“Prediction is difficult – particularly when it involves the future.” (Mark Twain)
I know all of the reasons I shouldn’t make predictions about the private equity industry or any other industry for that matter. After all, blog predictions are generally worth what you pay for them, and I’ve been incorrectly forecasting a recession for the past four years. However, I’m going to do it anyway through a blend of trendspotting and inferences about where this might take us. With any luck, one or more of these prognostications will prove to be true. Note that this list is not intended to be comprehensive, nor do I suggest that anyone act on any of the ideas below without sufficient contemplation or investigation lest you be dealt a heavy dose of regretful rumination.
- The Hunt for Recession Resistance Continues. We’re currently amidst the second longest period of economic expansion in our country’s history (second only to 1991-2001), and the list of investors willing to sign up for the career risk of championing an inherently cyclical business at peak valuations is ever diminishing. Therefore, companies that existed pre-2008 and weathered the Great Recession without issue or even grew will continue to enjoy elevated status during Monday Morning Meeting new deal discussions. Some typically defensive sectors or strategies might include healthcare, legal services, “found money” business models that compensate service providers based on savings generated, small luxuries, regulatory / compliance-driven businesses, and other non-discretionary services.
- Add-On Strategies Remain Important but Grow More Challenging. A great way to grow when valuations are high is through a disciplined acquisition strategy. This is because add-ons can usually be acquired for an EBITDA multiple that is less than the multiple applied to the larger acquiring entity. I don’t see pricing for relatively smaller businesses (say, <$3MM of EBITDA) ever reaching parity with the larger entities that have achieved the critical mass to historically enjoy a valuation premium, but the gap between purchase multiples based on size has been narrowing in many sectors. This is due, in part, to the growing competition for smaller assets by lower middle market private equity, search funds, independent sponsors, family offices and private equity-backed portfolio companies. Investors should preserve a healthy skepticism for new platform investments predicated on add-ons to create value that don’t also have a credible organic growth story.
- Everything-as-a-Service (“EaaS”). This was the year that recurring revenue jumped the shark. Just when I thought I had heard them all, I was recently introduced to Dental Practice Management and Digital Marketing as-a-Service. The valuation benefit afforded to companies that generate a majority of their revenue from ongoing payments has driven many sectors to attempt to re-tool their revenue models accordingly. Investment banks have followed suit in their presentation of these businesses which has forced us to take a much more critical eye to any revenue streams presented as recurring.
- De-Commoditization (or Humanization) of Capital. If I have to regurgitate the dry powder statistic one more time, then I myself may regurgitate. Ok, fine, only for you do I do this…there is over $1 trillion of private equity capital globally sitting on the (gulp) sidelines. What does this mean for the industry? In short, “Mo Money Mo Problems” 1 . In other words, private equity funds will have to increasingly fend off the image of commoditization given the dizzying number of firms from which an investment bank and/or business owner must choose. Prepare to see a lot more touchy-feely stuff on websites accompanied by an increasingly sophisticated marketing presence to lend a humanized element to private equity. I’m personally betting on the growing prevalence of things like testimonial videos, Mission Vision Values statements, clever digital marketing initiatives, snazzier websites and print advertising in our industry. With any luck, these efforts will succeed in driving business owners to the best private equity partner to suit their personal and professional objectives which is the ideal outcome for both parties.
- Renewed & More Systematic Pursuit of the Proprietary Deal. Believe it or not, proprietary deals could once comprise a material portion of a private equity fund’s deal flow. While many current private equity professionals may not have lived through or have yet been born during this era, it was a thing (or so I hear). Lately, many funds have differentiated themselves by sourcing deals through less competitive auction processes, but if necessity is the mother of all invention, we may see a revival in the pursuit of proprietary deals. However, this time around it is likely to be more sophisticated through the use of new data and direct marketing tools that were not previously available. We’ll call this Proprietary Deals 2.0. TBD if / how successful this strategy will be, because proprietary deals tend to have this timelessly elusive quality that make them hard to systematize regardless of the tools at one’s disposal.
- Private Equity Grows More Technology Enabled. The English word technology is derived from the Greek word teknologia which means, “A systematic treatment of an art, craft or technique”. Fascinating to compare that definition to the current state of private equity work streams which have been changing for a while now from more artisanal approaches to behaviors that are increasingly automated and technology driven. Today, technology has permeated nearly every functional area of the private equity activity set including business development, marketing, due diligence, financial reporting, and capital raising. What’s fascinating it that adoption is consistent in certain areas, such as CRMs which are now ubiquitous, but also inconsistent in others. In other words, our industry is still figuring out how to apply technology where it generates the highest ROI, and this creates opportunities for the early adopters who figure it out first.
- Cyber Security Creates Both Risks and Opportunities. Not to be too much of an alarmist, but the cyber-villain community is getting better at what they do. Perhaps they realized that the jig was up on the “Just Wire Me a Few Thousand Dollars, and I’ll Send You $100 million in Return,” game and decided to develop some new material, but I’m noticing increasingly creative strategies to attempt to relieve me or my firm of our financial resources. A recently popular rouse is to mimic the email address of a firm leader and direct an employee of the firm or one of our portfolio companies to do something beneficial to the scammer. For now, these sorts of schemes can be defended by (i) trusting one’s intuition about something that seems fishy, and/or (ii) hovering over the email address to inspect the link. However, my gut tells me that we will need to be increasingly vigilant to these sorts of attacks in the New Year. The good news is that where a problem arises, so does a business opportunity. Be on the lookout for new ways to play cyber security from an investment perspective.
- Pursuit of Historically Neglected Sectors. Competition is increasingly driving private equity to sectors that haven’t historically felt the love from investors. In a market characterized by elevated valuations and abundant capital, the creative investor will win the day if they can unlock strategies to deploy capital in industries previously perceived to not present compelling returns potential. A good example of this is the rise of private equity-backed retail healthcare. This year alone, I’ve been contacted about investment opportunities in Podiatry, Pediatrics, Ophthalmology, Oral Surgery, and Dermatology. Don’t be surprised if you start seeing private equity creeping into other consumer services realms such as drycleaners, plumbers, roofers or nail salons.
So, what do you think, do any of these trends or predictions resonate with you? Fire away with comments. Here’s to a Happy New Year and a successful 2019!
1 Notorious B.I.G.
About ClearLight Partners
ClearLight is a private equity firm headquartered in Southern California that invests in established, profitable middle-market companies in a range of industry sectors. Investment candidates are typically generating between $4-15 million of EBITDA (or, Operating Profit) and are operating in industries with strong growth prospects. Since inception, ClearLight has raised $900 million in capital across three funds from a single limited partner. The ClearLight team has extensive operating and financial experience and a history of successfully partnering with owners and management teams to drive growth and create value. For more information, visit www.clearlightpartners.com.
Disclaimer: The views and opinions expressed in this blog are solely my own and do not necessarily reflect any ClearLight opinion, position, or policy.