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Crain’s New York Business: Thriving in the Evolving Private Equity Space

By: Matthew John McNally |

Read this article at Crain’snewyork.com or Download a PDF.

The world of private equity is not what it used to be. A period of historically low interest rates continues to push investors out of public markets to seek better returns elsewhere. The steady inflow of buyers into the private equity space has made acquisitions more expensive, increasing the pressure on general partners to pick winners. A glut of data and constantly improving analytics give private equity firms more information to leverage. At the same time, more large companies are forgoing IPOs, instead accessing funding from venture capitalists and private equity firms.

A third pressure on private equity is the precarious global trade environment. Effects of America’s trade war with China are rippling across industries, and the general uncertainty it’s brought has complicated portfolio building.

All the while, the influx of data increases PE firms’ workloads and raises investors’ expectations of due diligence. And leaders of target companies must anticipate the changes they’ll need to make as their firms become part of an investor’s portfolio.

To learn more about how PE firms and portfolio companies are adapting to a swelling private equity industry in a unique trade climate, Crain’s Content Studio turned to three veterans in the private equity space:

Matthew John McNally, partner, True Partners Consulting

Anthony Minnefor, Jr., CPA, partner, EisnerAmper LLP

Todd W. Polyniak, CPA, partner-in-charge, Sax LLP Transaction Advisory

Crain’s: What are the most significant trends in private equity today?

Matthew McNally: One of the most significant trends in 2019 would have to be “buy-and-build” strategies. While the buy-and-build strategy has been around since the inception of the private equity industry, it has never been as popular as it is today. Using advanced analytic technology, general partners have been able to build value and curtail risk in ways that were unthinkable just 10 years ago. The increased popularity of the B&B strategy can be attributed to the ever-increasing pressure on GPs to find growth strategies that do not rely too heavily on GDP growth or increasing interest rates. However, finding these deals has become more difficult as the industry has grown to record levels in 2017 and 2018.

Crain’s: The deal environment has been expensive for the past eight years. How are private equity firms mitigating the risk of paying too much for an asset while still delivering the returns their investors have come to expect?

Todd W. Polyniak: With an overall increase in transparency requirements, as information is more readily available than ever before, private equity firms are further leveraging technology to analyze and dissect the potential assets they are acquiring. From artificial intelligence to deep dives in analytics and blockchain technology, there is a heavy focus on both traditional and alternative methods to determine the future benefits associated with the acquired property, capital, etc. Travel and other traditional costs may be mitigated by the usage of advanced technology. In addition, private equity firms can access expert-driven data from anywhere in the world to get a clear overall perspective on the risks and rewards of a transaction.

McNally: While the deal environment has become expensive to navigate, private equity firms can mitigate the risk of paying too much for a deal by performing the proper due diligence, which includes detailed due diligence upon buying, developing strategies to determine deal profitability and planning an exit, whether it be through a sale or an initial public offering. In addition to due diligence, private equity firms can also seek to mitigate overall risk through diversification. Similar to the stock portfolio space, private equity can benefit from diversified investments that allow managers to hedge risks with stable and reliable investments.

Crain’s: What should CEOs and other executives of growing companies be aware of regarding the culture and style of private equity firms?

Anthony Minnefor: Fast-growing companies often have an informal operating style that is established by the founder. Also, a rapidly growing company sometimes has areas of the business that are less efficient than they could be. Private equity firms typically add value by helping professionalize all aspects of a portfolio company’s business, which supports sustainable long-term growth. And with that support comes expectations of accountability.

McNally: When working with private equity firms, you gain a deeper understanding of how these firms operate. If this is your first time dealing with a private equity firm, especially if you’ve just come from a corporate environment into a private equity funded or portfolio company, you need to be able to differentiate between when you are having a discussion and when you are discussing a decision with your private equity firm.

Private equity firms are like computers: They follow certain algorithms and are used to running in specific ways, in which they’ve received specific results in the past. The portfolio companies of these private equity firms will have a similar rhythm. Their formulations for triumph—in increasing sales, reducing costs and focusing on particular operational areas—will be scalable and similar.

The best advice I’d share about private equity firms is that you are not in this game alone—it’s not just you and your board. You have a very important network to leverage: the portfolio companies’ CEOs and their teams. Get to know your counterparts in the portfolio companies. Bounce ideas off one another and learn from each other. Talk openly about the challenges you are facing and how each of you has resolved similar problems. Discuss your ideas and strategies for growth initiatives, what’s working and what’s not. These habits will help smooth out the journey of both your company and the investor.

Crain’s: What impact have increased tariffs had on private equity due diligence and investment, particularly when it comes to investments that rely heavily on imports and exports?

Polyniak: The situation surrounding tariffs has had a significant impact on private equity deals. The increase in certain tariffs and duties, coupled with the underlying political implications, has created an increased level of uncertainty across all industries. Specific to the importers and exporters, however, is a greater emphasis on tariffs and duties, as these costs significantly impact profitability and ultimately marketplace competition for businesses in this industry. Private equity firms, along with the buyers and sellers, must factor these costs into any deal they are considering. While there may be hesitation to proceed, the transaction should be looked at as a whole, including an analysis of any significant costs or benefits, when modeling out the short-term and long-term value of a given deal.

McNally: In instances of increasing tariffs, businesses will generally pass on the higher costs to consumers. However, this practice does not entirely alleviate the burden on companies to seek lower-cost alternatives. In a changing political climate, businesses can choose to remain in a holding pattern until the tariff debate settles or begin looking to import from other countries. Private equity firms can diversify by investing in companies that conduct import-export business with countries that have lower tariffs. If a private equity firm desires an acquisition involving trade with China, for example, metrics to monitor include the economic and political climate in which the business operates and the demand for the products or services in that country.

Crain’s: What are the smartest ways PE firms are using technology to manage their investing, fundraising and operations activities?

McNally: Operating a fund just in Excel is not possible anymore, and having the capabilities and competencies in place to support integrations for data modeling and analysis is extremely important. Private equity firms have introduced sophisticated data analytics into their pre-due-diligence process to increase the speeds at which they make deals and to improve precision in deal pricing. Data analytics is also being used to run different scenarios and growth analyses, enabling firms to develop growth models and strategically plan growth of both the firm and newly acquired portfolio companies. Private equity firms have also capitalized on technology to gather and analyze different market trends and social media signals in order to gain insight about unique investment opportunities.

Several private equity firms have implemented platforms that offer virtual data rooms or portals where investors can access data in real time. Many firms have applied robotic process automation to automate routine mid- and back-office manual operations, which may include customer-relationship management and fund accounting. Technology has benefited private equity firms by making it more cost effective to address risk and compliance issues, regardless of jurisdiction.

Finally, private equity firms are becoming more reliant on technology and are developing the in-house technological capabilities of the companies they invest in. In this way, private equity firms are moving away from just providing fundraising and capital and are becoming strategic partners, positively interacting with their portfolio companies to accelerate value creation.

Minnefor: The way private equity firms use technology to manage their investments and businesses has fundamentally changed compared to how things were done just five years ago. Many middle-market PE firms have implemented sophisticated CRM solutions to manage deal sourcing and investing activity. They’ve also implemented technology solutions that organize, analyze and communicate portfolio-company operating and financial reporting post-close. All of these systems speak to each other and feed into the private equity firm’s back-office accounting systems. This shift has enabled firms to much more efficiently filter through countless investment opportunities and, at the same time, effectively add value to existing investments.

Crain’s: What role do transaction advisory firms play in the deal flow of mergers and acquisitions?

Polyniak: There are a few important roles a transaction advisory group will play before and after a transaction. For pre-transaction, if the transaction advisory group is not performing the due diligence, they should be sitting in and considering what the strategic and accounting challenges currently are, and what the challenges will be once the deal is closed. Post-acquisition, transaction advisory groups are making sure all the proper adjustments have been booked and the PE systems are merging appropriately with the target company, so they have adequate reports moving forward. The transaction advisory group will also be assessing the finance department and other individuals who have a future role in the company to make sure everything is flowing successfully.

McNally: Transaction advisory services firms play a pivotal role in M&A deal flow by facilitating—and maximizing the value of—the M&A transaction. Typically, transaction advisory teams are comprised of M&A experts who work with companies to ensure a smooth transition and execution of all steps and stages throughout the deal. One of the key areas where TAS firms can provide critical assistance is post-transaction compliance support. Post-transaction compliance is one of the most critical areas of the M&A transaction and is too often not given the attention required.

Crain’s: What type of information do prospective investors ask for as part of due diligence that they didn’t ask for, say, five years ago?

Minnefor: The types of due diligence private equity firms perform on prospective portfolio companies continue to expand. The days are long gone where they performed just standard legal, financial and tax due diligence pre-close. Today, prospective investors also have in-depth discussions with significant customers and perform detailed assessments of a company’s cyber readiness, among other things. As in most areas of business and investments, a private equity firm’s ability to perform high-quality due diligence has been enhanced by the use of technology. While investors still accumulate frequent-flyer mileage, they no longer have to be solely on site at a company’s operating locations to effectively perform due diligence.

McNally: More than ever technology has become an increasing area of due diligence for PE firms. While technology itself isn’t anything new to investors, the way it’s used and the security measures that are in place have become a point of concern for the public and regulatory agencies. Within the past five years, a large amount of high-profile data breaches have impacted millions of people. Equifax went through a data breach in 2017 that exposed the Social Security numbers of over 147 million Americans. Facebook found itself in the thick of the Cambridge Analytica scandal and has faced record fines as a result. Even Target was a victim of a credit card data breach during the busy holiday season a few years back. PE firms want assurance that the companies they invest in are responsible in terms of how technology and customer data is used, and that secure measures are in place to protect data.

Polyniak: The purpose of the due diligence process is to evaluate all aspects of a company prior to acquisition. In our changing times, we have seen new areas of importance emerge with regards to what prospective investors look at as part of due diligence. These areas of new importance include cybersecurity infrastructure and policies, unreported data breaches, cybersecurity claims and resolutions, sexual harassment discrimination policies, unreported sexual harassment claims and allegations, and documentation of sexual harassment and sexual misconduct resolutions.

Crain’s: What important parts of a deal are commonly overlooked?

Polyniak: There are a number of items that are commonly overlooked during the process of structuring a deal, and I would argue that oversight occurs because much of the focus is on the numbers and not on proper integration planning and execution. Items like cultural challenges, assessing the skills of historical management, setting up-front expectations with the target team and providing the target team with needed assistance post-acquisition are critical to the long-term success of a deal. Many companies do not have experience with private equity firms or their requirements; providing adequate oversight and guidance can go a long way. Also, I believe there should be more weight on the importance of due diligence and assessing the quality and compatibility of financial reporting systems.

Minnefor: Not surprisingly, there tends to be a focus on the numbers when investors make deals and manage companies. Increasing a company’s profitability and long-term financial performance understandably gets a lot of attention and scrutiny, given the large investments they are making. As a result, non-financial considerations in deals are sometimes overlooked. Private equity firms will often make initial investments in “platform companies,” which, in turn, will make multiple “bolt-on” investments in similar companies. These bolt-on deals are done to achieve economies of scale and are frequently successful. However, when performing pre-deal due diligence on prospective bolt-ons, it is critical for PE firms and their platform companies to evaluate whether the potential bolt-on company has a similar corporate culture as the platform company.

Crain’s: For a deal to be successful over the long term, what are the best practices for the first 100 days post-transaction?

Minnefor: Often the most successful deals are the ones where significant progress is made pre-close on a private equity firm’s value creation plan. As the likelihood of a deal closing gets more certain and things fall into place, savvy private equity firms leverage the findings from their deep due diligence and begin working with company management teams to implement changes to improve the company, whether in finding new sales channels or implementing a new enterprise resource planning system. During the pre-close period or the first 100 days post-close, it’s essential for the new private equity investors to effectively communicate with a company’s management team and employees regarding the private equity firm’s vison for the company’s future.

Polyniak: Before the transaction takes place there should have been appropriate due diligence done. In the first 100 days post-transaction, there should be a priority list of key items that came out of due diligence and need to be corrected to ensure profitability goals are met (i.e. accurate reporting, recruiting for replacements, etc.). There should also be a good understanding of where the gaps are. The focus for the first 100 days should be to find solutions for those gaps to ensure a successful long-term deal.

Crain’s: Many of the large, PE-backed companies that have gone public in recent months have seen their valuations fluctuate substantially post-IPO. Why have there been such large corrections in valuations, and what can PE firms do to ensure that portfolio companies looking to go public do so at the proper valuations?

McNally: I think the reason we’re seeing large corrections to the stock price of many companies right after their IPO is directly related to the publicity and excitement surrounding the companies. Let’s look at Uber as an example. Due to its growth and mass appeal, many investors were excited to have the chance to finally invest in a new and disruptive company. This hype helped justify Uber’s initial price at $45 per share. However, record losses for the company continued to grow at the same time its main competitor, Lyft, had shown signs of a path to profitability. Furthermore, a wave of bad PR continued to affect Uber’s public image. These two factors significantly weighed down the price of the stock.

I think PE firms are watching IPOs such as Uber’s and taking them as a cautionary tale. The most effective tool PE firms should use when a company is looking to go public is to ensure strong corporate governance is put in place. This structure not only instills confidence in the public that the company is operating as a fully developed and reputable company, but will also reduce the risk of having any undesired PR at a time when the stock price is most sensitive.

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