Headwinds on the horizon?
By 2018, deal volumes had reached an all-time high, with valuations rising to pre-recession levels as investors took advantage of arguably the longest bull market in history. The first quarter of 2019 saw deal flow for North American private equity (PE) firms decline sharply in volume and value, by 27.9% and 26.7% respectively in the US1, compared to the first quarter of 2018. Furthermore, add-on transactions accounted for 71% of deals in the US in Q1 2019, indicating that while overall deal values have dropped, PE firms are utilizing mergers and acquisitions (M&A) to drive growth for their investments, which requires a more hands-on approach to value creation. In Canada, buyout and add-on transactions accounted for 28% of PE deals in the first quarter of this year. Canadian PE firms have also seen deal flow decline in Q1 in volume and value by 17.7% and 71% respectively compared to Q1 20182.
This decline has occurred despite there being over $1.2 trillion3 of dry powder in North America – $2.0 trillion globally – including venture capital. High valuations and intense competition for individual assets have resulted in a negative impact on deal activity. Attractive assets often receive multiple offers, with corporates often able to gain better synergies, resulting in greater competitive bidding and higher valuations in comparison to PE offers. With PE firms facing increasingly competitive deals, diversification of asset allocation strategies can also mean venturing into unfamiliar sectors.
While there is unlikely to be a shortage of companies to acquire, the real question is whether there will be enough investable companies at fair valuations to satisfy demand. Uncertainty in the markets due to increasing geo-political tensions around Brexit, tariffs and protectionism will no doubt be a consideration for those exposed to, and impacted by, these headwinds.
Identifying the right value creation levers on your next deal
Since 2010, deal returns have shown a decline, placing increased emphasis on the importance of value creation, versus multiple arbitrage and reliance on financial incentives for management. More recently, with record levels of capital to deploy and firms continuing to raise larger funds, PE firms need to differentiate themselves in developing strong investment theses that pull on the full range of value creation levers in order to put together more compelling bids and compete on price. This includes exploring strategic ways to allocate capital and extract value to realise significant uplift in returns.
A proactive approach to value creation
The increased focus in value creation has resulted in a shift by PE firms from a hands-off approach to more proactive partnerships with the management of operating companies. In addition, a growing number of PE firms are leveraging the scale across their portfolios to define opportunities.
In our recent survey conducted by Mergermarket on behalf of PwC, 100 Private Equity Partners were asked about their experiences with value creation through M&A. 80% of survey respondents said their last transaction taught them they need to do a better job of due diligence.
Operational due diligence as a strategic tool for prospective buyers
Historically, operational due diligence (ODD) was conducted to ensure dealmakers knew what they were buying; shedding light on the current state of operations or refining the cost baseline, particularly for carve-outs where standalone and stand-up costs had to be confirmed.
Today, savvy dealmakers are using ODD to kick-start the value creation process, helping to capture and quantify the value hypotheses achievable through post-close operational improvements or integration. As a buyer in an increasingly competitive market, it’s critical to be able to quickly focus on likely high impact value creation levers during due diligence and drive a hypothesis-driven due diligence process, rather than being reactive to a seller’s perspective on perceived value.
We have also observed an increasing number of sell-side processes completed with sell-side ODD analysis, driven by the goal to help the seller increase the perceived business value and materially improve the purchase price, as well as provide the buyer with visibility to performance and stand-alone costs.
Validating your pre-deal hypothesis
Operational due diligence helps to provide clarity on the potential value creation opportunities and touches upon every stage of the concept of a value bridge for enterprise value.
Areas of synergy to investigate during due diligence
Below are examples of major value drivers, along with key considerations that are commonly investigated during the due diligence phase to support upside estimates, assess downside risks and better inform the value creation strategy and plan.
Unlock long-term value on your next transaction
Operational due diligence is no longer a risk-focused defensive approach to knowing what you’re buying. Rather, it’s now value-focused, to assist in strategizing a competitive purchase price and formulating a sustainable strategy to accelerate unlocking long-term value in today’s increasingly competitive environment.
Well-informed and perceptive dealmakers understand that ODD helps them assess the entire company and detect the value levers that will identify potential opportunities and risks early on.
Through ODD, dealmakers are looking for clarity on value creation priorities that enable them to protect components along the value bridge continuum and drive shareholder value, resulting in more successful deals.
(2) VC & PE CANADIAN MARKET OVERVIEW Q1 2019 - CVCA