De-risking in a Pre-Recessionary Environment

Sponsors will need to go back to the basics. The days of rapid deals at lofty valuations are gone, and CFOs will be on the hot seat.

Transaction trends for the latter half of 2022 are indicating a proactive effort to get in front of what economists are calling an almost inevitable recession.

What does that forecast mean for an industry with more than $3 trillion of dry powder? Sponsors will need to go back to the basics. The days of rapid deals at lofty valuations are gone. Sponsors will need to go back to foundational financial and operational reengineering playbooks to drive value and returns, which will be harder won. Funds will be focusing on the following factors going forward:

Cashflow is king

PE firms will reward those companies that have strong balance sheets or that have done the yeoman’s work of creating real-time visibility into their cashflow. Smart companies have spent the post-covid period investing in systems and processes that provide meaningful financial transparency. Or, they have undertaken initiatives (like 13-week cashflows) that had previously been reserved for troubled companies but provide even well-performing organizations better insight into the state of their financials. These highly liquid (or liquid aware) companies will be among the industry’s most coveted wins.

Conversely, capital-intensive businesses with weak balance sheets will lose out. PE will look to invest in capex-light organizations that don’t require an influx of cash to maintain operations, in order to drive multiples without incurring a holding period penalty.

Shifting sectors

Sponsors will be looking at sectors resistant to recessionary headwinds. As inflation takes hold and consumers are reluctant to part with discretionary income (or simply have less of it), investment in luxury-adjacent companies will cease in favor of a focus on sectors of necessity – e.g., essential healthcare, consumer staples, etc.

That’s not to say that “favorite son” sectors will stop seeing their fair share of dry powder. There are bargains to be had for smart PE firms that need only commit a portion of the capital they would have needed to invest in last year’s market. Take, for instance, the tech sector, which been had been a darling of the PE community. Multiples are in a freefall, and tech companies that had gone public are now revisiting their private options. That means there are buy-low deals to be had for the smart sponsor that finds a capex-light, cash-rich and growth-high diamond in the rough.

Management matters

Post-deal PE investors retain the existing portfolio company CFO only 25% of the time. And that was in good economic times. As sponsors deal with in-time inflation and a near-term recession, their good graces will wear thinner. Managers without prior experience operating a PE-backed company and managing a business through a recession will be replaced, and quickly, with executives who are well-versed in austerity measures, creative supply chain maneuvers, and a back-to-basics playbook.

Moreover, sponsors who spent the last few years investing in well-curated operating teams will benefit, as will their portfolio companies from a more hands-on approach to portfolio management and operational value creation.

Finally, sponsors will spend more time scrutinizing the history of any potential target, and it will be those companies with a long track record of success (or at least viability) over at least one complete economic cycle that will benefit from the still copious amounts of dry powder available.

Transaction types trending now

A pre-recessionary economy favors carve-outs; larger companies look to spin off non-core businesses often at bargain prices to bolster their cash war chest. As inflation takes hold, interest rates rise, geo-politics remain uncertain, disruptions in the supply chain increase costs, and multiples recede, sponsors are increasingly looking to achieve returns from pre-existing platforms with add-ons – a significantly de-risked investment strategy. What will be markedly different than transactions of the past will be the focus on integration. The “bite now, chew later” approach to acquisitions is being replaced by well thought out synergy realization and integration plans prepared during diligence to ensure Day 1 readiness.

What will separate the winning sponsors from the losing firms throughout the rest of 2022? The winners will be those that have a laser-focus on portfolio company liquidity, that invest in capex-light businesses, that select and scrutinize their sectors and targets exhaustively, that make the management moves that are needed (in the moment they are needed), and that transition to transaction types that are better suited to withstand a downturn.