The “capital superabundance” in private equity is having profound effects on the market

Private equity (PE) firms have an enormous amount of capital that is sitting on the sidelines. Estimates of global private equity “dry powder” totaled nearly $1.5 trillion in 2016, which represents roughly a 500% growth since 2013.1 U.S. estimates for midway through 2017 sat at $739 billion, nearly half the global total.2 It’s safe to estimate that current U.S. total sits at over $800 billion.

U.S. PE Capital Overhang ($B) by Year

U.S. Private Equity Capital Overhang by Year

With this much capital primed and ready, the question remains… when and where will it be deployed?

Fundamental Conditions for PE Deal-Making

First off, the cost of capital has dropped dramatically in recent years. In particular, the average cost of debt is about half of what it was 15 years ago.3 Debt is also more readily available, due in large part to the abundance and growth of private debt funds. According to PitchBook, private debt funds raised $118.7 billion in commitments in 2017, the most of any year on record.4 Since PE firms typically fund M&A transactions with a combination of capital from their funds and debt, today’s debt environment makes deal structures dramatically easier to work, and helps minimize downside.

Purchase price multiples have also expanded, improving the returns for PE firms and restocking their balance sheets. According to Standard & Poor’s Capital IQ, average EBITDA (earnings before interest, taxes, depreciation and amortization) multiples grew significantly between 2000 and 2015. That means if a PE firm invested in a company during those 15 years, they could make considerable gains on their investment without growing the company a single dollar in EBITDA. Of course, private equity investments are aimed at driving growth, thus expanding the return even more.

We should note that EBITDA multiples vary greatly by transaction size. GF Data’s latest figures show average EBITDA multiples ranging from 5.8x for transactions between $10-25 million to 8.7x for transactions between $100-250 million. However, across the board, multiples are up in recent years.

Differentiated PE firms with notable track records are able to raise vast amounts of cash. There is now a business development component to private equity; firms are hiring dedicated business development professionals to make sure they are able to see more deals that meet their investment thesis and ultimately compete for businesses that stand out to them.

Factors in the PE Decision Process

With these factors at play, it seems that it is a better time than ever for business owners to exit their businesses or gain additional liquidity. There is increasing interaction between middle-market companies and PE firms; however, both parties typically need certain preconditions to be met for a beneficial relationship to ensue.

For companies or owners that are considering working with private equity, there are a few important factors to consider. Firstly, they should know that as financial investors, PE firms are primarily looking for a good financial return in the foreseeable future. There should be a clear path to either achieving greater revenue or reducing costs to increase profitability and maximize their return over time.5

Even with this path to greater income, companies should be sure they are willing to take the plunge. It can entail locking arms with the PE firm in an earn-out structure over several years based on hitting targets or retaining equity until the PE firm is ready to exit. This means the owners and management team often must continue to be involved to ensure the health of the business.

Private equity firms want to see a company with several defining features. The company should have a relatively clean state of financial health with profitability. Secondly, they want to see a company with a “moat” from competition and strong value to customers. Lastly, they want to see a company that is growing in a healthy market that is likely to continue to grow.

If these criteria line up, a middle-market business may be a good candidate to pursue the private equity route. The company should work with top advisors who have a deep understanding of the transaction process and can help match them with the best fit. The outcome can be profitable for current ownership and the newly invested PE firm.