- Capital Call by OneFund
- Founder-Owned Targets Dominate the M&A Buyout Landscape
Founder-Owned Targets Dominate the M&A Buyout Landscape
Capital Call - a bi-weekly newsletter from LPs for LPs, covering the latest and greatest from across the private markets
Calling all LPs! Welcome back and thanks for joining me (John Bailey, Co-Founder at OneFund) for the sixth edition of Capital Call. A bi-weekly private equity newsletter from LPs for LPs.
The mission of Capital Call is to deliver concise, top-notch insights and updates from the private markets tailored to what matters for LPs.
This week we will be looking at:
Why founder-owned targets dominate the M&A buyout landscape and the implications for LPs.
Fundraising updates and VC/PE reports from firms such as Goldman, KKR, and Oaktree.
GP Perspectives from Steve Cohen & Chamath Palihapitiya
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Large corporates and financial sponsors have significantly slowed M&A selling activity, but at the same time retain a strong appetite for buying considering their high levels of dry powder. With the sharp mismatch between buyers and sellers, it raises the question: Who is replacing sponsors to support recent M&A activity?
According to Pitchbook’s latest Q2 2023 research, founder-owned companies have been the main focus of acquisitions recently. Founder-owned companies have steadily increased their share of M&A activity for the past seven years before soaring recently to comprise 61.5% of Q1 2023 deals.
In this week’s newsletter, I’ll discuss how this trend is changing the PE landscape and the themes that matter most to LPs.
1. GPs Hold off on Selling and Shift Focus to Revenue Growth until Market Recovers
If LPs in PE funds are wondering why they haven’t heard of major exits in their funds recently, it’s because GPs would rather hold off until valuations recover rather than lock in significantly lower IRRs. Sponsor-backed M&A exits declined 39.9% in deal value in 2022 and activity is expected to remain lower for the foreseeable future. With the US IPO market also faltering, companies are forced to hold off on exits and focus on portco revenue growth instead.
Organic growth is the most sought-after, but smaller, bolt-on acquisitions to fuel revenue expansion have always been popular. Sponsors have been aggressive in pursuing add-on strategies, raising the portion of add-on acquisitions of US PE buyouts to a record 77% in 2022. These acquisitions can allow GPs to spread higher interest expenses over a larger revenue base and create synergy opportunities through integration.
How Do We Think Through This?
With these trends, LPs should understand that portfolio returns likely won’t be significant in the near term as most value is realized during exit. Instead, LPs should focus on how GPs are building up portcos to be attractive acquisition targets in the future once valuations return. GPs capable of supporting strong organic growth will be favored as always, but those pursuing bolt-on strategies should be assessed on their abilities to integrate and drive synergies rather than merely purchasing additional revenues.
2. Strong Opportunities in the Founder-Owned Segment
Founders have been motivated to sell recently as they are significantly more exposed to the tough economic and inflationary environment. The regional banking crisis further worsened their position, as the credit they once relied on has become harder to come by. With liquidity and business conditions expected to remain tight, many have been forced to sell rather than hold out.
Though sentiments appear gloomy, founders can take comfort in knowing their companies are highly prized by GPs and corporate acquirers. Founder-backed companies offer a “clean slate” for GPs to professionalize the firm including improving HR, marketing, sales, and finance departments that were likely run inefficiently. They’re also cheaper and easier to buy, often featuring a single majority shareholder, and carry little debt allowing them to be leveraged easily.
How Do We Think Through This?
GPs who can execute effectively in the founder-owned segment present an attractive opportunity to LPs today. A strong founder-owned acquisition pipeline is especially critical for LPs entering new funds, as GPs will rely on these companies for a significant share of acquisition opportunities in the near future.
3. Lower Middle-Market Funds Best Positioned for Founder-Owned Acquisitions
85% of deals involving founder-owned companies are bought for under $100 million, which is the range lower middle-market private equity funds operate in. Companies purchased for under $100 million had an average EV/EBITDA multiple of 6.8x compared to 11.4x for companies bought for between $100-250 million, allowing sponsors the opportunity for significant multiple expansion if they can grow companies to the next bucket.
How Do We Think Through This?
However, winning deals in the founder-owned segment isn’t as easy as offering the highest purchase price. Founders often carry sentimental value for their organizations and wish to see their life’s work grown respectably by the right partner. Sponsors and founders must also be aligned strategically, as founders typically retain CEO roles for several years as well as an average equity stake of 20%. When prospecting middle market private equity funds, LPs should consider that GP reputation and operational skill are crucial for winning deals and that founders may avoid sponsors who are known to cut personnel and costs too aggressively.
If you enjoyed this read and have any questions or would like to discuss further, feel free to schedule a call with us - we’re happy to chat.
Updates from Across the Ecosystem
In a brief interview, Morad Elhafed of Battery Ventures explains how the dislocation of funding in the market has opened opportunities for his firm to invest in companies that do not have sufficient growth to IPO. Battery can acquire and recapitalize these firms to help them reach their more realistic growth plans. In this example, LPs can see that some VCs are pursuing strategies more akin to growth equity or private equity due to current conditions.
Steve Cohen is very bullish on AI and believes the revolutionary technology will create new jobs and raise profit margins, which would reduce pressure on the Fed to curb inflation, given the technologies ability to deflate wages along with the cost of consumables and services. Other hedge fund managers have also taken interest in AI, including Duquesne Family Office and Maverick Capital, who both took positions in Nvidia hoping the chipmaker will rise further from the AI boom.
Chamath Palihapitiya (CEO, Social Capital)
Chamath offers an opposing view and criticizes hedge fund managers for showing “blind optimism” towards AI. There are undoubtedly opportunities within the AI boom, but it’s also important to remain level-headed and prospect each opportunity rationally.
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