Booming private equity is sticking to the fundamentals as rates start to move

As the costs of capital increase, private equity investors are staying focused on growth potential, the right teams and preferably a technology angle

Growth companies need investors, and the maths for both sides are heavily influenced by interest rates. Now that the Bank of England and the US Federal Reserve have started raising rates, albeit from record low levels, how will higher costs of capital affect that courtship dance?

Private equity firms typically borrow to fund part of their acquisitions and when rates are low, they have more money available. When interest rates have been low for a prolonged period, as they have been for the past decade, private equity funds also attract money from investors because returns on other forms of savings and investment are so low. As a result, the industry is booming: CVC has raised €16 billion (£14.4 billion) for deals across Europe, including the UK, and in July 2018, US private equity giant Carlyle raised a record $18.5 billion to invest in North American deals, exceeding its target for the fund by $3 billion.

Higher interest rates and higher costs of capital will undoubtedly start to affect the prices of assets being chased by all that money. But equally, private equity investors are looking to sell previous investments. “To some extent, private equity can thrive in any interest-rate environment,” says Kevin McCarthy, a partner in Mishcon de Reya’s corporate practice in London and head of the private equity group. “Private equity institutions are both buyers and sellers at any point in the cycle so, to some extent, it’s a zero-sum game – value can be derived whatever the economic landscape. However, it is in a changing economic climate that real opportunity arises.”

For growth companies seeking investment, price really should not be everything;

taking time to assess and choose the right private equity partner is of fundamental importance.

McCarthy believes there is still a perception in certain quarters that private equity comes in and embarks on a massive cost-cutting exercise, taking the company back to the bare bones before selling it at a profit. “That narrative is just wrong,” he says. “Private equity will assess a target business and then implement those things that need to be done to help the company realise its full potential. Many of these things involve investment, development and growth of people, networks and skills. The firms I work with choose very carefully where they’re going to spend their money.”

There are funds specialising in every sector, and whether the company needs to finance its expansion or bring in new expertise once it has outgrown its start-up model, private equity investors will be hands-on, sharing the experiences they have gained over years in the industry.

“Finding the right backer is just like finding any partner; both parties must be aligned from the outset in terms of buying into and sharing the vision that the business has and understanding the growth potential of the market,” says Adam Blaskey, founder of business members’ club and meeting space The Clubhouse. “However, more than anything the backer must believe in the management team to deliver this vision.”

Changing macroeconomic factors will not change the essence of what private equity funds look for when they’re seeking to invest. These are:

  • The product itself – is it scalable, does it have a future, where is the growth potential?
  • The financials – is the business model profitable and could it be made more profitable over the three-to-five years of the investment in order to generate good returns for the private equity fund’s investors when it’s time to exit?
  • The right people – for early-stage companies, this is the top priority because the CEO is probably also the founder. Is there a robust team running the business?

Private equity funds are also increasingly interested in technology-based companies, with the ICT (communications, computer and electronics) sector accounting for 33 per cent of all deals in the UK last year, the largest industry ahead of consumer goods and services at 21 per cent, according to the British Private Equity & Venture Capital Association (BVCA).

Iglu, the UK’s largest independent ski and cruise travel agency, is well aware of these trends. Richard Downs, CEO, explains: “Iglu has a distinctive and focused online offering that differentiates it from competitors in a market which is increasingly migrating away from the high street. Our high customer retention rate and excellent customer reviews also helped attract investment.”

Shifting the focus of a company in any sector to the technology platform that supports it – be it finance, health or waste disposal – can add to the valuation, says McCarthy of Mishcon de Reya. Doing so not only benefits the valuation in the event of a deal, it also makes the company fit for the digital future – and that is to everyone’s benefit.

This article first appeared on FT.com.