The dip in pricing due to the market climate creates potential for outsize returns on new investments
We might be living in a challenging economic environment, but the evidence is that investing during ‘difficult’ times is the smart thing to do. As Warren Buffett suggested, “Be fearful when others are greedy and greedy when others are fearful.” Now, I am not sure greedy is the term I would use, but just as late 2021 and 2022 has been a tough time to find good deals, 2023/2024 could be a good time to be investing in private companies, even if it may feel less comfortable than investing in more benign times. Evidence from Bain & Company[1] indicates that outsize returns have been made as economies recover from recessionary times.
Private company valuations are definitely down from their 2021 peak, partly driven by reduced debt availability and the cost of debt, as well as market uncertainty inducing more caution in the private equity community. We are seeking to take advantage of this dip in pricing to source good deals.
During 2022, we deliberately focussed on securing our portfolio, but we have now developed a good pipeline of new investment opportunities. The trend for ‘cash-out’ deals - where business owners seek to realise a portion of value of their shareholding while capital gains tax (CGT) is low – continues. We think these are attractive opportunities for clients to investment in a growing company but without the risk attached to a full management buyout (MBO) structure. We anticipate closing a clutch of these by the summer.
The corollary to the dip in valuations is caution in the buyer community for exits and two of our potential sales have been deferred to what we hope is a more active exit market ahead. This is an industry wide trend, with BVCA research indicating that the average hold period for a UK private equity MBO exit is now 5.6 years[2]. Nevertheless, we are finding a path through this landscape, with exits in the portfolio anticipated in H2 2023, and a target list for 2024 where preparatory work is underway. We remain committed to our goal of making investments in companies of £10-30m and exiting at £30-60m+, delivering at least a 3x gross return on investment.
Looking to our portfolio, some companies had their challenges in 2022, but we have ended Q1 of this year with a set of well-funded businesses that have reasonable levels of cash headroom. So, we can be confident that they have the room for manoeuvre to deliver their 2023 growth plans, with most companies on an upward trend line in EBITDA.
Management teams have put much effort into mitigating the impact of rising energy bills, and it’s paying off. Energy prices may have come down from their peak, but the expectation now is that they will remain high. The mitigation actions taken have reduced the impact on forecast EBITDA, although for some companies, the cost increase will have a meaningful impact on profit levels.
We all hope to have ridden the storm of inflation, which is predicted to fall dramatically in 2023. The level of public sector pay increases reported in the press should help keep wage inflation manageable. In the private sector, we continue to see the grading of increases to favour lower paid employees that many companies (including our portfolio) adopted in 2022 continue in 2023.
The relatively low gearing for private equity investments in our portfolio, with third-party debt at EBITDA for our MBO and cash-out deals, means our portfolio is in a good place to cope with the recent interest rate rises. This also means that we can pursue some debt refinancing of portfolio companies to return cash to clients. We currently have three portfolio companies in the process of securing bank debt which is expected to return significant sums to clients; in one case a significant multiple of the original investment, not just a partial repayment.
On the subject of debt, it has become noticeably harder to raise and is more expensive, regularly costing 10%+ even for secured debt lines. We have, therefore, adjusted the pricing of our private debt investments accordingly which, alongside the first charge security and the equity ‘kickers’ of 5-20% we can obtain, give these investments particularly attractive risk/return characteristics currently.
All in all, we’re in a good place, given the ongoing market uncertainty.
[1] Bain & Co, Global Private Equity Report 2023
[2] BVCA Report on Investment Activity 2021: Growing Great British Businesses