Thanks to the confluence of several factors, both business owners and private equity investors are likely to find more, and more attractive, opportunities for dividend recapitalizations than outright sales of middle-market businesses in the second half of 2021. Three trends are driving this focus on recaps.
Owners of middle-market businesses are concerned about the possibility of significant tax increases from the Biden administration, which is considering doubling the long-term capital gains rate, from 20.0 percent to 39.6 percent. While nothing is certain, the prevailing sentiment is that deals that close after December 31, 2021 are likely to be subject to a much higher capital gains tax.
Owners also realize that valuations for businesses are at record highs. Total M&A volume – including non-sponsored activity and sponsored tack-on acquisitions – is at a record pace, with $103.8 billion through April. Early data points to EV/Ebitda multiples increasing by around one turn in the second half of 2021 for both corporate and strategic deals. If the economic recovery continues, the median multiple may climb back to 10x or higher by year-end.
Behind these high multiples is a market flooded with private capital. Not only has the market returned to pre-pandemic levels, but pricing and leverage metrics have returned to among the most competitive terms in the last 20 years. Loans issued to finance buyouts surged to $19.8 billion in April 2021, the highest level since September 2018, up from $17.2 billion in March and a low 12-month average of $7 billion. Contributing to this large uptick in liquidity is the increasing magnitude of the non-bank direct lending community (which had reached over $900 billion in 2Q 2021), a healthy commercial banking system, increasingly stronger macroeconomic trends and continued decreases in leveraged loan default rates.
In addition, the Covid pandemic highlighted for many business owners the possibility that a business can lose value as a result of events beyond the owner’s control. So, the push for shareholder liquidity is being driven by both unprecedented valuations and fear of known and unknown future perils – taxes and natural disasters.
Limited Interest in Outright Sales
Many owners are not ready to sell because their business is still recovering from the Covid slowdown and/or the owner is too young to retire and believes there is still plenty of upside in the business. Furthermore, owners realize that few alternative investments can deliver a return that matches what a strong business delivers.
For these reasons, an attractive option for many business owners in 2021 is to take some chips off the table, while still maintaining control of the business, by selling a minority stake in the company. This allows the owner to hedge his bets against another Covid-like disaster and shelter his gains from potential tax increases in the future, while also assuring that the source of cash to maintain his and his family’s lifestyle remains firmly under his command – and setting him up for a second bite of the apple as big as, or bigger, than the first (assuming he can continue to grow the business).
Reflecting the widespread availability of capital on attractive terms for recaps, in 2020 we saw a significant increase in dividend recapitalizations and refinancings among private equity firms looking to return capital to their limited partners. Often, private equity firms are leading indicators of trends in the market.
PE Firms Need to Deploy Capital
Private equity firms exist to deploy capital, not sit on it, but they find themselves sitting on a tremendous amount of dry powder because so much money is chasing a limited number of deals. Contributing to this surplus of cash is the new and increased competition from family offices, opportunistic funds and credit funds aggressively moving down the balance sheet. For example, according to the UBS Global Family Office Report 2020, 69 percent of family offices see private equity investments as a key driver of returns.
PE firms are also operating with and competing against an aggressive debt market. The U.S. leveraged loan market resumed its rally in April, after hitting a brief pause in March, despite a boost in the net supply of new issues. Lenders also continue to amend and extend leveraged loans at an accelerated pace. The tally of A&E transactions through the first three months of 2021, at $24.2 billion, was already 44 percent of the total from all of 2020.
So due to an oversupply of money and demand restricted by business owners’ conflicted attitudes toward selling their companies, PE firms are facing several headwinds in what many see as the best M&A market in many years.
Because the markets are awash in money, PE firms will have to differentiate themselves by offering more than money.
PE firms Get Creative
Often, owners of middle-market businesses, especially those in the lower middle-market, are looking for a true partner in a PE firm, one who can provide management assistance as well as cash. Private equity firms that offer operational and/or strategic support, introductions to new markets or customers or other value-added aspects to their investment have a leg up with those owners.
Business as usual won’t get the job done in the second half of 2021. PE Firms have to get creative if they hope to stand out from the crowd and close deals. For example, it may be time to take a look at backing independent sponsors as a way to gain access to more deals, especially smaller deals, which tend to be labor-intensive.
Another way PE firms can be more creative is to consider taking non-control equity positions in companies. Through thoughtful structuring, private equity firms are able to have a say in major strategic initiatives and control the timing of their exit while business owners maintain operational control, benefit from the strategic assistance of institutional investors, have a ready source of additional capital for growth and are generally better positioned for their ultimate exit.
Yet another tactic is to adjust the hold period strategy to make private equity more attractive to business owners that want a longer investment horizon to realize the full value of the business they’ve built.
Bottom line: PE firms that can think beyond standard approaches can flourish in the second half of this year. Those who stick to business-as-usual may find it difficult to make the most of this historically strong M&A market.