Middle-market private equity firms have sustained a feverish pace of activity throughout 2021, as investors push to capitalize on booming economic growth and low interest rates before the macroeconomic tide turns.

Going into year’s end, dealmaking had already broken annual records in both volume and value, with nearly 2,900 transactions comprising $438.6 billion, according to our Q3 2021 US PE Middle Market Report, sponsored by Antares, Canton & Company, and LBMC.

Given how competitive the PE dealmaking landscape has been in 2021, what has helped your PE firm clients adapt in order to continue closing transactions?

The reality is that on each potential deal there are other investors that are also evaluating the potential investment. Sell-side age demographics, tax planning considerations, and increased valuations have helped increase the supply of willing sellers, but the demand for quality targets is still at a historical high, and earnings multiples are very rich.

With this comes pressures on early bid valuations, pressure from the sell-side to execute deals quickly, and internal pressures for investors to execute. As a result, our clients are performing more robust pre-LOI due diligence in not only financial but operational, compliance, and regulatory areas. The use of more data analytics during the pre-LOI phase to strengthen valuation models as well as financial and operational diligence has been a key ingredient to lowering the execution risks of deals in the post-LOI phase of transactions.

In this season of incredibly high valuation multiples, it is imperative that the impacts of COVID have been carefully considered within the deal model and pricing – not only with respect to revenue impacts, but the post-COVID impacts to the seller’s cost structure. Determining the “new normal” for operational / cost structures has proven to be extremely challenging in many situations where the sellers are still dealing with the impacts of COVID, particularly when sellers have revamped key employee compensation arrangements to address volume impacts as well as the intensely competitive labor market.

Where more of the deal issues are engaged with sellers pre-LOI, and financial and other due diligence is confirmatory, our clients are executing at record volumes. Where these issues remain to be understood and solved post-LOI, execution risk goes up as buyers are faced with either absorbing the updated financial information into their models internally or communicating and revisiting valuation with sellers and lenders.

There is a flip side to this attractive market for our clients that have more mature investments. As exit opportunities abound, more of our clients are having financial sell-side diligence performed irrespective of whether the portfolio company has been historically audited. With compressed transaction timelines, selling management having a view of their diligence adjusted earnings prior to launching a process will lend more credibility to and sustainability of the deal value and reduce the likelihood of the contemplated transaction being re-traded.

What are the underrated risks related to the current dealmaking environment, particularly for PE funds targeting middle-market companies? What about from the sell-side perspective?

The current environment, with deal pace being extremely high and valuations following the same path, increases the risk that target companies may have difficulty achieving desired success built into these valuations if the business environment changes. The valuations in times like these are generally supported using best case scenarios in many inputs to the valuation estimates.

We see these valuations impacted in a couple of ways. One is the normal cyclical economy which expands and contracts and has peaks and valleys; it currently feels like we are operating at or near peak level. The other place we see it is in specific industry sectors that have become popular; we have a number of those right now after COVID arrived in the first quarter of 2020.

In addition to valuation, we also see increased risk factors, oftentimes overlooked, with regards to “speed to close” and increased emphasis on getting the deal done, regardless of challenges that may show up. That doesn’t impact every deal, but in an environment like this, the risk is ever present.

Another underrated risk relates to indirect taxes. With recent law changes including the US Supreme Court’s decision in the Wayfair case, it is now easier than ever for state and local taxing jurisdictions to impose taxes on entities and transactions. As a result, these state and local jurisdictions are aggressively asserting that taxes are owed on new products and services under existing taxing authority. Software and SaaS are a prime example. Legislative bodies are enacting new laws that extend their taxing reach even further, allowing them to assess taxes on previously untaxed entities and products, such as digital goods and their equivalents. This trend is unlikely to change in the immediate future.

What are some of the most underrated hurdles for prospective dealmakers, and why?

If you asked ten sponsors for their biggest roadblocks to a transaction, I suspect the recurring theme of responses would be how to attract talent to support growth. The companies that find unique ways to attract and retain talent will be among the winners over the next several years.

Another hurdle that is often anticipated, but might also be underrated, relates to managing sellers who are going through their first exit. With the number of mom-and-pop operators in many subsectors of health care, dealing with inexperienced sellers can be exacerbated when you layer in navigating the various licensing requirements between states, and trying to ensure potential compliance risk is identified and mitigated to an acceptable level.

As sponsors gravitate down market to consolidate these smaller, mom-and-pop healthcare businesses, targets generally do not have the infrastructure in place to facilitate a smooth diligence process. These sellers may also push back on various insignificant deal points and may utilize advisors that do not specialize in M&A transactions. Unfortunately, with valuations continuing to climb across industries and no shortage of capital, sponsors will need to balance their “needs” in diligence and the transaction process with their “wants” to close their deals quickly. While sellers likely won’t withdraw from an LOI, they may become more sophisticated about the market and begin to utilize this leverage to push back on sponsors. Setting the stage and building good relationships with the sellers on the front end of negotiations will usually serve as a foundation to keep these issues from becoming problematic.

LBMC provides recruiting, staffing, and human resources solutions. Managers worldwide have noted intense challenges in staffing adequately; how is this evident in your work with PE firms?

Many things, since the first quarter of 2020, have been stretched thin from the supply chain to the labor force. It is definitely a time to stick with strong fundamentals and a straightforward game plan in recruiting and retaining people. The workforce, in general, is desirous of clear lines and communication, now more than ever, to alleviate more of the unknown factors in life. As a result, PE Firms and their portfolio companies experience these same issues, but the magnitude may vary depending on industry, geographic locale, management teams, company life cycle, etc. PE firms are looking at more out of the box approaches to the talent shortage, such as contract staffing placement and engaging outsourced accounting groups.

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