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Today’s private equity market has both slowed and changed dramatically in the past six months and private equity firms are being much more cautious in their valuations and crossing every “t” and dotting every “I” in their due diligence. They are still buying—but with a slower process and with greater scrutiny.
Meanwhile, sellers who turned up their noses at deal offers last summer are beginning to see they need to adjust. Inflation, escalating interest rates, and a looming recession have dampened private equity firms’ appetite to embrace seller optimism about double-digit growth rates. Given the possible impending recession, private equity firms are not modeling in big increases in EBITDA the way they have in the past. As well, interest rates play a big role in what is simple math for private equity firms. If a private equity firm wants a 25% Internal Rate of Return (IRR), and interest rates double, the firm must pay less to get to that same 25% IRR.
Private equity firms no longer feel the wind at their back that will carry them forward after the deal is done. They are right to proceed with caution and pay close attention to what is uncovered during due diligence. With the uncertainties in today’s climate, they are focusing on the smaller dollars, and they are drilling down into areas they would have breezed over just six months ago. They even need to “get in the weeds” to explore the less-than-obvious liabilities lurking in the fine print and the macro-economic trends that can quickly sap value after the close.
For example, it is no secret that employee benefits’ costs rise each year. When money was flowing, revenues were growing exponentially, and interest rates were low, this often earned no more than a shrug of the shoulders during due diligence. Now, with a national medical inflation rate of seven percent, private equity firms are looking at a 5-10% increase in employee benefits for each year they own the business. When they back into what they need in business growth just to pay for the healthcare increase—that is a scary number.
It is critical to have an insurance broker who knows how to get down in the weeds to find the hundreds of thousands, let alone the 10s of thousands, of dollars in costs. When the broker has both the broad knowledge and specialty expertise, they can unearth $50,000 over here, another $30,000 over there—it starts to add up. Whereas before that would not have changed the scope of the deal, now finding $250,000 in savings may save the deal.
Private equity firms are taking a lot longer to close a deal. They may have exclusivity for 30 or 60 days, but they are dragging it out even further because they want even more future certainty. The longer they can extend before the seller pulls the plug on them, the more visibility they have and the better they feel about the deal, particularly if they can see another quarter’s worth of financial results. Maybe that leads to the seller being able to get more, or maybe it leads to renegotiating the purchase price down. Either way, there is more certainty in the deal for the private equity firm.
This increased due diligence scrutiny over a longer period may raise concern for the seller. And it does not completely erase the cost unknowns on the buyer side. Representation and Warranties insurance (RWI) allows sellers and private equity firms to breathe easier. This insurance protects against losses stemming from a seller’s breach of representations in the acquisition agreement. It keeps sellers from needing to hold large sums of money in escrow for indemnification. Importantly, it allows buyers to recover losses stemming from breaches of the seller’s Representations and Warranties.
Because of the fixed underwriting costs, thorough due diligence, and minimum premiums, RWI can be challenging for smaller M&A transactions where there is often less margin for the unexpected. That said, premiums and underwriting are coming down as M&A activity softens and new capacity is entering the market.
We often hear deal teams tell us they could not get the right coverage from the RWI market, but this is simply an example of brokers not knowing how to get to the finish line. If your broker is not advising you how to do the right due diligence and with whom, then you have the wrong broker and process to yield the best coverage.
Mergers and acquisitions will continue, but the transaction process for private equity firms is looking more disciplined than during the heyday. Just as in the housing market, it is time for a prudent approach to avoid buyer’s regret.
Want to learn more?
Contact Neil Krauter, National Private Equity Practice Leader, at firstname.lastname@example.org
Connect with the Risk Strategies Private Equity Practice at email@example.com.