HR, Tech Take Center Stage in Q1: Private Equity Industry Update

Sean Mooney:
Welcome to the Karma School of Business Podcast. During this episode, we're going to talk about what the best business builders in the world doing and why they were doing it during the first quarter of 2023. This episode is brought to you today by BluWave. I'm Sean Mooney, BluWave's founder and CEO. BluWave is the go-to expert of those with expertise. BluWave connects proactive business builders, including more than 500 of the world's leading private equity firms to the very best service providers for their critical variable on-point and on-time business needs.

Today we're going to talk about BluWave's internal data from Q1 2023, which shows what the private equity industry is doing to both survive and thrive during these challenging economic times, and we're also going to talk about why they're doing it. So as a preamble thus far in 2023, I'm getting a pretty big sense of deja vu all the way back to 2008 and 2009 while I was in private equity. Back then it was big banks, and big companies, and a black swan that caused ripple effects downward across the economy. This time it's smaller banks and smaller companies causing butterfly effects upward.

As I reflect on 2008 and 2009, it was a scary time. However, we and our PE firm peers, once we kind of measured ourselves, and gathered data, and understood things, very quickly we're able to look past the haze, and find some pretty tremendous opportunities while others were becoming paralyzed around us. PE provided a tremendous stabilizing force for the economy back then, and helped the business world pull out of a dive, and begin ascending again. This time around is daunting as well, but less severe. In many ways, while visibility is still quite limited, it seems like it's a bit easier to see through the haze towards bluer skies in the days ahead.

As we look at BluWave's data, the PE industry has been leaping into action even before the bank crisis emerged in March of 2023. Before all of this, the private equity industry has already been finding diamonds in the rough, injecting capital to provide life wraps to companies in need, and providing every resource their portcos require to not only survive, but thrive.

And so let's talk about what they've been doing in the very recent past. And so if we look at Q1 2023, and we look at the breakdown between how private equity is spending time between due diligence and value creation, we see that value creation is skyrocketing. In fact, it was tied for an all-time high. And to give you a sense for where we're going to get this data, what we do is we look at all of the project data across hundreds of PE firms that we're supporting in their thousands of projects and in a very detailed way, ascribe everything they're doing against a taxonomy that helps us understand pictures across the economy.

So when we looked at Q1 2023, value creation accounted for a huge 78% of all PE activity that was supported through the BluWave ecosystem. And in some ways this is a normalized distribution of PE that we're serving, a large number of PE firms, a large number of projects across all industries and size of PE firms so it gives us a great sense for what's actually happening in the world amongst these business builders who are really at the top of the game amongst really everyone in the world.

And so 78% of all their activity was value creation, that means 22% of what they were spending their time on was due diligence. As it relates to the why diligence activity is relatively low versus value creation, a number of things drive this trend. Let's talk about what some of those are. First, deal flow continues to be slower with an emphasis on special situations and/or quality over volume, the private equity industry is being more selective, but they're also having fewer deals to look at because fewer companies are coming to market.

It's important to note that deal flow is almost always slower in Q1 versus all other quarterly periods because very few companies are also going to come to market even in good times until they get their prior fiscal year numbers closed, and often not until they even get their audited numbers done. No one wants to get their last big financial year wrong and have that as an opportunity for potential buyers to retrade. And so private equity firm-backed companies or independent companies, they're all going to wait to make sure that they get their numbers done. This takes time and so very often you're not going to see new deals starting in large numbers until March or April.

This year; however, is even more slow because there's so much haze in the market in part because of just the overall economic malaise that's been going on, but it's been meaningfully exacerbated by the 2023 March banking crises that emerged. And one of the things that any company that's going to come to market in a sale process is going to think about is can they project with confidence over at least a six to 12-month period of time? If you can't, you shouldn't come to market because you got to be able to at least project how your business is going to do at least through the sale process.

So as a result, there are stacks of what are called CIMs or confidential information memorandums, which are written by the investment bankers that would take these companies through an M&A process. All these CIMs are written right now, but they're all on pause because no one can really project what's going to happen during the next six to 12 months. And so once they get a good sense for when this market is going to open up, be on the lookout for lots and lots of deals to hit the market. Right now, there's a lot on pause until people get a better sense for what the near future looks like.

Additionally, being mindful of the unsteady economic environment, PE firms at the same time are being more selective about the opportunities that are coming to market because this is a really risky period, they don't want to get it wrong. The PE industry is still doing deals. In fact, lots of them, they're just doing fewer of them. They're focused on really a number of areas. First, they're digging deeper into sectors where there's a historical precedent of comparably thriving during a harder time.

So think about subscription-based businesses like those found in the software industry. At least the private equity-type software companies that have reached profitability and are throwing off cash flows, they're looking at business services companies that are asset lite. They're looking at healthcare businesses.

Next, private equity firms are evaluating turnaround opportunities where their capital offers a life raft to underperforming or cash-starved companies like many of those found in later stage venture capital that are looking to find safety in the flight of capital in someone who's going to unleash unity economics that should have, or could have, or already do exist and bring it to the next level.

Lastly, the private equity industry is actively looking at take private opportunities where really good companies now are trading below intrinsic value because the public markets at times like this often overprice fear, overprice paranoia. And so really good companies often trade at a discount and then the private equity firms will go in and say, "Hey, not only can we get perhaps a relatively more attractive valuation, but we can take you private, and then we can help you think about building for the next 10 years versus the next three quarters."

For deals that are moving forward, BluWave is supporting meaningfully deeper levels of assessment as PE firms seek stronger comfort and confidence that targets are going to survive and also be very successful over the near-term. So if you're going to cut a check in this time, private equity firms can't leave anything to chance, and so they're doing much deeper work on the deals that they're doing.

Let's turn the page to value creation. Value creation is relatively higher than due diligence, and it's getting higher and higher period over period for a number of foundational reasons. First, economics 101 is driving a fundamental increase in value creation in the private equity world over time. It's supply and demand that's going on here. Every year there is more and more private equity money chasing a similar supply of companies that are coming to market. So if you remember your econ classes from either high school or college, you'll remember when demand outstrip supply and demand grows, you're going to have prices go up. And so we're seeing that in the valuations in the private equity industry, purchase prices are going up.

Now, private equity firms are not just going to let returns go down, which would ordinarily happen in this kind of econ 101 environment where purchase prices go up, you'd expect returns go down and over time, they certainly have, but the private equity industries takes action. They're going to say, "We're going to do everything that we can to resist the gravity of econ 101." So what they're doing is more and more value creation. They're building bigger and better,, and more safe, and stronger companies that will create value inherently, in part because they want to resist the economic maturation that's occurring in the industry.

So today in PE, the name of the game is no longer about optimizing a company, it's about transforming a company. This secular trend requires more and more value creation, and this trend's only going to get bigger and bigger over time. Next, during times like now, value creation activity is particularly important. PE firms on average make one and a half to three times their money on each deal. They make money in this way with a very high degree of consistency in little variations. So they have to make money and they do make money on pretty much every deal they make.

This approach is what has made PE the most consistent outperforming asset class available and is a major reason why it's so popular with asset managers and asset allocators. So with relatively lower returns, it's very hard for PE firms to make up for a loss. If they ever were to lose money on a deal, if you think about you're only making one and a half, two, three times your money and you're doing 10 deals in a fund, it's really, really hard to make up for that and still make at least an 8% return and even above that, which is what your LPs are looking for.

So what happens is during times like now, the private equity industry runs towards the storm. They surround them with every resource they need to help them succeed in an economic downturn. And not only make things safe and strong, but then they look for opportunities once they bend down the hatches and they're able to look around and they go, "Oh, wow, there's actually some things we can do that are advantageous to us." This happens every time there's an economic downturn, private equity firms run towards their portfolio companies. This is the primary reason why private equity portfolio companies meaningfully outperform the rest of the market during downturns.

So let's break down the top three areas where private equity spent time, and diligence, and value creation in Q1 2023. The top activity area and the top trend in all of private equity is human capital. In Q1 2023, human capital reached an all-time high accounting for 45% of all PE activity as captured in BluWave's Activity Index. This compared to 42% during Q1 2022. To give you a striking sense for how far human capital has risen in private equity, this category counted for only 17% of projects captured by the BluWave Activity Index in Q1 2018. This is a staggering increase.

The reason for this huge increase goes back to my early point about econ 101. Private equity firms now need to transform their companies. Transforming companies requires lots of new and additional skillsets. This requires really good people and more and more of them. So we've been equipping private equity firms with droves of BluWave grade resources around the human capital area to support their transformations. And as part of that, they're doing lots and lots of hiring, and they're also doing a ton of organizational effectiveness work.

The second biggest area in the BluWave Activity Index is strategy. Strategic resource usage accounted for 14% of all PE activity in BluWave's Activity index. This compared to 15% in Q1 2022. PE firms understand that the market always wins. If you have a great team and a lousy market, guess what? The market's going to win. If you have a great market and an okay team, the market's going to win. The company's still going to do pretty well.

PE firms use strategic resources to not only help them understand the health of a company's core existing market and the related growth opportunities they're in, but also to find adjacent market opportunities where their company can grow in wholly new places. During times like now, we're seeing extensive strategic work being done with the understanding that the economy is causing many markets to flatten and shrink.

PE firms understand that the number one correlative value is growth. And if their portco market pies are getting smaller, they're going to do anything they can to get a bigger piece of that pie. So we're seeing tons of work right now about enabling portfolio companies to update their growth strategies to find pockets of growth whereby they can continue to grow through this choppy malaise that we're in. This is a great lesson for any company. You can and should do the same. Take fresh looks at your markets, find pockets of opportunity to find growth because that's the number one thing that's going to drive future valuations of companies.

The third biggest area in the BluWave Activity Index is technology. Technology accounted for 11% of all PE activity accounted for and captured in BluWave's Activity Index. This matched activity levels of Q1 2022. So once again, private equity industry they've been taking strong action for not just months and not just quarters, but years. The private equity industry is taking significant action to first understand the state of a target company's tech stack before they buy them.

Next, they're performing tech strategy work that enables them to put together digital transformation, and data, and analytics plans. PE's been a bit late to the game candidly on this vis-a-vis, there are VC peers, but they're starting to quickly catch up, particularly as it relates to more foundational technologies. So hopefully this gives you a good sense for the major trends underway in private equity. The PE industry always outperforms the rest of the market during challenging economic times like now. I'd encourage every business leader to keenly benchmark what the PE industry is doing to sharpen your own game plans and do a little copy paste in your own rights.

We have all sorts of additional insights and trends that we break down in our 2023 Q1 Insights Report. If you'd like further and deeper cuts of information, you can go to our website and request a copy or contact your BluWave Client Coverage executive and we'll get you the information ASAP.

If you're managing through this malaise and need private equity grade resources to help you assess opportunities, lift revenues, optimize costs, get the right people in place, upgrade your tech, enhance your strategy, or any other critical business initiative, BluWave can support your success in ways that very, very few can. So please give us a call and we'll help you win.

That's all for today. For more information, go to bluwave.net/podcast. Please continue to look for us anywhere you find your favorite podcast, including Apple, Google, and Spotify. We truly appreciate your support. If you like what you hear, please subscribe, review, and share. In the meantime, let us know if there's anything we can do to support your success. Onward.

Private equity insights for and with top business builders, including investors, operators, executives and industry thought leaders. The Karma School of Business Podcast goes behind the scenes of PE, talking about business best practices and real-time industry trends. You'll learn from leading professionals and visionary business executives who will help you take action and enhance your life, whether you’re at a PE firm, a portco or a private or public company.

BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.