Unsure about the benefits of private equity backing? Don’t be. It turns out that “Private equity backed, middle market businesses have a long history of outperforming their non-private equity-backed counterparts,” said Pat Morris, the President and CEO at the Association for Corporate Growth. New research shows that even during the Great Recession, private equity backed companies fared better, experiencing higher asset growth and increased market share relative to their peers.

Last year was no exception, with a record year in fundraising. Large institutional investors - i.e. mutual funds, etc. - have increasingly allocated their funds under management to private equity rather than to the public markets, enticing companies to stay private longer and reap the rewards of a seller’s market.

In a recent webinar, NetSuite featured a panel of industry experts to discuss these trends and others within the private equity market. Panelists included Pat Morris, Sal Fira of Grant Thornton and Cheryl Vijjeswarapu from NetSuite’s dedicated global Private Equity Practice. The session was moderated by Tom Stewart, Executive Director of the National Center for the Middle Market (NCMM).

Skyrocketing Valuations

It’s no secret that there is an exceptional amount of dry powder in the market right now. As funds under management have reached record fundraising levels, private equity firms are finding fewer attractive deals due to high asset prices. Thus, middle market M&A activity has been relatively steady in recent years, despite the influx of cash. Moreover, proprietary deal flow opportunities have dried up, so the landscape has become incredibly competitive and valuations are skyrocketing.

Increased competition has led private equity firms to reevaluate their investment structure, adopting more flexibility in their approach. In today’s market, it’s not uncommon to see private equity firms represented in early series rounds. By taking minority stake positions earlier in the lifecycle of a company, PE firms gain a more advantageous position for later.

“Buyout funds are willing to give up control to get in earlier and outpace the competition,” Fira explained.

Buy Small, Sell Big

In addition, deal strategy has evolved in the last several years to reflect current market conditions. “‘Buy low, sell high’ has been replaced by ‘buy small, sell big,’” claimed Vijjeswarapu.

In other words, hold times are increasing and add-ons are happening earlier in the investment horizon. Rather than buying companies merely because of their financial strength, private equity firms are targeting companies that they can combine in a meaningful way to increase returns.

These new add-on strategies, coupled with abundant dry powder, however, have created concern. “Some people have suggested that private equity may be over paying for deals,” Fira said. But the add-on strategy in this case is intentional. “Because add-ons are usually smaller, non-expansion growth businesses, you can usually get them at a fairly good price,” he suggested. By doing more add-on transactions, firms can average down the multiple and gain a better return.

The Rise of the Digital Operating Partner

While overall market strategy and structure has changed, so too has the role in post transaction value creation. No longer are firms just sourcing and executing deals.

“More and more, we are seeing private equity firms with dedicated operating partners or advisory teams,” Vijjeswarapu said. Operating partners act as independent advisors to private equity firms, using their sector or functional expertise and experience to increase a portfolio company’s value through greater operational efficiency and acumen.

Within the operating partner role, niche functions such as “digital operating partners” are emerging. These individuals are tasked with looking at the portfolio from a technologically strategic lens and assessing potential synergies within the portfolio. This includes not only assessing the software and technology in place at an existing investment, but also asking the question, “are we acquiring a company that can provide a service to the rest of the portfolio?”

An Influx of Dollars or Knowledge?

In such a complex and competitive market, both buyers and sellers often struggle to align expectations and find the right fit.

Buyers are far more experienced in communicating exactly what they are looking for, explained Morris. “Private equity firms are focused on expanding their knowledge in particular industries or verticals and sticking with that. They are looking for companies with a strong management team that can help with employee morale and stability during a transition.”

But while they may be able to articulate their message, private equity firms lack differentiation. “It’s important for a seller to find out where they want support. Do they want a capital provider? Or do they want someone who is going to help them grow their business?” explained Fira. In other words, sellers must discern which buyers will add value in dollars, which will add value in assistance, and more importantly, which type of investor they are looking for.

Watch the on-demand recording of this webinar to hear more insights from the panelists.

Thinking about selling your business? Tune into the next installment of our private equity series with leading investment back, JEGI, to learn how to prepare your company for investment and attract the right investors