The view from the Direct Investments team – Bernard Dale Q3 2023

News: Insight & Opinion | 9 August 2023

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Like most private equity (PE) investors, over the past 12 months or so we have prioritised looking after our portfolio of investments, which to some degree or another have been impacted by recent economic and political volatility.

We have found that this has affected our newest investments most, with those that had their tough time during the post-Brexit and Covid period bouncing back strongly.

Overall, the PE portfolio is recorded at 1.7x cost, which though below our target is positive, particularly as the exits delivered to date are typically at a money multiple above those we report to clients in quarterly Investment Reviews. I expect this to remain the case going forward.

A question we regularly get asked is “How much are your investments affected by the recent interest rate rise?” Connection Capital deals are not structured with a high level of bank debt, with third party debt on completion an average of 2.1x EBITDA across the portfolio. In addition, many have fixed rate loans, so though affected, our investments are reasonably well insulated from the worst effects of continued interest rate rises.

After a run of exit activity up to H1 2022, the market cooled later in the year. We have, however, instigated sale processes with a selection of the portfolio. M&A processes are lengthening: a successful or failed exit process can easily be 12 months. They are also highly volatile and so are not as likely to deliver a sale as two-three years ago. Nevertheless, we anticipate a realisation or two for clients in 2024.

Whilst the UK new PE investment rates have been low, they are expected to rise in H2 2023 and looking at upcoming investments in our pipeline, the number and quality is as good as we have seen for some time. We are prioritising investments with upside potential but lower financial risk i.e. those with what we would class as a ‘low’ level of bank debt and PE investment compared to EBITDA.

The market is open to this as we have a coincidence of:

  • Cautious banks, which means that PE investment is required to unlock deals which might otherwise have completed solely with bank debt;
  • Cautious management who do not want the pressure of high paid yield/repayment debt;
  • A cohort typically of founder shareholders looking to realise a portion of wealth whilst CGT rates are low, but not wanting to sell their entire business as they believe in the upside.

This is a great combination of dynamics for a PE investor and is further aided by prices being down on their peak of late 2021/early 2022.  We label these investments ‘Replacement Capital’ or ‘Cash-out’.

We like these deals for a number of reasons, including:

  • Typically they have a capable, complete management team, as smart vendors will have recognised a deal can only complete if there is a decent team in place;
  • Lower financial risk than a ‘full stack’ MBO where 100% of value has to be financed, with only 30-50% equity being realised. Some deals are funded solely by the PE investor with bank facilities used to provide working capital;
  • The vendors stay on as shareholders. A real sign of their faith in the company, its management and upside, as well as lending their knowledge at the board table on an ongoing basis.

We have a number of these investments in process to put forward to clients in Q3/Q4 2023.

In summary, with a stabilising portfolio, some potential for exits and a confluence of circumstances leading to new investments in the lower mid-market, which have great PE characteristics for those who understand that cyclical economic low points can deliver the best PE returns, there are reasons to be optimistic if not yet, reasons to be cheerful.