The year 2020 has been, perhaps, the most volatile year ever for private equity. The industry came into the new year with record levels of dry powder, then saw a vigorous Q1 deal market succumb quickly to almost no transactions due to the economic and health impacts of COVID-19, followed by a period in which the laser focus was on helping portfolio company management teams navigate a difficult environment and seize opportunities in the marketplace where available. As we look forward with the hope of returning to normalcy in 2021, this is a good time to assess how the industry has evolved and ensure we don’t lose sight of the lessons that have been learned along the way.
When we launched Sun Capital Partners in 1995, the private equity industry was in a much different place. The market was less crowded, multiples were lower, and firms pursuing traditional buyouts were able to make attractive returns through financial engineering. Highly leveraged deals designed to split up companies were commonplace.
Today, private equity plays a critical part in improving business operations for large and small companies alike. Three of the keys to this transformation have been the rise of operational capabilities, a significant increase in focus and transaction volume among middle-market companies, and an evolution in the use of leverage in transactions.
1. The Rise of Operational Capabilities
The standard private equity model in the mid-1990s was to buy well-run companies with outstanding management teams in order to create value, largely with financial structuring and little to no focus on operational improvement. It is only over the last decade that firms and their investors have embraced the opportunity to add value post-closing, especially as competition has increased and purchase multiples have risen. According to McKinsey, “Operating groups that support value creation in PE portfolios have become an increasingly important feature of private markets firms. Today, every one of the largest 25 firms has such a team.”
Since we launched Sun Capital without a track record and did not yet have the credibility to compete for traditional buyouts, we pivoted to buying companies that others overlooked, largely because these prospects required substantial help and support. From our first deals in 1996, we focused on companies that were struggling financially by rolling up our sleeves and providing operational support.
Four years after our founding, we added our first operating executive and have continued to build our operating team and capabilities. From the start, we established a compensation structure for operators that makes them true participants in each of our funds, rather than consultants or affiliates.
We also developed a keen understanding when our operations team should be involved with a company, and how they can best support management. We’ve grown better at knowing when to step in and which tools to use. We don’t swarm in and overwhelm management teams but provide guidance to help them move quickly and decisively. We recognize that it is the management team’s job to run the day-to-day business. They are the players and we are the coaches. To institutionalize best practices, we have assembled this knowledge into a system that guides management teams in tackling common challenges – driving revenue, lowering costs, building culture and implementing process improvements – in a systematic and rigorous way.
2. The Growth of Middle-Market Deals
Middle market deals have always played a big role in private equity. Even large firms like Bain Capital and KKR were involved in the middle market in the early days because they were investing small funds and were capital constrained. As larger pools of capital have been raised, the private equity market evolved, and middle-market transactions have occupied a greater share of deal volume while also growing in size and prominence.
AS WE LOOK FORWARD WITH THE HOPE OF RETURNING TO NORMALCY IN 2021, THIS IS A GOOD TIME TO ASSESS HOW THE INDUSTRY HAS EVOLVED AND ENSURE WE DON’T LOSE SIGHT OF THE LESSONS THAT HAVE BEEN LEARNED ALONG THE WAY.
According to Pitchbook, U.S. middle market deals have steadily accelerated in both number and value over the last decade, from 1,315 deals in 2010 to more than 3,100 deals in 2019, and from $193 billion to $531 billion in enterprise value in 2019.
One of the reasons middle-market private equity investments have performed so well is that there is a greater ability to impact results and add value than there is with large cap companies, which typically already have the scale and resources they need. Middle market companies may be lacking resources and experience that private equity is in an ideal position to provide, such as support for add-on acquisitions, operational improvements, and management talent.
Large cap companies also tend to be highly correlated with public markets. The relative lack of correlation in the middle market makes it attractive to institutional investors. They can get liquidity from their public equity investments, and supplement it with middle-market private equity investments that provide better diversification.
3. Less Reliance on Leverage
The use of leverage in private equity is another area where we have seen a sea change in perspective. Transactions in the industry’s early days were far more reliant on leverage than the deals we typically see today. In particular, higher levels of debt were used relative to the purchase price. Of course, decades ago deals were being done at quite low multiples, and it was possible to buy companies with an equity contribution of 25% equity or less.
Today, equity may represent 40-60% of the purchase price, with more moderate use of leverage. Indicative of this trend, equity contributions to private equity deals were up four percent from 2018 to 2019, according to LCD. The industry’s strategic focus has changed accordingly, from breaking up diversified conglomerates into pieces and employing financial engineering to deliver returns to building and investing in businesses to grow revenues, create jobs, and increase profitability.
We have learned that you need a different thought process to calibrate the appropriate amount of leverage for a company that is or may be facing stress or distress due to industry headwinds or challenges in product or service delivery. Less leverage is often a competitive advantage for these businesses, particularly in times of uncertainty, as we have seen during the pandemic. Additional financial flexibility and operational support also allows management teams to invest in growth opportunities when competitors may not be able to, and to pursue add-on acquisitions or business partnerships that can drive revenue and market share gains.
As we look to the future, we believe that private equity will be an increasingly pivotal asset class – one that will play a growing role as an engine of economic growth and positively influence people’s everyday lives. We look forward to being part of this exciting evolution.
Marc J. Leder and Rodger Krouse are co-founders and co-chief executive officers of Sun Capital Partners.