Introduction – The Present State of Sponsor-backed Dealmaking
A strong driver in global M&A activity in recent years has been the resurgence of sponsor-backed dealmaking. In 2019, financial sponsors – otherwise called private equity investment firms – completed US$551bn of buyouts (Fig. 1), accounting for 13% of all M&A activity globally. With the prevailing low interest rate environment and a record amount of “dry powder” – deployable capital raised but not yet deployed – amassed by funds globally, we see a compelling backdrop for sustained strength in private equity dealmaking going forward. In this article, we examine the pertinent trends and considerations across the private equity investment lifecycle, with a focus on the M&A processes involved.
Fig. 1: Private equity deal flow has been robust over the past few years (Source: Dealogic, Bain & Company)
M&A Processes – Three Steps in the Private Investment Lifecycle
1. Sponsor-backed Acquisition
A financial sponsor’s considerations for making an investment is typically much different than that of a strategic acquiror, with the focus shifting away from operational synergies and instead shining on target asset quality, expansion/turnaround potential, and reasonable pathways for sponsor value-add. With the need to hit desired investment return targets and without the justification of operational synergies, sponsor-backed deals typically command lower valuations than deals by strategic acquirors. However, in times where the credit markets and fundraising prospects are robust, sponsors, backed with ample dry powder and the ability to tap on significant leveraged financing, are able as well to bid at extremely compelling valuations.
In today’s market, where dry power is plentiful and competition for assets is extremely stiff, private equity funds are often compelled to come up with increasingly creative ways to execute deals and create value. An increasingly-pursued tactic is the complex “carve out” transaction, such as KKR’s $2.2bn acquisition of parts of food group Campbell Soup Company’s international operating units, where the private equity fund acquires and operates a specific business unit of a larger corporation. In such instances, a lack of division-specific corporate governance or a mismatch in strategic goals within the larger organisation may have compromised the operational performance of the business unit in question, and a focused sponsor-facilitated strategy as a stand-alone unit may well unlock value.
2. Portfolio Company Bolt-on Acquisition
Private equity firms are further involved in M&A deal-making through introducing and overseeing bolt-on acquisitions for their portfolio companies. These investment deals are closer to M&A in the traditional sense, with a core focus on synergies present with the portfolio company in question. For instance, the private equity firm that owns a localised fashion retail group may be aware of similar assets in surrounding cities, and so pursue bolt-on acquisitions to help the retail group expand its regional footprint and break into new markets, thus springboarding top-line growth.
In fact, an increasingly adopted strategy for PE value creation is the buy-and-build strategy (Fig 2.1), where a private equity firm purchases a suitable “platform company” and then pursues a string of add-on acquisitions. This follows the idea that the whole is often more than the sum of its parts, with potent revenue and cost synergies often harnessed when merging multiple complementary businesses.
Figure 2.1: Noteworthy roll-up activity in the private markets over the past decade (Source: Pitchbook Data, Bain & Company)
Value is also unlocked through this process due to “multiple arbitrage” – based on the findings of Pitchbook Data and Bain & Company, smaller companies typically trade for lower multiples and thus offer the opportunity reduce the weighted average cost of acquisition (Fig 2.2). Indeed, small companies may be available at compelling valuations for a multitude of concerns, such as a lack of visibility/liquidity and a higher perceived risk profile, that can be immediately alleviated on integration on a larger, established entity. Further, sponsors are frequently able to find these smaller businesses through proprietary, “on-the-ground” sourcing methods, and bypass the drawn-out bidding process that drives up valuation.
Figure 2.2: The “small-company discount” offers a compelling opportunity for returns generation through multiple arbitrage (Source: Pitchbook Data, Bain & Company)
3. Portfolio Exit
Finally, the portfolio company exit is an essential segment of the PE deal lifecycle. Depending on the characteristics of the company and conditions of the market (e.g. company size, equity capital market conditions), a private equity fund has multiple options in monetising its investment. Amongst the common options, which also include an IPO or a dividend recapitalisation, a sale of the asset to a strategic buyer or to another financial sponsor is typically the most straightforward pathway to a full exit. For reasons mentioned above, a sale to a strategic buyer is typically preferred as it likely entails a higher valuation, although abundant dry powder or a compelling portfolio fit can drive competitive sponsor-backed bids as well. In this process, a sell-side advisor is typically engaged by the sponsor to coordinate the sale.
Today, private equity dealmaking is showing no signs of slowing, as major players continue to load up on deployable capital. Despite Covid-19 disruption, 1Q2020 saw 267 funds raising a total of ~$133bn, exceeding the amount raised in 1Q2019 by 12%. As dry powder builds up and private equity firms are increasingly under pressure to put capital to work, robust sponsor-led dealmaking is poised to continue in the coming years, persisting as a core driver of overall M&A activity globally.