Looking beyond leverage to drive sponsor returns

October 2024 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2024 Issue

Private equity (PE) sponsors have encountered a series of challenges in the past two to three years, including higher interest rates (as compared to the prior decade, but not on a more long-term basis), depressed exit activity and difficult, prolonged fundraising periods. These developments have forced sponsors to look for alternative strategies and opportunities to drive returns for their limited partners (LPs).

Operating performance

The macroeconomic backdrop and depressed dealmaking environment has challenged key levers for return often relied on by sponsors, particularly highly levered capital structures built upon cheap debt and anticipated multiple expansion prior to exit. Higher interest rates, which were implemented by the US Federal Reserve in 2022 and 2023, increased the cost of capital for leveraged deals and put downward pressure on valuation multiples of portfolio companies. While the most successful sponsors have always focused on operating efficiency and performance in addition to seeking the advantages of high leverage with relatively cheap debt, sponsors more broadly have had no choice but to prioritise operating performance, with a particular focus on revenue growth and margin expansion.

Dedicated operating partner teams have become a vital tool for portfolio company performance. Operating partners are typically industry experts who are tasked with developing and executing on performance improvement plans. They also work with investment professionals during the sourcing and due diligence stages to assess the return potential of acquisition targets based on potential operating improvements. If the industry experts determine that a target is already performing efficiently, with very little to be gained operationally, then the sponsor may conclude that the opportunity is not worth investing in, particularly if the seller is looking to sell at a high price because the target is operationally efficient.

Many sponsors have built out operating partner teams with diverse expertise, including strategy, sales, product, marketing, finance and technology, and have created networks where operating partners and management across portfolio companies regularly meet to share best practices. Operating partners may serve as temporary managers or serve a portfolio company in a more permanent role, depending on the situation.

Operating partners are integral in optimising inorganic and organic revenue growth. Inorganic revenue growth via bolt-on acquisitions is a common tool, but doing bolt-ons in many cases has become more difficult due to a combination of the increased cost of capital together with antitrust regulators’ scrutiny of roll-up strategies, particularly in certain sectors, such as healthcare. Traditional organic methods of creating value, such as improving products or services, improving customer experience, optimising pricing, entering new geographies and implementing effective marketing, have all been a focus. Many sponsors also have focused on implementing new technologies, including artificial intelligence, improving IT systems and right-sizing workforces to drive margin expansion.

Some sponsors have built out in-house consulting teams who hit the ground running on newly acquired companies to implement the firm’s best practices and operational approach throughout its portfolio. The largest firms also are able to take advantage of purchasing power with vendors and service providers that serve companies across their portfolios, taking advantage of their size as a customer to drive better pricing than would be possible for any individual portfolio company to achieve on its own.

Sponsors who are known as ‘operators’ or with sector expertise are being rewarded with larger equity commitments from LPs, who are also observing that operational improvement is key to driving returns in the current market. This is particularly the case with certain LPs that are interested in developing expertise in a particular industry, as they look to co-invest with and learn from sponsors that are expert operators in a particular field. While general sector expertise is valued, LPs also are seeking subsector specialisation from sponsors, such as healthtech and medtech within the technology vertical.

Alternative deal structures

As another way to seek targeted returns, many sponsors are pursuing alternative deal structures to traditional control acquisitions of whole companies.

There have been several carve-out sales of businesses by corporate sellers to sponsors in 2024, such as Carlyle’s acquisition of Baxter’s Vantive Kidney Care Segment, CVC’s acquisition of Mallinckrodt’s Therakos business, and Apollo’s acquisition of IGT’s Global Gaming and PlayDigital businesses. The rise of corporate carve outs, which can be particularly complex, coincides with sponsors’ focus on operational improvements. A corporate seller may sell a division because it is no longer core to its strategy, and in certain cases, the divested business may suffer from underinvestment, bloated cost structures, lack of strategic direction, absence of technological innovation and unmotivated employees. Carve outs can be excellent opportunities for sponsors as they are often able to pay a lower entry multiple to the corporate seller given the issues attendant to the divested business. A sponsor with operational expertise can extract substantial value by correcting the operational issues impacting the divested business. Operating partners can also be valuable in assisting investment professionals in negotiating and implementing post-closing arrangements with the seller, such as transition services agreements or long‑term commercial agreements.

We expect corporate carve outs to continue to be a trend in the second half of 2024 and 2025. For example, there has been a number of recently announced large, stock-for-stock deals involving public companies, most notably in the energy space, and the combined companies may seek to divest to PE buyers non-core assets to optimise their portfolios. We also expect to continue to see activist campaigns where divestiture of non-core businesses is a primary investment thesis.

Sponsors also are pursuing minority investments and joint ventures as creative ways to generate returns, such as Brookfield Infrastructure’s up to $15bn investment for a 49 percent stake to jointly fund Intel’s under-construction semiconductor fabrication facility located in Chandler, Arizona and Apollo’s $11bn investment for a 49 percent stake in a joint venture with Intel for a chip manufacturing plant in Ireland. Sponsors may choose to invest in preferred securities or otherwise at the mezzanine level of the joint venture to lock in a threshold return, often paired with equity upside. These transaction structures can lead to extensive negotiation regarding the terms of the sponsor’s liquidity and governance protections.

Sponsors with a keen interest in certain industries are gaining exposure to such industries with various deal structures. For example, Blackstone has allocated significant capital to data centres through various structures, including take privates, asset acquisitions, joint ventures and secured lending facilities.

Guarded optimism for the return of activity levels

Although sponsor buyout activity was subdued in 2023 and on the road to recovery in the first half of 2024, many in the industry are optimistic that buyout activity levels will strengthen significantly in the second half of 2024 and 2025.

Expectations that central banks will cut interest rates is a significant factor driving this optimism. Lower rates will allow sponsors to be more competitive buyers relative to strategics in platform and add-on acquisitions. Lower rates should also unlock the logjam of portfolio companies that sponsors have been waiting to sell in a healthier market, since buyers that can borrow more cheaply are likely to pay a fuller price. We would also expect sponsors to explore alternative ways to capitalise on lower interest rates, such as leveraged recapitalisations, which allow for a distribution of capital prior to full exit. The cumulative effect of these activities should be to generate a higher ratio of distributed to paid-in capital, resulting in a more robust fundraising market as LPs will have capital to redeploy back into new funds, often as repeat customers to sponsors they have invested with previously. While continuation funds, secondaries and net asset value loans have been utilised to provide distributions, many LPs have stressed the importance of full exits within the target time horizon that had been marketed to them during the fund’s capital raise.

The anticipated positive factors for PE dealmaking in 2024 and 2025 may be offset to a certain extent by the regulatory environment, and as of now it is unclear whether the new US presidential administration will continue to press antitrust enforcement to the same extent as the Federal Trade Commission (FTC) and Department of Justice (DOJ) under the Biden administration, which was highly focused on alleged or perceived anticompetitive effects in some PE strategies. In June 2022, the FTC commenced enforcement actions against a sponsor in connection with its purported roll-up of veterinary clinics, and pursuant to a consent decree, required the sponsor to divest certain of these clinics and agree to strict prior notice and approval provisions. In September 2023, the FTC sued a sponsor in connection with a series of acquisitions of anaesthesiology practices in Texas. In December 2023, revised merger guidelines released by the FTC and the DOJ’s Antitrust Division stated that a buyer may violate antitrust laws if it engages in an anti-competitive pattern or strategy of multiple acquisitions in the same or related business lines. The proposed new Hart-Scott-Rodino (HSR) rules would require disclosure of acquisitions beneath the HSR filing threshold, which would reveal a sponsor’s roll-up plans.

We expect to see significant activity for certain types of PE transactions regardless of rate cuts. For example, there have been several significant software buyouts in 2024, including Bain’s acquisition of Envestnet, KKR’s acquisition of Instructure and Clayton Dubilier & Rice’s and TowerBrook’s acquisition of R1 RCM. Software buyouts often rely on less leverage relative to buyouts in other industries, or sometimes no leverage. Accordingly, solely from a financial perspective, these transactions can be easier to get done in today’s environment.

Many mid-cap software companies that became public companies in 2020 and 2021 are attractive take-private targets for sponsors. Many of these companies have underperformed the ‘rule of 40’, and sponsors with sector expertise in software believe they will be able to significantly improve growth and margins under private ownership. As many of these companies have significant stockholders from their recent initial public offerings or de-SPAC transactions, PE buyers are also able to limit the equity financing needed for the take-private transaction by requiring those significant stockholders (often founders or other PE funds) to roll their equity in the transaction. These factors, together with the mega technology funds raised in 2023 and 2024 needing to invest, suggest that software take-private activity is likely to be strong.

Brian E. Hamilton and Lee C. Parnes are partners at Sullivan & Cromwell LLP. Mr Hamilton can be contacted on +1 (212) 558 4801 or by email: hamiltonb@sullcrom.com. Mr Parnes can be contacted on +1 (212) 558 4492 or by email: parnesl@sullcrom.com.

Brian E. Hamilton and Lee C. Parnes

Sullivan & Cromwell LLP