Private Equity Market Commentary Q4 2019
6 December 2019
"Ambitious SMEs remain keen for capital to put plans into action" - Bernard Dale, Managing Partner - Private Equity at Connection Capital.
- Large private equity players moving into smaller deals presents dilemma for businesses
- Trend for “cash out” deals continues
- Signs that pricing may have peaked
For UK small and medium sized businesses (SMEs) seeking external capital, the funding landscape looks positive. While political upheavals may be delaying growth plans for some, ambitious businesses are keen to move forward and investors remain on the lookout for good opportunities.
The early stage end of the private equity market is better served from a funding point of view than it has been for some time, demonstrating that appetite from venture capital (VC) funds and private investors remains strong and that recent amendments to enterprise investment scheme (EIS), seed enterprise investment scheme (SEIS) and VCT tax reliefs are now successfully guiding this cash to the early stage companies. At the other end of the scale, some of the larger private equity houses are starting to turn increasing focus onto smaller deals, broadening their outlook as they look to deploy $trillions in unspent cash .
Major private equity houses’ strategies may be unsuitable for SMEs
While that may sound like an exciting prospect for SME owners and management teams, this emerging trend is fraught with pitfalls on both sides. Yes, it may present businesses with more funding options and a high level of ‘cash out’, but there’s a risk that the investment strategies and wall of capital intended for big corporates may not suit SMEs. For example, the availability of cash results in unrealistic targets for deployment of capital. This puts huge strain on businesses, which have high levels of compounding interest debt to support and on managers who are tasked with spending the private equity funds’ cash in a ‘buy and build’ model - at a rate they and their business may not be ready to do. Not only that, smaller businesses are at real risk of being the unloved runt of the litter within a larger fund portfolio.
We have seen this on a number of occasions recently, where the company owners’ initial plans get hijacked by the cash and the ambition moves away from the reality of what is realistically deliverable. The risk being that the poor old company and its senior management are set a task on paper which may not be deliverable in practice. Connection Capital continues to take a real partnership approach to investment, being happy to represent our clients as shareholders and develop the business plan which the company can realistically deliver.
Moves to “future-proof” value gain momentum
One area where we are able to take advantage of a burgeoning market niche is in situations where SME owners are looking to unlock some of the value of their businesses without selling up entirely. Uncertainty over the future of tax breaks or the economic outlook are prompting some to consider crystallising a portion of their gains now, using private capital to do so. Often, taking cash out in this way involves an external investor taking a minority, rather than a majority stake – something that few major private equity players are prepared to consider. Our flexible approach to funding structures (as we have no fund rules to follow) give us a unique market position. We can structure investments with loan characteristics or as a minority (or majority) private equity investment, dependent on circumstances.
We also have arranged a number of follow-on funding rounds for portfolio companies seeking to roll-out expansion plans or make strategic acquisitions, so we can work with companies pursuing a buy and build plan as well as those with an organic growth plan.
While private equity’s record “dry powder” has driven asset prices higher and higher in recent years, there are signs that the market may have peaked, and that valuations are cooling slightly as private equity houses and banks become more cautious in their outlook. In our market segment of small-mid-market deals, multiples remain a couple of digits lower than for the larger deals, with lower levels of bank gearing involved. As ever we continue to focus on the strength of the management team and the robustness of the business and its prospects, rather than concentrating on particular sectors.
As Connection Capital has evolved to deliver a wider range of alternative asset and private debt investments, alongside private equity, clients are getting access to a well-rounded array of alternative options with which to increase portfolio diversification. It’s clear though that private equity will remain a core area of interest, with 91% of our clients who responded saying they plan to increase or maintain their exposure to the asset class in the coming year, according to our recent survey.
Awareness is growing, and our model is a major driver in what one client described as the “democratisation” of private equity, enabling more sophisticated private investors to get a piece of the action alongside institutional investors. We believe this is important as it offers a different dynamic in a market where a one size fits all approach is the norm.