This opinion piece article first appeared in Alphaweek on 28 November 2022
The macro picture is driving more intense due diligence
We are in a difficult economic environment where the cost of capital has risen sharply at the same time that growth has been decelerating. These are unusual conditions and central banks are prioritising tackling runaway inflation above other considerations.
Current inflation stems from a combination of unprecedented monetary expansion and supply/demand imbalances. The supply side has been knocked out of kilter by global lockdowns, Russia’s invasion of Ukraine, and China’s commitment to its zero-Covid policy.
Together, these risk factors are playing a larger part in the equity story, forcing analysts to delve deeper into companies’ pricing power, supply chain resilience and counterparty exposure. Now more than ever, PE funds’ deal teams are scrutinising entire value chains – from suppliers through to customers and even direct competitors – to identify hidden strengths and weaknesses.
Private equity firms now depend on research partners that can pinpoint key relationships and potential fragilities. This is a challenge for some research providers because value chain information is often outdated, fragmented, asymmetric and even unavailable to them.
To meet these extensive and time-sensitive challenges, research firms need to partner with PE investors on shorter-cycle due diligence workstreams and adjust their focus to where it’s most needed. This includes a greater emphasis on stress-testing contrarian viewpoints – which bodes well for research partners who can source and deliver expert observations acquired through past crises and previous business cycles.
Large and mega-cap fund managers are putting more emphasis on deal sourcing and focusing on strategy work
The high velocity of deals coming from investment banks has slowed to a halt, pushing larger private equity firms into more proprietary deal sourcing.
This is having a pronounced impact on research requirements. PE fund managers have highly structured and often specialised deal teams, that are now having to place a larger emphasis on sourcing deals themselves. Doing this well can put PE firms at a competitive advantage. They often stand a better chance of convincing management teams to transact than investment bankers do, by demonstrating an intimate knowledge of the sector and the company in question.
However, proprietary deal sourcing is both time-consuming and resource-intensive. Therefore, a premium is being placed on research providers that can reliably identify and assess thematic trends and companies that are ripe for investment and strongly positioned to benefit from secular tailwinds.
At the same time, large and mega-cap GPs are shifting towards more active ownership, for a number of reasons. In times of economic expansion, low rates and freely available credit, asset valuations rise. The reverse is also true. PE firms can no longer rely on leverage and multiple arbitrage for returns. Instead, fund managers are having to be more operationally minded to create revenue and margin growth. This requires more strategy work to optimise portfolio companies and achieve value creation with carefully selected bolt-on acquisitions.
Mid-market PE remains busy and is finding new ways to accelerate due diligence
With the macro picture having dimmed and investors pivoting away from sub-investment grade debt, lenders have pulled back from financing large buyouts. The mid-market is currently private equity’s busiest segment, largely because mid-cap funds can leverage alternative credit sources. Even so, deal volumes have fallen in the latter half of the year so competition for quality assets is intense.
To mitigate against this, managers are keen to accelerate what can be lengthy due diligence processes. This favours agile research providers that enable PE managers to move faster by providing bespoke insights into niche industries and sub-sectors.
The best mid-cap deal origination teams continuously develop relationships with CEOs. Right now, they are reaping the benefits of that groundwork and the track records they have developed in operational value creation.
These teams require support, however, and consequently, our mid-market research volumes are currently elevated. We have seen deals with over ten sponsors vying for a particular asset and conducting deep due diligence across the entire value chain. These deals are highly competitive and have rapid time frames. Overall, this period of turbulence is putting the investment research sector to the test. These times call for closer engagement with clients and that has to be a good thing. As an industry, we need to be much better at understanding our clients’ workflows and needs. We must move towards more tailored servicing, ensuring the timing, structure, and content of what we produce reflects what clients need. PE firms are growing tired of hit-and-miss, undifferentiated, low-quality research. They are having to pivot and adapt to a unique set of challenges – and we have to adapt with them. This is the time for research firms to step up.
