The private equity (PE) industry is experiencing a very challenging investing environment.
In simple terms, there is too much money chasing too few deals. Dry powder has soared increasing 13 % since December 2014, according to Preqin.com, rising to a record level of $1.24 trillion in March 2015. This amount has risen every year since 2012. As a result, valuation multiples continue to increase, making it more difficult for PE sponsors to find profitable investment opportunities.
The Reason: Supply and Demand
The reasons that prices are so high are familiar ones—supply and demand.
In the middle market—companies with $20 to $300 million in revenue—the sellers clearly have the strong hand. Doug Tatum (our firm’s chairman) has synthesized research from a number of sources to conclude that PE sponsors have already overbought some segments of the middle market. While many PE investors estimate that 5% (1 in 20) of companies fully meet the investment criteria of private equity, Doug’s most recent data shows private equity already holds investments in 10.2% of middle market firms. The overbought condition is even worse within the upper revenue segment, where private equity ownership exceeds 15.6% of companies.
As a result, PE investors are trying to find investment opportunities in less crowded market segments. We see a number of investors who have lowered their sights and are now willing to consider smaller companies, with less than $5 million in revenue and $500,000 EBITDA. The risk/reward ratio for these smaller companies is problematic. These less proven, less mature companies have more embedded risk—their customer base is less robust; their leadership teams are less developed; their organization tends to be thin; and their systems and processes are often ad hoc and poorly documented.
Another problem with these smaller deals: the cost of investing in a closely held private company and growing its value often does not scale well. It takes nearly as much time and work to screen, value, acquire and add value to a $5 million company as it does for a $50 million business.
Most PE investors are very aware of this troubling environment, but feel tremendous pressure from their investors to put their capital to work and start generating returns. What can they do? How can they find opportunities that other investors have not considered and where competitors are less likely to bid up the purchase price?
Based on my years of experience building and running process control and engineering/construction companies in the Midwest and Rocky Mountain region, I think there are three types of opportunities that agile, creative investors can mine.
Invest in Technology Users, not Technology Innovators
Billions of dollars are invested every year in companies that have developed disruptive technologies and products. We all know the success stories and the outsized returns that investors make when these bets pay off. But, when these bets are unsuccessful, billions can be lost.
Most PE sponsors and their investors do not want to make investments with this type of risk/reward ratio. This is the world of angel investors, venture capital and growth equity funds. So how can PE investors capitalize on the benefits of disruptive technologies without incurring the technology risk?
Many studies show that companies that adopt disruptive technologies to improve their production and distribution processes achieve just as “unfair” competitive advantage as the companies that create the technologies they use. Companies that excel at combining technology and operating savvy gain market share and generate profits well above the averages for their industry. Their advantages are directly attributable to their investment and successful implementation of process automation technology and software. I can attest to the higher levels of manufacturing and distribution efficiency produced by investment in sophisticated process control equipment, automation and engineering technologies.
In my own experience developing and implementing information-rich process automation in a diverse group of middle market companies, this opportunity can be found in many industries, including pharmaceuticals, power generation, midstream oil and gas, food and beverage, aviation and consumer packaged goods.
Additional advantages can be found outside the four walls of the production plant itself. Similar competitive advantages and outsized profits can be generated by tying together the entire production and distribution chain. Middle market companies that capture the efficiency gains of integrating best-in-class production planning software, process automation, and ERP systems can be excellent acquisition targets for private equity. They offer a compelling opportunity to grow rapidly through market share gains or as a platform for a roll-up strategy.
In my next blog I will present several other ideas to find promising investments that other private equity investors may be overlooking.
About the Author
Bill Heermann is a partner in the Colorado practice of Newport Board Group. Bill has deep expertise in building and running industrial manufacturing and construction companies. To learn more about Bill’s background and to contact him click here.
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