In this marketplace, Providus Capital Partners General Partner Naimish Patel says good deals are getting done. And, at least from what he’s seen in the engineering and construction space, the multiples for good deals and great assets are as high as they've ever been.
“We have been blown out of the water in a couple of processes,” Patel said at the Detroit Smart Business Dealmakers Conference. “And it's really pushing us to think, do we need to adjust our lens here? And so what do those good deals look like? Good deals are companies that have been able to grow margins through this inflationary environment, really show strength because labor costs are up, occupancy costs are up, material costs are up. And if you're able to grow your margins through this environment, it shows that you're able to really extract more value on the revenue side.”
Another aspect of a good deal, says Patel, who’s worked as an investor, buyer and operator, is the ability to grow organically.
“If you've been able to grow organically through this environment, particularly coming out of COVID, you've really shown that your business is very, very resilient, and it's a strong operating fundamentals, both internally and in the market you're operating,” he says. “Those businesses command high premium multiples.”
While the higher interest rates have been causing private equity firms to struggle to make their deals work, the strategics that aren’t as affected by rate increases have been able to win deals. But still, buyers must be more selective. He says he’s looking for well-run businesses, or businesses that he thinks they can operationally help improve in a dramatic way. That’s made the underwriting funnel narrower, but there are still great opportunities if buyers can be involved in the businesses in a way that can truly help them.
“That's really how we're responding is we're peeling a few more layers back,” he says. “We're getting more conversations with our sellers.”
So, if a deal has some hair on it, even in this market there is still the possibility of a transaction. But it’s critical to communicate to the seller where there are issues as well as opportunities, and how the buyer can help. It means getting the seller to understand the plan.
“If you see hair on the deal, and they don't, and you're really looking to back that management team in executing the business going forward, you can get into some real challenges around how you actually execute the growth and improvement,” Patel says. “So, when we see a good business that we like, but there's some things that we need to change, we lead with it, and we'll lead with a lot of those conversations pre-LOI. Some people take the strategy of sign it up and then we'll figure it out. Our view is, before we spend a bunch of time in diligence and really absorb a lot of both sides’ time, let's figure out are we aligned in the path forward to overcome some of the challenges. We're trying to help the sellers understand they're buying us.”
Ultimately, he says, a buyer needs alignment with their sellers on the path forward to increase the probability of success.
In this environment, buyers and investors need to maximize cash flow through moves such as collecting receivables more efficiently or investing in technology or other places that can create leverage in the operating model. That, he says, is forcing more efficiencies on the operation side.
“If you're not driving operational efficiencies as a response to the higher interest rates, we're missing a big opportunity because it's not going back to 4 percent bank debt,” he say. “So, companies that are taking advantage of that now are starting to stand out as they enter these exit scenarios, and they're trading at great multiples because they've been able to drive that efficiency. It just puts a heightened premium on using cash extremely efficiently because it's more expensive.”
Though his expectation as he entered into an environment in which money is no longer free and lending has tightened is that earn outs and seller notes would become much more prevalent. But those have not been as accepted as he expected.
“Earn outs, you always have the challenge of who's making the decisions in the business,” he says. “One of the things that I've always struggled with earn outs, even before this current environment, is you want people thinking long-term about the growth and the success of the business, and not just next year's earn out. So, it sounds great on paper as a way to bridge buyer-seller expectations. But, if you've got a great opportunity to do an acquisition or make a key hire to invest in a new service line and that's going to depress your earnings for an earn out, does that lead that management team to make a decision that's good for tomorrow, but not for the long-term? And so, these are some of the challenges that we've experienced with earn outs. We're still seeing sellers have some apprehension. What we find is it just gets discounted severely. Cash at close is No. 1, then a seller note, roll over equity and earn out is kind of fourth in line. I was hoping it’d be more accepted.”
