has validated our approach and we intend to continue this focus going forward.

What are your expectations for deal activity in 2021?

We expect there to be a significant uptick in M&A next year driven by low interest rates, high stockpiles of cash on corporate balance sheets and $1.6 trillion of dry powder for private equity. Overall sentiment is improving given the positive indications for vaccines and any major tax reform with the potential to stifle M&A is unlikely to materialize in a divided government.

We saw a consistent and increasing level of deal making start in Q3 as many deals that were put on hold in the spring came back to market. We expect this to continue playing out in 2021. It is a great time for cycle resilient companies to consider a sale given the amount of capital available and low interest rates. We also believe that the lingering effects from the shock of crisis will drive some businesses to do deals to increase scale while others will simply want an exit now that there is greater certainty, or less severe uncertainties compared to the spring. 

What has been the impact of low interest rates on valuations and how you think about deploying capital?

Low interest rates have boosted valuations, even relative to pre-pandemic multiples that were already at historic highs. This has not materially changed how we think about deploying capital and our investment approach, but it does increase the need to add real value post-acquisition.

However, the essential ingredients to a successful investment are the same: identify the opportunity, develop a clear conviction for the growth and value creation opportunities, test assumptions and ensure that your vision aligns with management. We will only invest in a company if we believe that we are the best partner for the business and can help it achieve its value creation plan.

How has the pandemic impacted fundraising and what are your future expectations?

We operate in a relationship-based, people business and it’s difficult to replicate that interpersonal connection virtually. However, the efficiency of being able to meet multiple investors from different regions in the same day is a major boost to productivity. In the past, you’d be on the road for weeks at a time flying to Asia, stopping in Europe and coming back to the U.S. to meet with LPs. Now, I can do all those meetings in a single day without ever leaving my office. I believe that even after the pandemic that we will see much less travel for in-person meetings. We are also operating in a yield-starved environment and investors are increasingly turning to private equity and alternative asset classes to meet their return objectives. This will be a key tailwind for attracting capital, especially for firms with established track records and longevity in the market.