This Q&A was published as part of PitchBook Q3 2021 US PE Breakdown sponsored by Stout.

As we head into the last months of 2021, which key indicators in the PE market are you watching most closely?

Tricia: With low interest rates and plentiful capital under management, PE has been on a tear this year, pushing for new platform investments and record add-on acquisitions. This, coupled with possible capital-gains increases on the horizon, has made for a perfect storm of sellers wanting to conclude transactions before year-end and buyers eager to deploy as much capital as possible, as soon as possible. We’re certainly watching the market for regulatory changes but expect continued PE activity into 2021 as freely flowing capital reigns.

Kevin: We’ve been seeing PE firms become much more selective given the rapid rise in the quantum of transactions hitting the market. Firms are dropping much earlier from processes if they don’t feel they have a unique angle or a clear view of the potential process dynamics. This backdrop has impacted process pace and strategy in a meaningful way. As we enter Q4 2021, we will be closely monitoring how firms adjust to a more “normalized” level of deal activity.

What are the primary concerns clients have in the current market that they bring to you as they work through transactions, from either the buy or sell side?

Tricia: Most private sellers are completely focused on the potential tax changes and trying to get transactions done before year-end. With the proposed increase in capital gains from 20% to 25%, rather than the much higher 39.6%, anxiety levels have dropped and transactions may start to move at a more normal, measured pace. On the buy side, for the first time in years, we’re seeing a dearth of available third-party due diligence providers—finding available quality of earnings (QoE) and technology specialists for confirmatory due diligence seems to be a gating factor. From every sector, we are hearing, “schedule early!” or else we may not be able to close by year-end.

Kevin: Given how busy the market has been, sellers are concerned they aren’t getting the right “mind-share” from the most logical PE buyers for their potential business. Conversion percentage data from confidential information memorandum (CIM) to indication of interest (IOI) has trended down, so the data supports that concern. It has never been more important to have a clear, crisp investment thesis and a focused marketing strategy. For buyers, they are focused on high-quality businesses and/ or industries where they have prior experience and/or operating partner bench strength.

Over the past couple of years, which aspects of due diligence and broader transaction advisory have gotten easier, and which have gotten harder?

Tricia: We’ve seen a whole new paradigm for due diligence and transaction advisory in the time of COVID-19. So much of what had been previously done in person is now handled by phone or Zoom, possibly more efficiently. Conversely, it has never been easier to add too many people to the transaction teams. The multiple workstreams of accounting, technical, and employee due diligence can now all happen simultaneously, consuming seller attention without proper guidance.

Kevin: It’s truly remarkable how quickly due diligence processes have evolved to become mainly virtual. The in-person management presentations have returned, but it can be easier to host pre-launch “fireside chats” virtually with a targeted group of buyers in any given process. The ability to create more connectivity early on in a process has become important in a crowded field of deals. Scheduling in-person meetings when needed has become more challenging given how jammed everyone’s schedules have become with the expansion of virtual diligence – “everyone is stacked up almost every day.”

Given the current dealmaking environment, which risks are underrated by PE fund managers that they and their prospective portfolio companies should be monitoring?

Tricia: We would argue that every PE fund manager should take a second and third look at net working capital (NWC) across the portfolio and particularly in targeted acquisitions. COVID-19 bumps in revenue, inventory and supply-chain issues, use of PPP funds, and signing of multiyear contracts with cash paid upfront have all distorted NWC in ways that impact the dealmaking process. While there’s always arm-wrestling over these items close to transaction completion, it’s worthwhile to look back at historical levels, pre-pandemic.

Kevin: Evaluating a normalized level of earnings has become even more complex given the pandemic backdrop. Yes, there are COVID-19 bumps to analyze—but there are also counterbalancing COVID-19 add-backs, medium- and longer-term implications on numerous end market drivers for every business, employee insurance cost implications, employee availability concerns as it relates to supporting strategic growth initiatives, and supply-chain constraints and/or pricing volatility given international shipping challenges. All of these factors are also drivers of any debt underwriting process, so we’ve seen an even wider range of leverage availability due to these complexities. Therefore, casting a wider net from a financing perspective is important.

From a sector perspective, where do you see the most potential for dealmaking that is not yet taking place, and why?

Tricia: PitchBook estimates that the $50 billion digital software market will grow to $120 billion by 2025. This is a highly fragmented market, where the switching costs have traditionally been low. However, in the last few years, many of these companies have found ways to increase their customer stickiness, improve growth in recurring revenue models, and prove ROI. We see an incredible opportunity for sponsors to roll up and aggregate enterprise revenue in this market. To date, there has been a lack of middle-market strategics to act as the center of gravity for smaller companies.

Kevin: We are seeing a rise in activity related to anything service-oriented. Many of these businesses are localized or regional and typically have a repeatable and/or recurring theme to their revenues and earnings. Service roll-up strategies aren’t new, but the breadth of those types of businesses that are being evaluated has expanded dramatically. Beyond services, technology, healthcare, e-commerce, and food & beverage-related businesses that provide a “new, value-added” capability are unique opportunities that should drive significant interest for the foreseeable future.

It appears there are still significant shortages in various supply chains, potentially due to the unique confluence of shocks stemming from adverse weather and the COVID-19 pandemic—how have you noticed these affecting clients across different sectors?

Tricia: For hardware-related clients in particular, those shortages are rippling through the profit and loss statement (P&L) and balance sheet and into the dealmaking process, resulting in heightened attention on NWC. For example, we have a client now that is stockpiling inventory in response to suppliers asking for large preorders, as well as long lead times. The NWC analysis not only has to consider the COVID-19 bump in business, but also the result of a positive purchase price adjustment as the extra inventory increases asset value. On the flip side, another client predicts that the inventory shortages will delay installation and implementation, potentially pushing out revenue recognition by two quarters and hurting the bottom line.

Kevin: We’ve seen a real focus on financing a breadth of reshoring opportunities, given the reality of the supply-chain shortages many industries are facing. With significant advancements in automation, numerous industries are reconsidering the economic benefits of strategic domestic production capabilities versus foreign supply-chain dependencies. These potential investments take many years before they result in meaningful impact— in the meantime, companies are also proactively looking at other ways to diversify their supply base. Ultimately, even if the supply-chain shocks subside, we expect a greater emphasis on geographic diversity when it comes to supply-chain concentration issues.

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