Navigating uncertainties: The impact of current economic realities on private equity-backed buy-and-build strategies

In the intricate landscape of private equity (PE) investments, the art of crafting successful strategies requires a keen understanding of the prevailing economic conditions. The year 2023 has witnessed a confluence of factors, from global macroeconomic uncertainties to shifting inflation trends, which have significantly impacted the dynamics of the PE sector. This article delves into the implications of the current economic environment on PE-backed buy-and-build (B&B) strategies, shedding light on both existing initiatives and potential future undertakings.

?

Challenges amidst uncertainties

The first half of the year has been marked by declining transaction volumes, attributed to ongoing macroeconomic uncertainties, inflationary pressures, and elevated financing costs. These factors have caused reverberations of uncertainty across various aspects of the PE landscape; impacting investments, exits, fund-raising, and overall portfolio management. With a full year of relative inactivity, PE firms are facing mounting pressure to generate returns for limited partners (MacArthur et al., 2023a). It is within this backdrop that the significance of B&B strategies comes to the fore, despite their potentially longer holding periods (see, e.g., Hammer, 2018). This is due to their potential for yielding superior returns (see, e.g., Nikoskelainen and Wright, 2007; Acharya et al., 2013; Valkama et al., 2013; Cohn et al., 2022; Hammer et al., 2022a, 2022b) and their inherent strategic emphasis, which bolsters their resilience against market uncertainties.

?

B&B strategies in the current environment

1. Investment strategies and portfolio review: The extended period of subdued activity has compelled PE firms to reevaluate their investment strategies, particularly those rooted in B&B approaches. The diminished transaction volumes and prevailing market uncertainties necessitate a comprehensive review of investment priorities and an in-depth reassessment of value creation plans (MacArthur et al., 2023a). PE firms, recognizing the limitations of traditional buyouts in the current climate, are increasingly turning towards B&B strategies. Existing B&B strategies need to be recalibrated to align with current market conditions, and opportunities for value enhancement must be reexamined. The pivotal determinant of value creation continues?to be operational engineering—wherein industrial and functional expertise is applied to portfolio companies (see, e.g., Kaplan and Str?mberg, 2009; Brigl et al., 2021; Hammer et al., 2022a).
2. Exit challenges and value realization: The stagnant exit channels and a backlog of unrealized assets have created challenges for PE managers seeking to realize value from their investments. The current environment calls for a more strategic approach to crafting exit narratives and identifying suitable buyers, ensuring that the intended synergies and growth trajectories remain compelling despite the economic headwinds (MacArthur et al., 2023a). Concurrently, it seems increasingly necessary to recalibrate expectations on the sell side.
3. Fund-raising realities and dry powder: The decline in global private capital raised underscores the impact of economic uncertainties on fund-raising efforts (MacArthur et al., 2023a). In this environment, PE firms—both for existing B&B initiatives and potential platform acquisitions—must navigate a landscape where limited partners are cautious about committing capital. The vast amount of uninvested dry powder provides an opportunity for add-on acquisitions, serving as a potential avenue for action. However, the prolonged holding periods pose a challenge, hindering the timely return of capital to limited partners (see, e.g., Hammer, 2018).
4. Inflationary pressures and financing costs: Current market insights emphasize the fluid nature of inflation trends, with implications for interest rate decisions and economic growth (Kalish, 2023). Elevated inflation results in higher financing costs, which directly affects the execution of B&B strategies. Managing these cost dynamics becomes crucial in ensuring the feasibility of acquisitions, integration, and value creation. Notably, in this context, the implementation of smaller add-on deals funded through the balance sheet of a portfolio company can serve as a strategic cushion against sudden spikes in financing costs (MacArthur et al., 2023b).

?

Conclusion

The confluence of market uncertainties, inflation, and financing costs has engendered a challenging environment for PE-backed B&B strategies. To navigate this landscape, PE firms must adopt strategic agility, emphasizing portfolio review, exit narrative refinement, and prudent fund-raising practices. While the current economic realities pose challenges, they also present opportunities for innovative adaptations that can ultimately drive value creation and resilience within the PE-backed B&B landscape. For PE practitioners and investors alike, understanding and responding to these developments is imperative for sustained success in the ever-evolving global economy.

References

Acharya, V., Gottschalg, O., Hahn, M., Kehoe, C. (2013). Corporate Governance and Value Creation: Evidence from Private Equity. Review of Financial Studies , 26 (2), 368–402.

Brigl, M., Jansen, A., Schwetzler, B., Hammer, B., Hinrichs, H., Schmundt, W. (2016). The power of buy and build: How private equity firms fuel next-level value creation. The Boston Consulting Group .

Cohn, J., Hotchkiss, E., Towery, E. (2022). Sources of value creation in private equity buyouts of private firms. Review of Finance , 26 (2), 257–285.

Hammer, B. (2018). Buy-and-Build Strategies and Buyout Duration: Evidence from Survival-Time Treatment Effects. SSRN Scholarly Paper , 2819995 .

Hammer, B., Hinrichs, H., Schweizer, D. (2022a). What is different about private equity-backed acquirers? Review of Financial Economics , 40 (2), 177–149.

Hammer, B., Marcotty-Dehm, N., Schweizer, D., Schwetzler, B. (2022b). Pricing and value creation in private equity-backed buy-and-build strategies. Journal of Corporate Finance , 77.

Kalish, I. (2023). Weekly global economic update: Week of August 14, 2023. Deloitte .

Kaplan, S. and Str?mberg, P. (2009). Leveraged buyouts and private equity. Journal of Economic Perspectives , 23 (1), 121–146.

MacArthur, H., Burack, R., De Vusser, C., Rose, G., Rainey, B. (2023a). Stuck in Place: Private Equity Midyear Report 2023. Bain & Company .

MacArthur, H., Burack, R., Rose, G., Lamy, S., De Vusser, C. (2023b). Global Private Equity Report 2023. Bain & Company .

Nikoskelainen, E., Wright, M. (2007). The impact of corporate governance mechanisms on value increase in leveraged buyouts. Journal of Corporate Finance , 13 (4), 511–537.

Valkama, P., Maula, M., Nikoskelainen, E., Wright, M. (2013). Drivers of holding period firm-level returns in private equity-backed buyouts. Journal of Banking and Finance , 37 (7), 2378–2391.