November 28, 2023

Investment Banking

Let Your Investment Banking Do The Walking

Deloitte’s Head Of Investment Banking Reads The Private Equity Tea Leaves

This is an excerpt from Deal Flow, Forbes’ twice-weekly newsletter about the latest billion-dollar deals from venture capital, private equity, M&A and beyond. Want a new edition in your inbox every afternoon? Subscribe here.

Phil Colaco knows his way around the middle market. He’s worked as an investment banker in the space for the past two decades, including the past six years as CEO of Deloitte’s U.S. investment bank—last year, his team advised on about 700 transactions. So as questions swirl about what volatile stocks, rising interest rates and a shifting economic outlook could mean for private equity firms and other strategic acquirers, his brain seemed like a good one to pick.

The market looks different today than it did at the start of the year. Gone is the era of dirt-cheap debt and surging stock prices. Rising rates, rocky equity markets, war in Ukraine and inflation have combined to create a dealmaking slowdown. But Colaco suggests a dose of perspective: What things are slowing down from, after all, is the most breakneck year in the history of private equity. On a longer timeline, current conditions don’t look so unfriendly.

“Is it worse than it was four months ago? Yes. Is it bad in any sort of historical context? No,” Colaco says. “The big change is there has been a little more bifurcation. If you’re a B+ to an A+ company, you’re still getting very high multiples, great valuations, lots of bidders. If you’re a B- or below business, I do think valuations have come down.”

For private equity firms, the most significant shift may be higher interest rates—and the likely prospect of further increases in the months to come. When rates were near zero, firms were able to rely on piles of essentially free debt to finance their buyouts. Now that debt is getting more expensive.

“Just doing simple math, either the buyer is going to have to take a lower return, or they’re going to pay less,” Colaco says. “That’s where the rubber really hits the road.”

Before the global financial crisis, major Wall Street banks were the primary lenders that fueled the buyout industry. But their activities were curtailed by new regulations in the wake of the crash, and in the past decade, a new class of private debt lenders has filled the void—business development corporations, hedge funds and other investors willing to embrace a little more risk in exchange for potentially higher returns.

That risk was minimal in recent years, when times were good. Now, it might be getting a bit more significant. When the economy took a turn for the worse in 2008, it was big banks that felt the crunch first. If it happens again in 2022, Colaco says these sorts of private lenders will be on the front line instead.

Another slice of the private market that could be in line for a shakeup is ESG. Using environmental, social and governance principles as a guiding light for investing has grown more popular in recent years. But for private equity, it’s become more popular largely because that’s what LPs are asking for—not necessarily because the firms themselves think it’s the best path to profits.

There are different schools of thought. Much of recent Wall Street history has been driven by the idea of maximizing shareholder value—essentially, that the point of a company is to make as much money as possible for shareholders. More recently, we’ve seen a rise in maximizing stakeholder value—essentially, that the point of a company is to do the most good for everyone whose life it touches, including shareholders but also employees, customers and other citizens. might maximize shareholder value, but it sure doesn’t maximize stakeholder value.

There’s a body of academic research indicating that embracing ESG principles can help increase a company’s profitability. Unfortunately, that’s not always the case. Often, there’s a financial sacrifice. Is it a sacrifice LPs are still willing to make? Early returns suggest the answer might be no.

“It seems like ultimately, it’s going to come down to the LPs themselves, and the LPs are going to have to say: How do we prioritize ESG versus pure financial return? And are we willing to take less of a return in order to be positive on the ESG side?” Colaco says. “That’s an easier decision when everything is good. It’s going to be a much harder decision now that things maybe aren’t as rosy in the equity markets.”

KKR’s proof of concept

KKR is a key player in Ownership Works, a nascent nonprofit that’s working to give employees at private equity-owned companies a piece of the industry’s profits. On Monday, the firm provided the collective with an early success story.

KKR agreed to sell garage-door maker CHI Overhead Doors to steel producer Nucor at an enterprise value of $3 billion, logging a roughly 10x multiple on its original equity investment—the firm’s highest-returning buyout in the U.S. in more than 30 years, per the Wall Street Journal. Thanks to an employee ownership program installed by KKR, about $360 million of those profits will go to CHI employees, including an average payout of $175,000 to all hourly workers and truck drivers.

Launched last month, Ownership Works is an alliance of investors and bankers that includes 19 private equity firms that have pledged to implement similar ownership programs at a small group of portfolio companies. The idea is that giving workers a financial stake in a company’s success creates incentives that lead to better financial outcomes for everyone. The group was founded by KKR partner Pete Stavros, who provided some more proof of concept for the idea last year: Employees received about $500 million of KKR’s $4 billion profit when the firm exited an investment in Ingersoll Rand.

Private equity has a reputation for rapaciousness. And to be sure, there are plenty of buyouts that don’t work out too well for the rank and file. But these days, private equity is a big, sprawling industry encompassing many kinds of deals and many strategies beyond the traditional slash-and-burn.

As the original barbarians at the gate, KKR helped establish the leveraged buyout as a fearsome corporate weapon. Now, it wants to pioneer what it considers a much friendlier approach. Said Stavros: “When you invest in employees, positive results will follow.”

Buying the dip

It appears that a venture downturn is upon us. In some ways, it’s just what firms like MBM Capital, Stage Fund and Ginkgo Equity have been waiting for.

All three are venture investors that specialize in backing startups that have lost favor with traditional VCs for one reason or another—maybe growth is slowing, or maybe the target market is just too small. MBM, Stage and Ginkgo try to swoop in and restructure these companies to clean up their books and set the table for a more modest exit.

It’s one thing to hunt for these kinds of deals in a red-hot market like last year’s, when everyone seems to be growing and funding is plentiful. It’s another thing entirely to do so today, when layoffs and lowered valuations have begun to dot the venture landscape.

My former coauthor Becca Skzutak may have left this newsletter. But before departing Forbes, she took a look at how these firms are navigating the VC market’s shifting tides.

Apollo eyes life sciences with Sofinnova

Add Apollo Global Management to the list of private equity heavyweights dipping a toe into early-stage healthcare investing.

The firm announced on Monday that it will acquire a minority stake in European life sciences investor Sofinnova Partners, part of a new partnership that also includes a commitment of €1 billion ($1 billion) from Apollo to Sofinnova’s funds. For Sofinnova, access to Apollo’s vast resources should allow for accelerated growth. And for Apollo, access to Sofinnova’s industry expertise should create new opportunities for significant returns in a high-growth sector.

Some of Apollo’s rivals have had similar ideas. In April, Carlyle Group agreed to acquire Abingworth, another life-sciences venture capital firm headquartered in Europe. Back in 2018, Blackstone acquired venture firm Clarus, which now operates as Blackstone Life Sciences. Sofinnova was founded in 1972 and claims about $2.5 billion in assets under management, giving it a profile strikingly similar to that of Abingworth; the latter was founded in 1973 and manages around $2 billion.

Apollo co-president Scott Kleinman described healthcare and life sciences as a “significant growth area” for the firm. Sofinnova closed its most recent flagship fund in October with €472 million in commitments.

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