When Grand Rapids, Mich.-based Auxo Investment Partners acquired Saylor Technical Products, a manufacturer of flexible, non-metallic wire and hose protection and has since expanded into cords and tapes, which will operate under the Precision Products Group brand it, didn’t instantly cause an avalanche of activity. However, one dealmaker believes the plan to build on an existing platform under a collective focus is one way to survive current macro conditions.
It had been smooth sailing over the course of the last six years for the M&A market. Fundraising was strong, public markets drove verticals high, and multiples were high. It was a speculative market where firms were deploying capital and driving the price of assets up as cost of capital was considerably less. However, today, just about all of those numbers are skewing the opposite direction. Here’s how PE are navigating these hurdles.
“I think a lot of private equity sponsors are taking a look at their portfolio companies and they’re doing two things,” says Matthew T. Simpson, a co-chair of Mintz’ private equity practice. “One is they’re looking for strong fundamental businesses that they could add as a platform but with reduced leverage. Sponsors that are in a position to do these deals with less debt or defer the debt at closing that’s really putting them at a comparative advantage.”
As a result, Simpson adds that the other key feature he is noticing among recession resistance are bolt-ons and add-on transactions. These are transactions that characteristically do not require debt at closing.
“If you already have a platform and you have a senior secured facility there or some sort of transaction financing facility, you can go out and you can add on businesses either off your balance sheet or by drawing down on an existing credit facility without having to finance new debt,” says Simpson.
He notes that many sponsor-backed firms are building out their platforms by focusing on the inorganic growth of existing portfolio companies to boost Ebitda numbers. Rather than hunting for the next platform, Simpson advises that firms look inward to build up existing platforms as it is a lot less expensive to tap into existing debt facilities.
PE shops by nature are looking to hold investments for a limited lifespan and the integral mechanism by which these funds make a profit and grow the business is described by increased revenue and Ebitda. However, the crux is that firms don’t necessarily know where multiples are going to go throughout the course of a holding period and so firm’s must work to drive revenue.
As private equity firms hunt to create growth and specifically revenue and Ebitda growth, it is crucial to ‘feed the beast.’
Simpson says, “I think there’s going to be increased desperation over the next six months to a year when folks start burning through cash a little bit faster than they thought they might. And especially with inflation going up, everything’s getting more expensive, including operating a business.”
So what Simpson is starting to see in response to the cost of capital issue is increased creativity below the holding company as to how debt is brought into the system.
“I think funds are realizing that there’s opportunities to have transaction financing lines trying to get to a closing without any debt on the books, but anticipating that they’ll finance debt in the next 12 months,” says Simpson. “I think there’s more increased creativity on again the financing itself, seller notes and how you structure those, earnouts are getting more creative and more complicated. The working cap adjustments and how we value businesses, I think folks are looking at and not necessarily pulling from the same playbook as they otherwise usually would have.”
Tatjana Paterno, a member of Tennessee-based law firm Bass, Berry & Sims, and her team work with Fortune 500 companies. She believes the recent uptick in earnouts is driven primarily by buyers. “The uncertain economic environment reduced visibility into the anticipated performance of acquisition targets, which resulted in an adjustment of buyer expectations with respect to valuations. Buyers have taken a conservative approach to valuation, offering earnouts to reduce the risk of potential underperformance.”
Additionally, there can be a big role to play for the insurance industry. Representation and warranty insurance has taken off over the course of the last seven years and continues to evolve and solve problems for M&A, as well as new products like transactional tax insurance, contingent liability insurance or environment insurance can take the burden off of buyers and sellers.
“Anytime you can shift some of the risk off the buyer and the seller and put it on an insurance company there tends to be value in that and people are happy and willing to do that,” says Simpson. “I do think that is also a way to get creative and and to build out a structure that works for everybody and to continue to find ways to get deals done.”
–Cole Lipsky
