Among the chief pressures that middle-market businesses have faced in the past year, which do you see carrying over to next year or growing even more intense? What about for PE fund managers?
Jim Meade: We anticipate the impact of rising interest rates on variable-rate debt will become more significant in the coming year. When speaking with clients in the past several months, we’ve learned that increased personnel costs and costs of goods and services continue to be the norm, and certain industries are still affected by staff shortages and supply chain constraints. Clients are strategizing to reduce expenditures through outsourcing noncore functions, reducing variable-rate debt, offshoring for cost-effective labor, and utilizing technology in new processes.
While supply chain issues have improved in the past year, there is still disruption, and the continued rising cost of goods and services has placed significant pressure on gross margins. In 2024, we expect to see increased pressure on EBITDA, cash management, and debt covenant compliance.
On the PE/VC side, the rising cost of capital and market uncertainty are major concerns. As interest rates increased, it became more expensive to leverage acquisitions and investments, which could have led to lower returns on investments. Market volatility and uncertainty also makes it harder to accurately assess the value of target companies, which has resulted in delaying both acquisitions and portfolio exit plans.
There are plenty of funds available to deploy, and at some point, these funds’ managers will begin to deploy them in the form of acquisitions. However, deal multiples have decreased and will continue to be down from the highs we saw in recent years. This is particularly true in later-stage capital raises.
Which are the most intriguing and/or challenging concerns that your clients are bringing to you, and why?
Jim Meade: Clients are concerned with the pause in M&A activity due to the downward pressure on deal values and cost of credit/capital. Except for the manufacturing and distribution sector, where supply chain issues still exist, growth remains strong; however, margins and bottom lines are contracting.
Technology clients (such as software-as-a-service providers) have significant cash needs to support sales growth and the continuous development of software/products. The cost of capital/debt has become, or is becoming, a significant challenge for earlier-stage technology entities.
Also, we have observed that the scarcity of quality in-house accounting staff often resulted in transaction delays or errors or changes in revenue/income which were discovered in pre-transaction diligence or audits. Making the investment in the right financial partner well before a transaction is anticipated will help ensure there are few surprises and delays when that time comes.
Which regulatory and/or tax issues are you watching most closely, and why?
Lisa Nix: The applicability of sales taxes has been recently underestimated by many buyers and sellers, particularly within the healthcare industry. There is a common misconception that healthcare is immune to the complexities of sales tax, but this assumption is far from reality.
Durable medical equipment, prescription drugs, medical appliances, and healthcare diagnostic equipment often catch healthcare providers and suppliers off guard, as qualifications for sales tax exemptions in these areas are based on specific criteria that varies by state.
Another common misconception in the healthcare industry is that if a product or service is reimbursed by Medicare or Medicaid, then it automatically qualifies for a sales tax exemption. However, this is not always the case.
It’s essential for businesses in the healthcare industry to research and understand the specific tax treatment of their offerings in each state where they operate. For healthcare industry players as well as others, addressing sales tax issues is not just about compliance; it’s also about protecting your financial health.
Multiple years of incorrect compliance or inattention can generate significant and unforeseen sales tax liabilities. These liabilities can directly impact EBITDA, which is a critical metric in assessing a company’s financial performance.
Which risks in the current market do you think are still underrated and should prompt more heed?
Lisa Nix: As noted, the scarcity of quality accounting resources, lack of appropriate financial expertise employed during a deal process, and/or the lack of a timely investment in financial systems and processes persist as common “pain points” for many buy-side due diligence processes in the middle market.
Given the current economic environment, buyers are even more cautious and disciplined during the deal process than in previous periods, when the cost of capital was much lower. Sellers that are looking to achieve a maximum valuation should not overlook the importance of being prepared for a deal process and sell-side due diligence. If buyers have tremendous difficulty in determining the quality and realizability of pro forma earnings due to lack of relevant and reliable financial data, values and deal structures become less favorable to sellers.
The availability of quality financial data that supports real-time financial and operational decision-making is a business imperative. If sellers have gaps in their data, buyers will immediately begin to question the additional cash investment needed to address these risks and exposures. Achieving data quality and data security is essential before any AI strategy can be adopted and successfully executed, which is top of mind for many buyers today.
How are you advising clients as it relates to leveraging the adoption of Artificial Intelligence (AI) efficiently?
Jon Hilton: Between inflation, recession, workforce struggles, and hindered access to capital, businesses will sink or adapt so they can swim. A big part of adaptation will occur in the AI space. This has already affected all aspects of the PE landscape.
AI adoption is much like the adoption of any new technology or process in a company. Following a deliberate plan and taking measured steps in innovation are the key to unlocking AI’s potential. A good way to think of AI adoption is to apply a three-step approach:
- Strategize: Find the area or business process that is the best place to start with AI adoption. This would likely be a highly manual process or one that involves reviewing a lot of data or forecasting the future based on historical data.
- Organize: After finding that first business process, get your data “AI ready.” This means understanding how data flows through that process, who handles that data, and where it is stored. Next, the data needs to be organized and structured in the cloud to be available and accessible by AI models. As long as data remains scattered, unorganized, and stored in various systems, it will remain inaccessible to AI models. Think of data as the fuel for an AI engine.
- Apply: Start experimenting with AI, even with small subsets of data. This is about learning and innovating on a small scale to move into larger-scale applications.
You can follow this framework to scale AI across your organization. An additional strategy will need to be developed to create a roadmap of which business processes and areas you will address based on business prioritizations.
Report Summary
Deal-making in 2023 is viewed as the start of a five- to eight-year growth cycle for private equity. Anticipating a sell-off of lower quality investments, PE firms will “bet on the bottom” despite lingering market uncertainty through 2024.
Only 5% of our business executives surveyed expect an infusion of cash from private equity firms; however, analyst predictions reflect the optimism of these executives to focus on growth and vision for 2024.
