January 2019 Issue
FW moderates a discussion on creating value in PE exits between Neal McNamara, Tim Czmiel and Dean Dussias at Virtas Partners, and C. Craig Lilly and Michael J. Fieweger at Baker McKenzie LLP.
FW: In your opinion, how challenging is today’s PE exit environment? Which exit routes appear to be most favourable for PE firms?
McNamara: Currently, the exit environment for PE-backed companies is attractive, with sellers of companies having both private sale and IPO exit paths available. Which exit route is most favourable varies significantly by PE firm, industry of the portfolio company and the size of the portfolio company. We are seeing more firms go the IPO route given the current market conditions, and many that have not used that exit route in the past. Well-prepared firms that own companies delivering consistent results have the ability to explore private market interest – or pursue a dual M&A/IPO exit track – and if they do not reach the valuation levels and deal terms they find satisfactory, they can choose to access the public markets.
Lilly: PE companies in the middle market, in mature industries with proven performance, are receiving IPO valuation premiums above the level of their peer groups. As of the end of Q3 2018, 173 companies have gone public in the US, with a 46.5 percent increase in proceeds versus 2017. This IPO trend is expected to continue globally in 2019 due to favourable corporate profits and macroeconomic environments in the technology, consumer and finance sectors.
“Representation and warranty (R&W) insurance has become an important tool to facilitate PE exits and bridge negotiation gaps.”
FW: What, in general, are the key drivers of value for a PE exit? How should these factors be identified in the lead-up to exit?
Dussias: The data is not surprising: proven revenue growth, repeat customers and above-average, consistent margins drive attractive valuations and exit results. Capital structure and liquidity also have a significant impact, since portfolio companies vary widely in their leverage profiles, dividend policies and reinvestment choices. The better PE firms match industry maturity, the perception of risk, the ability and willingness to invest cash in profitable projects with investor profiles and preferences to maximise value. Identifying these factors starts years before an exit process, by having the accounting discipline, financial acumen and strategic and operational understanding to deliver performance and communicate it well. PE firms that build strong relationships with their leadership teams, develop talent and engage in a consistently recurring conversation about value creation with their business leaders, create the highest likelihood of impacting the key drivers of value.
FW: What steps can PE practitioners take from the outset to prepare a portfolio company for exit and generate expected returns? What best practices are they following to capture additional long-term value once the initial value levers have been pulled in the post-deal phase?
Czmiel: The best firms not only have a ‘100-day plan’, but more importantly get the right talent in place as soon as possible and focus the company’s leadership on sustainable value creation. PE firms mostly rely on CEOs and management to deliver revenue and margin growth, create cultures that support value creation and efficiency, and work through organisational complexity. Capturing long-term value comes from a PE firm not trying to time its investment, but from being truly an active investor which seeks to get the right mix between its fiduciary activities, the scope of its leadership team actions and where third-party expertise can most capably enhance value. Ensuring that the operating leadership of a company has the opportunity to seek creative solutions and also address its most important risks, results in value creation beyond the typical levers identified at the time a deal is closed.
“Buyers have become more sophisticated and have expanded their institutional knowledge.”
FW: In terms of valuations for portfolio companies, how would you describe the expectation gap between private equity sellers, and the interested buyers or investors considering a deal? What are PE firms doing to help bridge this gap and achieve exit in today’s market?
McNamara: Growth expectations and risks inherent in the portfolio company’s activities and market environment create significant valuation gaps. Addressing growth is best done with a model that can be well explained, taken apart and then put together in a way a buyer can understand and believe in, with performance that matches realistic expectations about the market environment and competitive alternatives. As importantly, legal teams that can explain risks in an accessible way for business leaders and provide alternatives to address those risks diminish valuation gaps. PE firms can reduce surprises when they ensure risks are addressed in their data room preparation, as well as working with their legal teams to explain risks at a more granular level and then seek operating changes to address those risks or explore creative insurance solutions. Purchase documents are becoming more standard with their treatment of representations and warranties and post-closing remedies to reduce buyer/seller friction. However, more PE sellers are using earn outs during the last 12 months to address expectation gaps in valuations.
Fieweger: Representation and warranty (R&W) insurance has become an important tool to facilitate PE exits and bridge negotiation gaps. R&W insurance serves to shift responsibility for most of the seller’s representations and warranties to a third-party insurance underwriter. The main benefit of this insurance is to limit or eliminate a seller’s post-closing liability for breaches of reps and warranties in the definitive M&A agreement. R&W insurance provides PE sellers with certainty as to the sale’s net proceeds. Thus, this insurance is very helpful for funds near the expiration of their lifecycles to make LP distributions.
“PE firms that build strong relationships with their leadership teams create the highest likelihood of impacting the key drivers of value.”
FW: What role can sell-side due diligence play in getting a deal done? How important is to provide adequate disclosures and demonstrate future potential to a new owner?
McNamara: Neither standard sell-side due diligence or a quality of earnings report that is discounted by buyers is at all helpful. Alternatively, a thorough excavation of the historical results – ensuring that you have a clear and accurate depiction of the business results, identify specific items that will impact value, and have a clear and reasonable bridge to the projections – is absolutely critical to getting a deal done. Generally, PE sellers are encouraged to perform a readiness assessment at least 18-24 months before the projected exit date. Negative surprises reduce price and increase the probability of a broken deal. From the start of a process, sellers want buyers to have positive momentum and confidence in what they are purchasing. Complete and accurate disclosures around every important issue are the sign of a well-run, professional process. Active management of unpleasant surprises will reduce risk and provide deal certainty. Unpleasant surprises often occur in non-operation areas such as litigation, regulatory changes, labour disputes or underfunded pension liabilities. When a seller is able to openly and fully discuss the risks and uncertainty in a business, it is much better positioned to demonstrate future potential that will be paid for by buyers.
Lilly: Buyers have become more sophisticated and have expanded their institutional knowledge. Buyers are seeing fewer ‘unique’ deals because their deal teams specialise in industry verticals. The due diligence process is more specialised because deal teams know the industry space, competition, and financial and operating metrics. Consequently, management must be prepared for a challenging diligence process and difficult questions to reduce risk and provide deal certainty.
“Neither standard sell-side due diligence or a quality of earnings report that is discounted by buyers is at all helpful.”
FW: To what extent are PE firms using new technology to facilitate and enhance exit processes?
Dussias: Data rooms and efficient conferencing are table stakes for well-run deal processes. Cloud computing, data analytics and artificial intelligence have been hyped but the use of these technologies in the exit process is not a common practice today. Most firms have not seen huge rewards, while the smartest firms have used technology and machine learning to build scalable infrastructure that enhances business performance cost effectively – where they can show it in the numbers and have talent that can speak to what is working for the business, they can realise returns.
Fieweger: In addition, the legal complexities of agreements have increased in order to address ownership rights and express value in a way that buyers are willing to pay for the current value and some portion of the future possibility of new technology. Sellers are also using data analytics for business performance, market trends and customer preferences to provide more control over exit timing. For buyers, we are just on the front end of them using those technologies to inform their due diligence and negotiations with sellers.
“The real tells of a poor process are not in the documents but in the amount of time, resources and roles PE firms and their management teams believe are required to have a successful exit.”
FW: In your experience, what does a poorly planned or executed PE exit look like? How can PE firms avoid common pitfalls?
Czmiel: The real tells of a poor process are not in the documents – confidential information memorandums (CIMs), strategy documents or financials – but in the amount of time, resources and roles PE firms and their management teams believe are required to have a successful exit. Frankly, the responsibility lies almost entirely with PE firms and their chief executives to demonstrate leadership and responsibility for a thoughtful, value-enhancing exit. Smart exits are planned 18 to 24 months in advance; leadership teams are evaluated for both capacity and capability, and PE firms and their boards have a clear understanding of what role the PE professionals, the chief executive and chief financial officer and support resources – financial, legal experts and bankers – have in the process.
Lilly: The most successful PE investors create an exit committee, which often consists of the fund’s investment committee members, the responsible deal team and operating team members. The exit committee generally develops performance milestones to determine when is the time to engage in meaningful discussions with potential buyers. Collaboration, focus and strong communication among team members that have a set of capabilities designed to deliver a successful sale eliminates most of the common pitfalls and creates the opportunity for a superior result. Management should also continue to capture value while preparing for the exit. For example, a portfolio company should, first, develop value creation strategies that a new owner can execute from day one or later as the company matures and, second, continue to remove risks from its customer and supplier base.
FW: What are your expectations for PE exit activity over the coming months? How is the PE value-creation playbook likely to evolve?
Dussias: We are smart enough not to have a market call on whether exit windows will widen or close. Yes, some industries will experience valuation increase and buyer enthusiasm and others will experience the opposite. The PE playbook will evolve toward the best firms executing as active investors that embrace better preparation and demonstrate a real awareness of the exit process that delivers increased speed, greater transparency, responsiveness, less disruption to their portfolio companies and, ultimately, more value. The best firms realise a skilled exit can create as much or more alpha for their investors as their buy-side activity.
Neal McNamara is co-founder of Virtas Partners, an advisory firm specialising in preparing companies financially and operationally for M&A, capital raises and restructuring. Mr McNamara has a particular emphasis and expertise in preparing companies for exits including carve-outs, private sales and IPOs as well as standing up carve-outs purchased by private equity firms. He can be contacted on +1 (312) 307 6409 or by email: nmcnamara@virtaspartners.com.
Tim Czmiel is co-founder of Virtas Partners focused on capital structuring & formation and restructuring. Over the past 30 years, he has executed turnarounds, capital restructures and placements and served as the financial adviser, chief executive and chief restructuring officer for numerous private equity-backed and privately held companies across a broad spectrum of industries in the US and Canada. He / She can be contacted on +1 (630) 886 7051 or by email: tczmiel@virtaspartners.com.
Dean Dussias is a managing director at Virtas Partners focused on clients’ most important transitional events: acquisitions, divestitures and financings, strategy, integration and change management, growth and turnaround situations. He translates strategic goals to actionable execution that delivers financial results, develops talent and creates alignment among organisational roles, culture and sustainable value creation. He / She can be contacted on +1 (847) 612 1010 or by email: ddussias@virtaspartners.com.
Craig Lilly is a M&A/corporate partner in Baker McKenzie’s Palo Alto office. He has extensive experience in advising strategics and private equity clients on stock and asset acquisitions, mergers, divestitures, recapitalisations, consolidations, auctions, leveraged buyouts, venture financing and distressed investments, among others. Mr Lilly frequently writes and lectures on legal and business issues regarding mergers and acquisitions, private equity investments and corporate finance. He can be contacted on +1 (650) 251 5947 or by email: craig.lilly@bakermckenzie.com.
Michael Fieweger represents private equity and venture capital funds, institutions, family offices and hedge funds and strategic acquirers in their formation and global acquisition and investment activities. Mr Fieweger has a background in corporate finance, having previously served as a commercial lending officer with a division of JP Morgan Chase in Chicago. He is the chairman of the firm’s global private equity practice group. He can be contacted on +1 (312) 861 8232 or by email: michael.fieweger@bakermckenzie.com.
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