By Jim Childs, Head of Citizens M&A Advisory

Why it matters

  • Private equity-backed companies have outnumbered publicly held firms since 2012, and the megatrend continues as the private equity (PE) industry flourishes.
  • Rising PE demand for middle-market companies has contributed to higher valuations.
  • The share of PE-backed firms has also raised the standard required to compete, in many sectors.
  • PE owners upgrade business practices and operations, push for profit gains, deploy expertise to hire and retain skilled management, and consolidate fragmented markets or capture vertical synergies.
  • Middle-market company owners and managers should consider ways to replicate the benefits of private equity partnerships to remain competitive.

Private equity ownership of U.S. companies continues to rise as the private equity sector flourishes and initial public offerings (IPOs) decline, a trend that has helped to boost company valuations to record highs. But this trend also has implications for the business environment. PE-backed companies, now a significant portion of the market, have access to both capital and operating expertise. This combination has pushed many industries to be more sophisticated and competitive. The practices PE-backed companies adopt are becoming the norm. To keep up, middle-market owners and managers have to take an aggressive approach to upgrading their own practices, or consider ways to tap into private capital.

A megatrend decades in the making

The move away from publicly held stock toward private equity ownership has been underway for decades. According to a 2019 report from Ernst & Young, the number of U.S. companies that are publicly held has declined by 50% since the late 1990s. Meanwhile, private equity funds proliferated during that period, soaring from fewer than 1,000 PE funds to nearly 4,000. As a result, PE-owned companies have outnumbered publicly held companies since around 2012, and the trend continues as the private equity industry expands.

The appeal of high returns

Investment returns are a powerful engine driving the shift toward private capital. According to the McKinsey Global Private Market Review 2021, a pool of private equity funds from 2007 to 2017 had median annual returns of 13.3% through September 30, 2020, based on the internal rate of return (IRR) calculation that is standard for the industry. In comparison, the S&P 500 Index returned an annualized average of 8.6% in that same time frame, while the Russell 2000 Index returned 3.6%.

Of course, private and public equity investments are not interchangeable. They have significant differences in terms of liquidity and risk, and most institutional investors consider private equity a higher-risk/higher-return option than public stocks. Still, the lofty historical returns of private equity have attracted institutional investors, like pension funds and endowments, to increase their private equity allocations over the last few decades, according to McKinsey.

Higher allocations fuel industry growth

As institutions direct more money to private investments, the industry for private capital has ballooned and become more sophisticated. What was once a cottage industry specializing in leveraged buyouts of distressed assets, private equity has evolved into a complete ecosystem of capital. There is now a competitive menu of private funds covering every sector, company size, and growth stage, and capital structure—from short-term debt, to mezzanine funding, to equity.

As the private capital industry has proliferated, the market for public capital has contracted. Companies have a wider set of options for raising funds—and private capital often comes with different terms and trade-offs than other options.

What it means for middle-market companies

This megatrend shift toward private capital has several implications for middle-market companies.

First, the trend has created an appealing environment for potential sellers. Valuations for private equity transactions are at record highs, boosted even higher as near-zero interest rates were deployed by the Federal Reserve to combat the challenges of the COVID-19 pandemic. While it is difficult to predict where valuations go next, there is good reason to expect high valuations to continue. Private equity fund managers are forced to put funds to work in investments or risk the viability of the firm itself, since insufficiently invested funds are not able to generate positive returns in future periods. The race to commit capital becomes ever more competitive as the industry for private funds expands. In other words, private-fund demand for companies has grown exponentially and continues to increase. The supply of companies, on the other hand, is essentially constant.

The impact stretches beyond companies considering a sale to private equity. It has also led more broadly to a changing operating environment for middle-market companies. The estimated market value of PE-owned firms has exceeded the public market capitalization of global companies since about 2007, according to McKinsey’s Global Private Markets Review 2021. PE owners take an aggressive approach to value creation, and they use sophisticated tools and processes to drive growth and profitability. With a large share of PE-backed firms in the marketplace, the performance baseline for day-to-day operations has escalated across most industries.

5 ways that PE-backed firms are changing the competitive landscape

PE-backed businesses are better managed than non-PE-backed private companies, according to a 2009 paper by economists from Stanford, Harvard, and MIT. Though their study was limited to manufacturing firms, the research established a measurable difference in both people management and operations management for PE-owned firms compared to non-PE privately held companies.

1.) Governance advantages. Private equity owners often use more advanced governance as a process to institute discipline and accountability throughout the operating structure of their holdings. One of the key methods of achieving this is through a board of directors. The board typically includes outsiders who bring experience to the business from across the industry and across operating disciplines from supply chain management to accounting practices.

2.) An edge on strategic planning. Using an operating partner model or skills from the board of directors, private equity investors have pushed many industries to a new level of strategic planning. PE-backed firms use a repeatable process for establishing or updating company strategy, outpacing the approaches of smaller operations. They also excel at vertical integration, including pairing complementary companies within their portfolios.

3.) Incentives that attract top talent. The structure of PE investments can work favorably in the design of executive-level compensation. PE-backed firms often create pay structures for key personnel including equity awards that monetize when the PE firm exits the investment. In contrast, non-PE private companies often work with straight bonuses or more ambiguously designed equity awards. Public companies can even have a bonus structure that includes potential claw backs, where they can later demand the return of a bonus under certain conditions. Compensation packages are an important tool for securing management talent in a competitive market.

4.) Aggressive investment in technology. With clear data on the return on investment, or ROI, of expensive technology outlays, PE-backed companies are likely to spend more on technology. This kind of investment can pay off quickly in the smaller, fragmented markets that middle-market companies often serve.

5.) An acquisition mindset and skillset. Buy-and-build has proven to be a successful approach across many industries as companies capture synergies and the economics of scale. Because the PE industry is rooted in transactions, PE-backed firms are at a huge advantage taking this strategy to their markets.

Staying competitive in the era of private capital

There are ways for non-PE-backed firms to keep up as the operating environment matures. Middle-market company owners and managers can essentially take a do-it-yourself approach to mimicking the advantages that PE-backed competitors have, moving to elevate their own practices.

However, there’s a key ingredient to succeeding with this kind of upgrade: you need the talent to manage these processes. PE firms often bring in highly experienced and educated managers to pilot the turnarounds and growth initiatives that bring value to their holdings. To compete, non-PE-backed companies must staff their teams with the same level of skills and professional networks.

How to mirror PE-backed company practices

  • Implement a board, and audit financials. Like private equity owners, look to build out a range of skills and experience across a board of directors, mixing outsiders with company stakeholders. Auditing financials is also a critical process that will ultimately boost your company’s governance practices. If you don’t already have financials regularly audited, it’s a worthwhile investment—and will be a requirement —if or when you decide to sell or partner with private capital in some form.
  • Upgrade strategic planning with consultants or operating partners. Consulting services can be a big investment—and they’re only worthwhile if you bring in the right mix of advisors and implement recommendations successfully.
  • Overhaul compensation packages to compete. To attract and retain the level of talent that PE-backed competitors have, look at ways to make competitive compensation packages that monetize at a clearly determined date. There are three key ingredients to structuring a PE-like package: 1) a motivating bonus of a certain dollar amount or percentage of estimated company value at the time of bonus; 2) a defined link between the bonus and improvement in a target metric, like profitability, increased EBITDA (earnings before interest, taxes, depreciation, and amortization), or revenue growth; and 3) a stated performance-measurement period with an end date that is far enough into the future to drive long-term performance yet soon enough to be appealing.
  • Invest in technology. The cost of upgrading technology can be significant, but the efficiencies and benefits are becoming a necessity to stay competitive with PE-backed peers.
  • Consider mergers or rollups. In the majority of fragmented industries, consolidation is inevitable. It’s important to take an unbiased view of the consolidation trend in your own industry and consider what steps your company needs to take to keep up, including the possibility of acquiring or being acquired.

Partnership advantages are here to stay

Private equity dominance is not an inevitable outcome. There are factors at work in the current environment that are helping to boost the megatrend toward private capital. The tax treatment of long-term capital gains is a major support, and that factor could change in the near future. In fact, the possibility of tax code changes is driving a flurry of transaction activity. Interest-rate policy is also a major factor, as historically low interest rates over the last decade have made leverage more appealing and enabled buyouts at high valuations. Interest rates are sure to change over time, though they are still likely to remain generally low compared to historical levels. But still, private ownership is not inevitable. There are enduring advantages to public capital markets. Investor liquidity is a benefit and allows for flexible funding options in the future, while reporting requirements enforce a high degree of oversight and transparency. Likewise, many privately held companies will remain independent for the long term.

However, the megatrend toward private equity has already changed the business landscape permanently. Today’s sellers care as much about partnership advantages as they do about price—an indicator of what a powerful force the right PE partnership can be. With private equity operating partners, boards, and top-tier management talent, PE-backed companies have major strategic advantages. The shift to more competitive operating conditions is a permanent change.

This megatrend has also generated broader options for middle-market companies. In the market for capital, companies now have access to various options for majority and minority equity investments, and private debt options have proliferated. Middle-market companies should consider the range of options carefully, as they could tap into the partnership benefits of PE investors without being limited to a complete sale of their businesses.

Key takeaways

  • The megatrend shift toward private equity ownership has contributed to the strong market for sellers
  • PE ownership has also driven more competition in the operating environment as PE-backed firms upgrade business practices
  • Non-PE-backed firms should take a proactive approach to staying competitive, and adopting PE-style practices can help
  • With an expanding private equity sector, companies also have more options than ever before to access private capital across debt, minority or majority equity investments, which could enable middle-market companies to tap into the value of a private equity partnership without fully divesting

Partner post sponsored by Citizens.