Hauser Private Equity's Mark Hauser on Middle Market and Growth Equity Trends

Hauser Private Equity’s Mark Hauser on Middle Market and Growth Equity Trends

Despite the impact of the COVID-19 pandemic, dealmaking and capital raising continues in U.S. middle markets. However, trends have shifted to accommodate the economic changes the world has witnessed over the past 24 months.

Mark Hauser, the co-managing partner at Hauser Private Equity (HPE), comments on middle market and growth equity trends. With over 30 years of experience in investments, acquisitions, and mergers, Hauser has become a thought leader in market trends and offers insights into how the private equity market has responded to the pandemic.

Investors Are Rethinking Strategies Following COVID-19

Private equity firms and portfolio companies have had to reconsider their strategies as unprecedented changes have impacted industries across the board. Those changes include declining foot traffic in brick-and-mortar stores, higher costs for personal protective equipment (PPE), supply chain spikes, and labor shortages. Here are some of the modifications companies have had to make in light of pandemic-related trends.

To begin, many companies have had to revise definitions in purchase and sales agreements to accommodate unforeseen downturns. Firms have had to justify purchases to ensure ongoing deal flow, including buying at inflated prices and seeking investments in less desirable markets. Transactions are now emphasizing earn-outs, longer earn-out durations, and tighter performance metrics, while uncertainty has led to more conservative strategies for ensuring liquidity in the evolving market.

Investors Are Turning to International Opportunities

International markets are presenting investors with new, potentially profitable opportunities. Despite a slowing economy in Latin America, where the gross domestic product (GDP) is expected to be 2.5% next year, well below this year’s 6.7% and the average worldwide GDP estimate of 4.4%, venture capitalists are turning their attention to Latin American startups. So far in 2021, startups have raised a record $14.1 billion in private capital, more than triple the amount recorded in 2020.

Ed Eduardo Miras, head of investment banking at Citigroup Inc. in Brazil, spoke on the subject, reporting, “Tech startups can have cost structures much more efficient than incumbents, so investors are pretty rational when pricing higher return rates for them in the future.”

However, investors should be wary, as markets in Latin America tend to be uncertain and volatile. Brazil, for instance, is expected to hold presidential elections in 2022, which could raise doubt in scheduled initial public offerings (IPOs). In addition, the ongoing accumulation of debt is leading to a vulnerability in the Mexican market. As a result, valuations could decline in less liquid markets, placing investors at higher risk in the coming years. In addition, private equity firms are now turning to mid-tier banks in the United Kingdom due to low valuations.

Following years of low profitability and constant restructuring amid lower interest rates, valuations for banks are below average. Investors perceive this as an opportunity to acquire low-cost opportunities, valuing them based on recent conditions. However, boards are reserved in responding to immediate interest, foreseeing an uptick in values post-pandemic.

For example, U.S. buyout firm Co-operative Bank PLC, backed by J.C. Flowers & Co. LLC and Bain Capital Pvt. Equity LP recently approached Spain’s Banco de Sabadell SA about acquiring its U.K. subsidiary TSB Bank PLC. “Co-op Bank’s reported £1 billion move for TSB was rebuffed by Sabadell.” However, “the Spanish bank said it saw no need for a ‘fire sale’ of TSB but nevertheless left the door open for a later approach when it said it was not a transaction it wished to explore ‘at the moment.’”

Furthermore, boards are considering the position of current investors and determining that a “disposal would not offer better value for shareholders compared to retaining the [banks].” Instead, investors who have been through the recent pains of the pandemic want a significant premium from prospective buyers.

Unprofitable Firms Are Getting VC’s Attention

Firms reported to be unprofitable in 2020 and 2021 are gaining the support of investors and venture capitalists (VCs) as they hunt for opportunities in an increasingly expensive market. Although these deals may appear out of favor, Mark Hauser contends that they may allow investors to maintain deal flow.

As a result, investors are looking away from favorable industries, including financial and business services, and looking for distressed opportunities in sectors such as education and food, and hospitality. Deal volumes in these sectors are expected to spike, as most negotiations are in preliminary phases. Although they currently indicate low or no profit, long-term growth is perceived to occur in these sectors.

Private Equity Firms Are Leveraging Favorable Debt Terms

In response to favorable loan terms, private equity firms continue to seek dividend recapitalizations, buyouts, and debt refinancing opportunities at favorable terms. October 2021 marked an all-time high in loan volume, reaching $509 billion. This statistic surpassed the previous high of $503 billion in 2017. A majority of this volume results from dividend recaps, which as of October 2021 were up 84% since the previous high in 2018. Questionable credit quality for targets, however, should raise concern. For example, reports reveal that mergers and acquisitions in the United States this year have been driven by lower-rate transactions, and loan volume issues to borrowers rated single-B have set an annual record at $360 billion.

Hauser supports the concern that “should interest rates and rising valuations stop the ongoing M&A [merger and acquisition] mania, quite a few financial sponsors could be left holding highly indebted portfolio companies with historically low abilities to cover their debt burdens.”

Investors Should Be Cautious When Making Moves Based on the New COVID Strain

The uncertainty caused by Omicron’s arrival has led to another shift in the market, increasing the value of healthcare stocks and hurting travel companies. Because the impact of the strain is still uncertain, investors should reconsider making big moves until after the dust settles. Most industries are bouncing back quicker than before, and strategic analysis could reveal critical entry points into the market.

Mark Hauser supports the concerns of major investment groups who have indicated that investors should pause before making sudden shifts in their investment strategies. The dip is expected to be short-lived, as the vaccine is tweaked to offer a quick response to consumer fears.

The focus on tech stocks, however, remains optimistic. Their ability to generate revenue and cash flow growth, in spite of the pandemic, has proven that they are much more durable.

Private Equity Firms Will Begin to Broaden Their investments

As the world starts to enter a post-pandemic environment, private equity firms will begin to expand their investments, taking into consideration factors such as the Build Back Better bill and the push toward greener processes. These firms will seek value creation opportunities in newly associated sectors while expanding on pre-targeted industries such as infrastructure and finance.

However, private equity should also take caution. They will need to navigate a number of headwinds in the upcoming months, including the disruption of supply chains from the COVID-19 pandemic and questions surrounding the permanence of emergent inflationary trends.

No doubt, the global private equity industry is hot. Pent-up demand for deals was unleashed during the second half of 2020, following a brief hiatus as the COVID-19 pandemic sent economies all over the world into lockdown. As the U.S. economy heads toward 2022, there is little sign of this momentum letting up.

About Hauser Private Equity

Founded in 2008, Hauser Private Equity is a Cincinnati-based hybrid private equity fund management firm that focuses on direct co-investments in the lower-middle to middle-market range. Investing via partnerships with control buyout funds and selectively with managers of growth equity and special situation funds, the firm’s four funds have invested more than $300 million in capital in privately owned businesses nationally across a diverse set of industries.