Outlook for Private Equity in Current Macroeconomic Environment

EMS:
Absolutely. So Pat, to kick off today's conversation, I'd like to learn a little more about Cowen and how you got to where you are today.
PC:Sure. So Cowen is a hundred-year-old independent, full-service investment bank. And so what that means is we offer the full range of services from investment banking, to sales and trading, to capital markets, to research. And Cowen focuses on a handful of key industries, which would include healthcare, TMT consumer, business services, and industrials. M&A advisory services is a core offering, and that's really where I've spent most of my time and most of my career. I personally have focused on sell-side M&A for over 20 years. And I've worked at small boutiques, big boutiques, very large banks, and now Cowen. And so given that experience, I have seen a few market cycles. So happy to chat about what we're seeing right now.
EMS:Absolutely, Pat. And that's a nice segue into the topic of today's conversation. Given everything going on in the current macroeconomic environment, what are your off-the-top thoughts on the private equity industry and M&A activity?
PC:It's a great question, especially for right now. And I actually get that question a lot. So I've had some time to think about it. Look, there's a lot of noise out there right now; recession fears, rising interest rates, supply chain problems, runaway inflation, the highest we've seen since 1981, I actually remember 1981, and now Russia's invasion of Ukraine. All of these things have destabilized the market and created a lot of uncertainty out there.

And so as you look at how that's impacted the markets, we've seen a significant stock market correction. The IPO market is effectively closed. The SPAC market is effectively closed. Just to get a little more detail around that, the IPO market is down 90%, 9-0, 90% year to date. And the SPAC market is similarly challenged. Admittedly, that's compared to a record-setting year in 2021, but this is still a massive and historical correction.

On the more positive side, the M&A market, and particularly the middle market or lower-middle market, remains very much open for business. And I used to have a saying that the middle market never sleeps, meaning that at almost any phase of the cycle there would still be willing buyers and willing sellers. That theory was tested back in the 2008-2009 meltdown. But so far now, we're seeing the M&A market hold up pretty well this year. Private equity investors are sitting on record levels of dry powder, nearly 1.4 trillion in equity dollars. And the companies in the S&P 500 are similarly holding record levels of cash on their balance sheets, nearly $2 trillion. We have seen M&A deal volume come down a bit this year, but again, that's compared to a white hot M&A market last year in 2021.

One thing we like to do is keep in touch with the accounting firms out there that provide quality of earnings services, which has become almost a mandatory part of every sell-side process. And so we think of those as leading indicators of transaction activity. And those guys are still extremely busy and we're seeing three to four-week lead times, which again, is consistent with what we saw last year.

Another anecdotal bit of evidence at Cowen, our pitch volume has doubled through the first seven, eight months of '22 versus 2021, which again, provides some evidence that sellers still want to sell, so that's probably the important first step. To that point, I recently returned from a private equity conference where I met with over 20 private equity firms and every single one of them is still actively hunting for deals, both platform acquisitions as well as add-ons, and not a single firm said that they were putting their pens down or pulling back their horns. So all those are generally positive sentiments.
EMS:Pat, very interesting your perspective on what's going on right now. So as a follow-up question, I wanted to ask you how the current macroeconomic environment has impacted current transactions?
PC:Again, another good question. The short answer is it depends. And I would say in general, we are seeing transaction timelines stretch out a bit. Buyers are keenly interested in how target companies performed during COVID. Was there a COVID bump? How sustainable is that performance going forward as the COVID environment starts to wane? For buyers that are reliant on accessing the capital markets to fund an acquisition, they are seriously disadvantaged. And we've seen a couple deals get derailed where the buyer couldn't raise the funds required to close.

The other key consideration for buyers today is asking the question, how will this company perform in a recessionary environment? So a lot of the buyers that we're dealing with are looking back at past cycles to see how the target companies performed. And they're getting increasingly focused on what happened last quarter, last month, last week, yesterday to look for signs of softness.
EMS:And Pat, as a follow-up question, how is the current environment impacting deal valuations in both the level and type of due diligence that's being performed right now?
PC:Yeah, valuation, that's always the $64,000 question. Look, from our perspective, there are certainly some negative pressures on valuation in the market right now. No doubt about it. Most notably, rising interest rates, declining stock prices. And then depending on the company or the industry, you might see some softer performance. That said, we haven't seen those dynamics translate into major changes in multiples in the middle market and lower-middle market. I would expect to see lower-quality companies will feel more multiple contraction, certainly more than A-quality businesses. And for A companies, we're still seeing very strong, double-digit EBITDA multiples in many processes.

There does tend to be a flight to quality when you get into unsettled or more volatile markets. And I fully expect we'll see that here this year, next year. But one thing to point out, it's no surprise that the debt market have a major impact on M&A multiples. But again, in the private credit markets, which really drive lower and lower mid-market deals, we have not seen much pullback in absolute debt levels. Those lenders are still very much open for business. And while interest rates are ticking up, we haven't seen a significant pullback in absolute leverage available, again, for higher-quality deals.

In terms of the level and type of due diligence we're seeing, again, not seeing major changes there. Timelines are stretching out. I think a lot of that is buyers are very interested in and focused on real-time performance, and again, a real heightened focus on how might this business or this industry perform in a recessionary environment. And we weren't fielding those types of questions that much a year ago.
EMS:Pat, that segues nicely into the next question I'm going to ask you about. Which industries do you see being presented with the greatest challenges as it relates to M&A, and on the other hand, where do you see the greatest opportunities looking ahead?
PC:Yeah, no, it is an interesting topic. And given the broader economic and market conditions and the volatility I touched on earlier, buyers are gravitating to the traditional safe havens that are perceived to be less vulnerable to economic cycles. So that's sectors like food and beverage, pet, aerospace and defense, healthcare. Those are all good examples of sectors where investors tend to get more interested in during economic down cycles. We've got several active transactions going on across those industries right now, and buyer interest remains exceptionally strong. And those companies are continuing to perform, which is also really important.

Another sector that's getting a lot of attention is home services. That's been very much in favor for the last couple of years. And we're continuing to see really strong valuations, double-digit and mid-teens- level EBITDA multiples with really no discernible falloff versus last year. Software, SaaS businesses, especially those with subscription and recurring revenue stories, also continue to receive exceptionally high multiples of ARR. And some of those ARR multiples start to feel like EBITDA multiples, which boggles my mind.

Now, on the flip side, buyers do have their antennas up when looking at sectors that are more discretionary in nature. So specialty retail, restaurants, hospitality, other real discretionary items, pleasure boats. That's always a sector that struggles during economic down cycles. COVID was an interesting impact on the market. All the COVID relief measures of the last couple of years put a lot of cash into the system, which clouds the picture a little bit. Everyone's sensitive to businesses that may have outperformed during COVID. And again, they're trying to figure out how real was that strong performance and what can we expect going forward?

One good example of that, we sold a business late last year that designed and marketed high-end ergonomic seating solutions. So think fancy, really comfortable office chairs. And this business really boomed during COVID, as everybody was kidding out their home offices. And so buyers were naturally concerned that what does that trend look like? So we conducted a lot of industry research that demonstrated that the home office trend is here to stay, even as people start to go back to the office. And so I actually saw a headline this morning that confirmed that thesis. So in some cases, we need to do a little extra homework to get people comfortable.
EMS:Pat, ESG continues to be more prominent in evaluating companies. And I wanted you to discuss how you've seen dealmaking being impacted by this?
PC:Well, ESG has been front and center for Cowen for several years. And we are seeing heightened levels of interest in and focus on ESG really across all sectors. Companies across the board are increasingly focused on their environmental footprint. And we've seen real change in emphasis placed on diversity and inclusion, both at Cowen and within our clients.

In California, where I live, the impact of climate change is really center stage for us as our state has been struggling with brutal wildfires in recent years, so much so that they're becoming an expected part of every summer, and sadly, people are starting to plan vacations around wildfire season. For many investors, ESG is a core part of their investment criteria. And in fact, we're seeing more and more funds where ESG may be the most important criteria.

Early last year, Cowen became one of the first major Wall Street firms to assign an ESG rating to each of the 800 public companies followed by our equity research analysts. And as a result, we are providing investors with an unbiased quantitative assessment of each company which gives them the ability to compare similar companies and their relative commitment to ESG, which we think is really unique and differentiated.
EMS:Pat, we've covered a lot of ground today, and I wanted to see if there are any final thoughts you would like to share with us?
PC:It does make me think of a quote that Confucius said or was rumored to have said, which was, "May you live in interesting times." And we are certainly living in extremely interesting times right now. Given some of the geopolitical issues that we're facing around the world, maybe a bit too interesting. And that said, I've always looked at the market through a pretty simple lens and evaluated it with what I would call the fear-greed meter. And in strong markets, that fear-greed meter seems to be pegged on greed. When the markets get choppy, it invariably swings hard to the fear side. It almost never sits comfortably in between.

I do think one of our biggest challenges for the next year or so will be in managing seller expectations as valuations cool off a bit. Sellers, especially owner entrepreneurs, tend to get anchored on the high multiple they heard about from a friend or read about in the paper, and educating them as to what is currently realistic takes effort and takes time. We're going through that reeducation process right now with several clients.

But on the positive side, the M&A market is not only alive and well, we are still achieving historically strong outcomes for our clients across a range of industries. We remain fully committed to guiding our clients through the long and sometimes arduous transaction journey. And I would say we are cautiously optimistic for the remainder of 2022 and into 2023.
EMS:Pat, I wanted to thank you so much for sharing your perspective with our listeners. And thank you for listening to the EisnerAmper Podcast Series. Visit eisneramper.com for more information on this and a host of other topics, and join us for our next EisnerAmper podcast when we get down to business.

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