Private Equity Dealmaking for Primaries, Secondaries & Co-Investments

Andrew Bernstein:

Thanks very much for having me. It's my pleasure to be here.

Elana Margulies-Snyderman:

Absolutely, Andrew. So, to kick off the conversation, tell us a little about your background and how you got to where you are today.

Andrew Bernstein:

Sure. So, without going too far back, before I came to Capital Dynamics, I'd spent the first decade of this century, I spent that period of time in mezzanine debt. And then as we got into the financial crisis, there weren't a whole lot of new deals getting done, new buyouts to do, and so started looking around for something else and I got introduced to Capital Dynamics. I hadn't been familiar with this firm up to that point. But as I learned more, I was really intrigued by a lot of the stuff that Capital Dynamics was doing, really pioneering a lot of areas within private equity, first in securitization of private equity, and then really being one of the first players in both secondaries and in co-investments. So, I made the jump over here back in 2009, and it's been off to the races ever since.

Elana Margulies-Snyderman:

Thanks for sharing your journey, Andrew. So, in terms of focus on private equity, primary, secondaries, co-investments, I would love for you to share your outlook for dealmaking in those areas.

Andrew Bernstein:

Sure, I'll take each one of those separately, and they're somewhat interconnected. It's been a difficult fundraising environment over the past few years, largely because there haven't been a lot of exits, and so LPs have been short on capital to make new commitments. What that's led to is many, many managers being in the market trying to raise capital all at the same time. And so, for our primaries business, it's a challenge on the one hand because there are a lot of our existing managers that we want to continue to re-up with. But with so many back in the market at once and us really not trying to change our normal cadence of investing in a balanced and measured way across vintage years, it's forcing us into some pretty difficult decision. We can't necessarily even do all of the re-ups we want to do and have room for new managers at the same time. I think it will result in us being super selective and having a pretty strong selection of managers that we ultimately choose to commit to during this period where there are so many managers in the market at once, but it creates some difficult situations. For secondaries, there's a knock-on effect from this difficult fundraising period where managers that are having difficulty and taking longer to get their funds raised.  They are beginning to invest their funds during their fundraising period and by the time they get toward their final close, in some cases, half the fund has already been invested and some of those deals are already marked up and so what that does is create early secondaries or late primaries where we can make a secondary commitment in a primary that has all the attributes of secondaries. And at the same time, the other thing that we've seen in the secondary market is the emergence of continuation vehicles becoming a very significant part of the market, where managers finding that the price available in the market for assets they want to exit is not attractive. So instead, they put that asset into a continuation vehicle in order to create an exit opportunity for the investors in their fund, and then that allows us to through a secondary invest in an asset that wouldn't otherwise be available, typically very strong attractive assets, really beacons of their industry that managers just want to continue to own. We're very pleased to be seeing those opportunities in secondaries land. And then the effect of the difficult fundraising market on co-investment has also been interesting, where on the supply side, the supply of co-investment opportunities has gone way up as managers have less capital to deploy. When it's more difficult to fundraise, they're tapping into the co-investment market more. But then at the same time, the same LPs that are not as active investing in funds also aren't as active investing in co-investment deals. And so with supply up and demand down, what that's translated to for investors like ourselves who continue to be very active in co-investments is sort of an embarrassment of riches when it comes to deal funnel and the amount of opportunities that we're seeing come across the transom over the past year or two. It's really exploded and is allowing us to be that much more selective and raising the bar and choosing which deals to ultimately commit to.

Elana Margulies-Snyderman:

Andrew, as a follow-up to that question, I would highly welcome your thoughts on some of the specific greatest opportunities you see in those spaces and why.

Andrew Bernstein:

One of the themes that we've been investing behind is the reshoring of manufacturing back to the United States. During COVID and then the supply chain crisis, what we saw was that this country is really far too dependent on countries in faraway places for many key inputs and products, things like pharmaceuticals and semiconductors. And so, there's been a big push to bring that manufacturing back on shore here in the United States. Many of the investments that we have done over the past year or so have really been benefiting from that tailwind.

Elana Margulies-Snyderman:

Andrew, on the other hand, what are some of the greatest challenges you face in this space? I know early in our conversation you touched upon fundraising, but I'd welcome your thoughts and other hurdles you're up against.

Andrew Bernstein:

Yeah, that's an interesting question. One of the things that we bump up into particularly in our co-investment business is the presence of what I would call less sophisticated investors in the market. What I mean by that is when we're making a co-investment, we're pretty rigorous in our demands of the manager in terms of the information we require, the access to the management team. And in many cases, what they'll tell us is that the other co-investors that they're talking with are not asking for all those same things, and why do we need all this special treatment? From our perspective, we're not really asking for anything out of the ordinary. They're basic things that we really need to know about the company that we're contemplating making an investment in. But we find that a lot of other co-investors just really rely quite heavily on the manager itself and trust them to be making a good investment if they've already made a commitment to that particular fund. For us, we do all of our own work, so it makes it more difficult for us to get our work done. I'd say that nine times out of 10, we do get what we need. And if we don't, we simply aren't going to proceed.That's not our style to invest blind like that. But more often than not, managers do appreciate having a more sophisticated, reliable partner like ourselves as part of their equity syndicate and will accommodate the needs that we do have.

Elana Margulies-Snyderman:

Andrew, to shift gears a bit, I would love to discuss how the current climate has impacted dealmaking and transactions.

Andrew Bernstein:

Right. Obviously, we've been in this market over the past year or two now where interest rates have shot up, and that's put a real clamp on the deal market. There's been a real gap between bid and ask in the market, and a lot of managers are holding off on selling companies. But the companies that are trading tend to be industries that are thought to be more resilient, things like healthcare, food, IT. And those assets, which are performing really well, are still trading. And it's given rise to an interesting phenomenon where despite the rise in interest rates, the market multiples that we see, industry averages, have really held up quite well. The reason for that is the complexion of the deals that are trading in the market has shifted to be more concentrated in those "more resilient industries," which typically do trade at higher multiples. And so, the more cyclical type companies, industrial type businesses are not trading as much, and those are the types of companies that typically trade at lower multiples.

Elana Margulies-Snyderman:

Andrew, as a follow-up, what are some best practices you advise for companies contemplating both buy-side and sell-side transactions?

Andrew Bernstein:

I guess on the buy-side, really trying to spend as much time as possible with management. It's one of the hardest things to get right is the management team when we see deals that had go sideways after the investment's made to often a result of having the wrong person in the CEO seat or the members of the management team needing to be replaced. It's one of the hardest things to do, especially in an auction type of process where the amount of time that you can spend with management is somewhat limited, but really trying to understand who they are, what their motivations are, making sure that they're aligned. And if they're taking money out of the deal, making sure that their rollover back into the transaction is really very meaningful for them individually, even if it's not a massive amount of capital. That's really one of the things I'd highlight the most on the buy-side. On the sell-side, when deciding to sell a business, one of the most important things...We were just having a discussion with a GP this morning about one of our companies that is going to be hitting the exit market next year, and we're talking about the banker selection process. And that's really critical is choosing the right banker. There are brand name bankers out there that you could hire who can really canvas the market and get it in the hands of every private equity firm and all kinds of different potential buyers but there are really specialized bankers in specific industries that have reach and understanding of these niches. And these bankers aren't necessarily household names. They're quite niche, but those groups can often find the best buyer and the highest price. So, really being thoughtful about the specific banker that you ultimately choose I think is a key factor.

Elana Margulies-Snyderman:

Andrew, I'd like to discuss the due diligence process on transactions and your thoughts around that.

Andrew Bernstein:

One of the areas that we really focus on in due diligence is the veracity of the numbers that are being presented to us. For the last several years, the quantum of addbacks and adjustments that we see to the EBIT figures has really skyrocketed. We spend a lot of time really scrutinizing the quality of earnings. We really want to make sure that we're comfortable with those addbacks and adjustments. We'll often not just review the report that was prepared by a third party that was engaged, but we want to get on the phone with that accounting firm to really understand things. There was a deal that we saw just a year ago that was a company with $100 million of EBITDA that was being presented and it had $105 million of addbacks. Clearly, there was a lot of massaging going on at these numbers. And in this particular case, we didn't have access to a buy-side quality of earnings study. We only had a sell-side available to us, and that wasn't sufficient as attractive as this deal was, we couldn't get comfortable with those numbers and those addbacks, and so we ultimately passed on what seemed like a really interesting investment opportunity.

Elana Margulies-Snyderman:

Andrew, we've covered a lot of ground today and wanted to see if there are any final thoughts you'd like to share with us.

Andrew Bernstein:

Yeah. I'd say private equity is an asset class that it's really important to maintain a consistent pacing and cadence of making investments and commitments across vintage years. It's very difficult to time the market. So, we are very deliberate about not trying to do that and investing a very similar amount vintage year after vintage year. That would be my best advice for those investors listening out there. That said, fully appreciate that there are many investors who recognize that and look back at the years after the financial crisis, 2010-2011, which were fantastic vintages, and they sat out the market and ultimately missed those vintages. And as much as they would like to avoid doing the same thing this time around, they do have constraints on their ability to invest right now based on the nominator effect, as well as just the lack of distributions that have come out of private equity over the past year or two, which makes it more difficult for them to put money back into the asset class. I certainly advocate for increasing allocations in order to maintain a balanced pace and cadence, but I do recognize that's not always possible for certain types of investors.

Elana Margulies-Snyderman:

Andrew, I wanted to thank you so much for sharing your perspective with our listeners.

Andrew Bernstein:

Thank you very much for having me. It's been my pleasure.

Elana Margulies-Snyderman:

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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