With the first quarter of 2023 now behind us, investors are hoping the rest of the year will bring them a level of certainty. Depending on who you talk to, there are differing opinions on the outlook for the remainder of the year.

Layoffs are occurring across multiple sectors. Inflation and interest rate hikes have caught up to the consumer. Businesses that provide goods and services to those consumers, both directly and indirectly, are feeling the impact. All of this would suggest a less optimistic outlook, making it difficult for investors to justify EBITDA multiples that have not yet been recalibrated to reflect current market conditions.

While the lower middle market, a “sweet spot” for Independent Sponsors, has remained fairly active, it is not nearly as dynamic as what we experienced in 2021 and 2022. Acquisition finance is readily available through non-bank lenders but it has become expensive. Traditional banks and senior lenders have pulled back so there are fewer options for getting deals done.

Our discussions with several investors who have traditionally targeted Independent Sponsors – including SBICs, family offices, and private equity – have painted a concerning picture. Capital providers, who understand business cycles and the macroeconomic environment, are seeing additional risk associated with Independent Sponsor-backed deals. This means equity sources are shrinking as fewer providers will back stop Independent Sponsor capital needs.

The good news is that capital providers who are 100% committed to the Independent Sponsor model still exist along with a dedicated strategy for an asset class more willing to ride the wave of uncertainty. This makes it imperative that Independent Sponsors know who to approach for capital as time is never on one’s side when trying to close a transaction. Debt and equity are unlikely to be as free flowing and accessible as we have seen over the past 24 months.

Differentiation through value creation

Differentiation – through a comprehensive value creation plan that is both realistic and executable – is a key opportunity for Independent Sponsors moving forward this year. This is especially important since investor scrutiny, which includes a comprehensive diligence process, is back in full force. Innovative structuring of a transaction through earnouts and seller notes, which relies on EBITDA multiple arbitrage and the like, will no longer be sufficient to close deals.

So, how do you develop a value creation plan and what does value creation entail for Independent Sponsors?

While a value creation plan means different things depending upon the nature of an industry, the type of business, and the level of sophistication of the organization, it generally focuses on low hanging fruit as a starting point and works its way into more complex areas moving forward.

Value creation strategies are typically composed of:

• Revenue/sales growth strategies that focus on top-line improvement, pricing, sales force effectiveness, and customer development
• Operational strategies including cost optimization, process improvement, supply chain optimization, insourcing vs. outsourcing, and finance transformation
• Human capital and change management strategies that may involve reassessing the organizational structure, management teams, and benefits and compensation plans to better align with revenue and performance goals

Layered across each of these three core value creation strategies is digital transformation/technology that enables tracking, measurement, efficiencies, and integration. Digital transformation is core to each component of the value creation plan.

It is important to embark on a value creation plan that won’t cause too much disruption all at once. The plan must be designed to be flexible and nimble as it may need to pivot to address changing market conditions. The strategic plan for any business should incorporate the value creation plan and clearly define specific areas for improvement within the existing business as well as growth plans (such as expansion through existing and/or new products or services).

A value creation plan typically begins with an assessment of the current state of operations, finance, and information technology that identifies gaps and areas for improvement. The assessment provides the foundation for development of a roadmap to address key findings and implement recommendations through the building of a 100-day and beyond plan.

Recently, ESG has become a key driver for businesses and for the investment community. Independent Sponsors that discount ESG do not fully understand how an integrated ESG strategy can enhance the overall value creation plan, creating a more attractive platform for both current and future investors. While an ESG strategy can add value to a targeted acquisition, institutional investors – including credit platforms – have ESG reporting requirements to their LPs. Having ESG KPIs and goals that are measurable and relevant can add significant value.

While everything mentioned here may seem intuitive and logical, properly documenting and articulating the value creation plan to stakeholders is extremely important. Without a solid value creation plan in place that is effectively communicated across the organization, Independent Sponsors may find themselves unprepared for the rigors of escalating investor diligence. This may mean that they will be unable to close a deal that, 12 months ago, had investors clamoring to provide the capital.

Contact

Claudine M. Cohen, Managing Principal, Value360 Practice

646.625.5717