Strong Year of LMM Deal Activity Expected in 2021

Private equity is emerging from a tumultuous 2020 in a transformed landscape, with a set of opportunities that would have been impossible to predict 12 months ago. The industry will seek to extend Q4’s rapidly expanding deal volume into this year. Many of the catalysts remain – paused deals and pent-up demand will boost 2021 activity, there is still an enormous amount of dry powder sitting on the sidelines, portfolio companies have largely stabilized and don’t require the same support as last year, and PE firms have adopted to the logistical and analytical challenges posed by the new global economy.

Activity in the lower middle market was discreetly buoyed by strong LBO volumes last year, as funds were taking on divestitures from corporations that were shedding non-core divisions amid the crisis. It’s hard to see this tailwind persisting in a rebound period, so it will need to be offset by increases elsewhere. To fill that void, we are likely to see a return of exit activity, the resumption of larger deals that were deemed too risky during peak uncertainty, and higher multiples pushing aggregate deal value upward. The recovery of credit markets and sustained low rates should also be a stimulating factor.

There are complicated dynamics at play as we move into 2021. Understanding the different factors influencing the 2020 bust-boom arc should set up middle market professionals to manage risks and tap opportunities.

Disruptions will Continue to Influence 2021

It’s not shocking that deal volumes are forecast to rise substantially in 2021 from last year. The catalysts driving activity, however, are unequally distributed across sectors and geographies. Just under half of lower middle market companies reported top-line growth in 2020, down from 75% in the prior year. Net sales expansion is expected for this segment in 2021, but only half of the management teams are confident that they will actually grow. Different businesses are clearly at different points along the recovery timeline.

By and large, the business models that were popular last year are expected to retain that momentum. Telehealth, life sciences, data centers & adjacent businesses, and e-commerce related services (eg logistics, fintech, virtual communications) are set to be good sources of growth and near-term cash flows. Sustainability-focused companies are also commanding attention along with strong valuations. The lower middle market has begun to show particular interest in add-on deals in business services as well as residential services such as HVAC, home renovation, and repair. This is a fragmented space where scale gains could yield meaningful accretion, and funds are positioned to be the beneficiaries of exiting owners who aren’t interested in riding out ongoing economic volatility.

Meanwhile, energy and financials continue to rank among the lowest-potential sectors due to uncertainty and risk. There could be excellent opportunities in overlooked subsectors such as asset management and the midstream, where cash flows were quicker to recover stability and balance sheet values are less contentious. Distressed sectors such as retail, leisure, hospitality, and travel are gaining some clarity and bouncing back in some places, but overall headwinds are sure to produce some capital-draining flops.

Keys to Performance in 2021

It’s going to be easy to get caught up in the fervor of high deal volume, lofty valuations, and expansive recovery. That’s especially true when capital is plentiful and competition is present. That makes discipline and stewardship even more important in 2021. We aren’t out of the woods quite yet, and the world is still changing rapidly.

Valuations still need to be anchored in fundamentals. It’s okay to pay a premium for assets with unassailable growth drivers, or if there’s a clear plan to augment fundamental returns with efficiency gains, but it has to be quantitatively justified. This can’t be lost as a primary piece of any investment thesis. High-multiple deals are bound to be more common than ever, and they can’t be predicated on the belief that valuations will remain high; the current combination of macroeconomic stimulus and institutional allocations is unprecedented, and disruptions to that stasis are likely to trigger an adjustment to valuation norms. To be considered a viable investment option for any fund, consumer-facing companies or businesses in distressed sectors should demonstrate that they gained market share or competitive advantage over the last year. Otherwise, it’s hard to justify what are likely to be aggressive multiples.

Funds should also consider the merits of adapting to new trends and evolving best practices. High-quality financial management processes are even more important among portfolio companies now. Navigating issues like PPP have created accounting challenges, along with potential cash flow opportunities (and risks). While exit activity is likely to tick up, firms should also consider the merits of continuation funds in these unique circumstances. These are poised to become more popular as LPs adjust for the lost year and portfolio companies solidify their roles in the new economy. Building comfort and competency with alternative deal structures could also yield meaningful benefits in a competitive landscape. SPACs, PIPEs, add-ons, and minority holdings all rose in prominence last year, and they are likely to continue playing a more important role as the market becomes more familiar with their merits and processes.

It’s an altered world in 2021 as we return to growth. Middle market firms need to recognize where the new opportunities and risks lie, and the best operators won’t let frothy market conditions dictate their decision making.