When does a PE portfolio hold become too long? Current data and return upside is making the decision difficult

The US economy appears to be seeing some light from the last 16 months of Covid recession. Company culture and office footprint decisions are becoming the focus of conversation. Additionally, what are hybrid work excellence trends coming out of this period into the new-revised normal. All will impact quality of Private Equity deal flow.

How middle market companies respond with their value creation execution (and measurement) will be interesting. How is a borderless human capital world providing C-suites depth to deal with issues like fast rising commodity prices, transformational models, growth via disruption and extending hold periods.

What trends have been playing into the middle market of Private Equity as selling versus holding becomes more important?

1.    Longer Holds 

Value creation has been enhanced by increased number of add ons per platform from 2019 onward. The successful integrations will provide value yet even cross selling, growth, and top line alignment (if not full brand integration) will create challenges and perhaps complication in hold time decisions but will provide value creation if managed. 

News feeds have been providing hard data and industry context that that long hold vehicles are emerging and special industry vehicles that are designed for more than a 10-year fund are becoming more visible in the market. 

Transformation is driven with analysis, development, and execution of plans and that is becoming harder in a 5-year hold. The realization that a change in the C-Suite, a change in market position and value chain consideration can provide the runway for the growth. We should also watch how cash on cash measures and exits to sponsors overtake ROI and SPAC strategy exits. Perhaps this can provide normalcy and ease of measures and optics in the market for 2H2021.

2.    How Long is too long ?

There is certainly the drive to move the company from T0 to exit in 4-6 years with a 3X Cash-on-Cash. There are cases outside of initial investment multiple that drives the timing of the exit in the new normal economy.

·      Performance 

The firm needs to execute on a well-developed value creation plan and add ons (as a strategy in growth) will drive further value creation. The cash flows can be such that recaps and driving value through dividends can exist and if fully considered in returns could provide reasons to hold. It may be wise to hold as interest rates creep up and good deals continue to be scarce. Those creeping interest rates may impact your debt stack in the next deal.

·      Who is on the other side 

Deals are coming through carve outs, thesis driven by industry or stage and sponsor to sponsor. Anyone now can emerge less an intermediary to pose a thesis of time to sell. If the price is right and executives are running short on industry run way, it may create a quiet and less disruptive exit. 

A firm that sells is always in the market to deploy and the deal market is complicated. While 2020-21 deal’s done metrics industry wide has been surprisingly steady ( as it returns to pre-Covid levels) the quality is questionable. Think of the perfect storm for 2021-22, rising commodity pricing, weaker executive leadership pool, poor processes in place, weak data and tech cultures and CFOs with a limited success record in value creation in a rising interest rate market.

 ·      Is it better to sell at year 4 via an unsolicited offer or can you have a new life-new performance paradigm with the second CXO suite 

There is first an industry consideration. If you have a solid and coordinated management team and they harnessed disruption to a new market position in a changing value chain, it’s hard to walk away from timing ( and some good fortune... dare I say luck). Such a position though could extend via reworking the debt stack and taking advantage of a rising market position to attract rapid add ons. This could be especially attractive to add on targets getting progressively challenged by rapid and shifting commodity impacts and supply chain issues that will not work through quickly. Hence strategy and CXO suite 2.0 could impact timing.

 3.    Market Confusion in Supply/Demand for Deals

Private Capital in the middle market or public to private has provided market clarity and reasonable approaches to exits and restarts to complex situations. However, the current expansion of PE funds and the multiple vehicles with non-fund participants ( direct investing LPs, Family Offices, Sovereign Funds) with increased exuberant demand around SPAC strategy has taken a tight market supply and created new issues around deal flow and valuation.

4.    Commodity Demand( and inflation) and Debt availability

A day does not go by where core market commodity prices and availability is not creating a headline. Some 2021 examples are steel, wood and copper to name a few. Undeployed labor globally through COVID is a root cause though the long wait for inflation through monetary policy is crashing together at a time where we have not historically seen with early recovery trends potential with already historic high commodity pricing ( and supply chain challenges). Al deployment and the talk about reworking and enhancing supply chain efficiency via digital and could not have been better timed. 

Exit into the real “new normal” will challenge the notation of time hold periods in private equity. Deal supply will be challenged by trend and fad and by the number of times company may trade in its maturation. Disruptions, human capital underwriting, borderless talent access, BI, supply chain transformation and roll up possibilities will all be impacted and transformed through 2021 and beyond. Length of hold is less constrained by the number of years and market timing and more by the rate of transformation that a company can adapt to.

John Bova is a Transformation and Operational Excellence Leader in Private Equity Firms and Portfolio Companies. John has played many roles in the private capital space over 30 years Including senior executive to fast growing middle market companies, Independent Sponsor, PE and Family Office Advisor and Consulting Practice Leader. John has a BA in Economics from Fairfield University and an MBA from Pace University.