Making the Most of All That Dry Powder

Julie Neal is a Director and Private Equity market expert, while Tom Acfield is Strategy Director at Vendigital. They recently shared their insights with Alphaweek.

With dry powder at record levels and business valuations down on where they were in H1 2022, private equity (PE) firms are cash ready to react to market opportunities – but there is still a high degree of caution.

Instead of going on a spending spree, fund managers are focused on realising value from existing portfolio companies, whilst looking for opportunities to invest in bolt-on acquisitions or existing PE-backed businesses looking for growth capital. This cautious approach is primarily due to recent rises in interest rates and high inflation, which has remained stubbornly high. Both have made it more difficult for fund managers to deliver value for investors.

A recently published report has confirmed that European PE deal valuations fell by 8% in Q1 2023 compared to the same quarter a year ago, although deal volumes have remained relatively stable. This could suggest that the PE market has become more competitive, due to more funds actively looking to invest in fewer low-risk options.

At the same time, private equity firms are facing pressure to realise value from their existing portfolios and deploy as much dry powder as possible, as if PE firms don’t invest this money, they won’t be able to charge fees on it. . In response, some larger private equity firms are extending their field of vision to include more SME businesses, as in many cases these can be funded without the need for additional borrowing. Mid-market private equity has demonstrated resilience as a result, which is focused on investments of between £10-100m.

Despite the pressure to invest, fund managers are acutely aware of the risks, particularly at a time of significant macroeconomic and geopolitical uncertainty. Meeting investor expectations at the same time as applying the right level of due diligence has always been a delicate balance for fund managers, but it has become even more so. At some point, fund managers know that they must find a way to do deals, despite the unfavourable macroeconomic outlook, so it makes sense to focus on lower risk opportunities in the short to medium term.

In a low-growth or flatlining economy, fund managers are increasingly likely to focus on realising value from their existing portfolios. Whilst revenue synergies are harder to find, strategies put in place to improve operational efficiency and reduce costs can create excellent opportunities to increase market share and boost enterprise value. For manufacturers, close analysis of cost and procurement right across the supply chain can help to identify opportunities to optimise margins. This comparative real-time data can be used to inform procurement strategies and protect margins from the erosive effects of inflation. Cost engineering principles can also be applied by closely analysing the cost of a single product and finding ways to make it more cost-effectively, without compromising their quality and performance, and maintaining a high standard of customer service. Once learned by the portfolio business, these value-driving strategies can be used on an ongoing basis, bringing opportunities to drive value sustainably.

In addition to driving value from existing portfolio businesses, some fund managers have been showing interest in bolt-on acquisitions, where there are likely to be opportunities for revenue synergies. Often, they are looking for a target company with a complementary capability set or a customer base that is potentially trading in a different territory, where cross-selling activity could help to drive revenues. Equally, investing in a business that already has PEbacking is more likely to satisfy due diligence criteria and help to mitigate risk.

With the uncertain economic outlook ongoing, fund managers should continue to proceed with caution. Broadening their field of vision could bring forward some strong investment opportunities to utilise dry powder and realise strong returns for investors, but a rigorous approach is needed.