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The climate has changed for the private equity investor. M&A is down, valuation multiples are being recalculated and debt markets are tightening. With all this as a backdrop, Rutland Partners’ Will Southgate explains how the special situations firm is investing in the current market.

The past three years have seen businesses face a series of unprecedented challenges. Many have found themselves under intense pressure from multiple angles. Cost inflation, supply chain disruption and general market uncertainty in the wake of the pandemic have all contributed to an extremely challenging operating environment. The sharp increase in interest rates over the past 12 months has exacerbated these issues even further. We’re now seeing a growing number of fundamentally good businesses struggling, both in terms of their ability to service debt and remain covenant-compliant under existing facilities, and in their ability to raise new finance to manage short-term liquidity issues.

The teams that we’ve seen manage these challenges most effectively are those that can react quickly to changing market conditions and adapt their operating models accordingly. 

Absolutely central to this ability is that the business has clear and up-to-date management information so that it can quickly identify where there is a need for change. It also needs sufficiently robust processes to allow teams to actually implement changes in strategy.

Seasoned support

At Rutland, as a special situations investor, we have always sought to partner with teams that are looking for more than just a source of finance from an investment partner. As a result, in many ways the current market plays to our strengths. Operating in such a challenging market for a sustained period can take its toll on management teams. In particular, it limits their ability to lift their heads and focus on longer-term strategic goals. 

That is one of the key areas in which a seasoned special situations investor can help. The process of developing a plan alongside the team forces them to take a step back and critically evaluate recent successes and failures. It gives them the space to develop a strategy for the next few years in what might well be a very different market. 

This then allows the special situations investor to identify areas that would benefit from support or resources, whether that be through additional personnel, investment in operations, or just implementation of better systems to provide a more resilient platform upon which to deliver growth.

Once we’ve worked alongside the team to put together a plan for the investment, our approach as an investor is generally to stay well informed without becoming interfering. By having an up-to-date understanding of the issues faced by our portfolio companies, we are able to move quickly and offer support as and when any problems arise, rather than waiting to be briefed at the next board meeting.

Investment drivers

Our focus has always been on identifying fundamentally good businesses with some element of complexity, which require a more hands-on investor. That’s more relevant than ever in the current economic climate. The combination of a worsening macro-economic backdrop and a tightening lending market means the opportunity for investors to rely on leverage to generate returns has all but disappeared. A level of operational involvement is increasingly becoming essential to deliver a successful investment.

Attractive sectors

We’ve always been fairly sector agnostic, focusing more on the situation and where we can add value. In more challenging economic environments, there is clearly an enduring appeal in sectors such as healthcare or infrastructure services where there is an inherent level of resilience to macro-economic factors. But there are attractive pockets in even the most cyclical sectors, so open-minded investors will do well.

From a financing perspective, our approach to leverage at Rutland has generally been conservative, preferring instead to invest more heavily in equity. This provides greater flexibility to portfolio companies as plans develop. In that sense the tightening financing environment hasn’t significantly changed our investment theses or approach to structuring deals.

Due diligence focus

The volatility of the past few years has shifted the focus of due diligence, in particular around historical trading. While recent performance needs to be understood, it’s less useful as a source of comfort around forecast trading. There is now more focus on understanding how the business has coped with the challenges presented over the past three years. Has the business been able to manage the impact of inflation on margins and, if so, is that sustainable? Did supply chains come under pressure? What sort of disruption did the management team face and how was that addressed?

It’s also very important to form a view on the management team itself and how it has dealt with the past three years. Did management look to take advantage of the situation rather than just battening down the hatches? Has it evolved and refined the systems and processes in the business as market conditions have shifted? This is often a work in progress, and the absence of robust controls and processes in a business can represent an attractive opportunity to add value as a special situations investor. However, such an investor will need to establish a good understanding of what’s required up front in order to make an informed decision on whether to back a deal.

Added value

With private equity deal volumes down and continued pressure on GPs to deploy capital, there has inevitably been increased competition in auctions for high-quality businesses. That said, our focus is on identifying situations with some element of complexity where we can add value. The ability to effectively convey where that value can be added to the seller during the acquisition process tends to be what helps secure a deal over headline price.

Downside protection

Equity investors need debt for deals.After a challenging start to the year there has been a general improvement in lender appetite for new opportunities and refinancings, particularly from credit funds as retail lenders generally remain more cautious. However, with the ongoing level of uncertainty in the market, lenders are more focused than ever on downside protection, and the ability to demonstrate resilience in a downside scenario is key to securing finance for an opportunity. 

This is also reflected in pricing and covenants, and care needs to be taken to avoid putting new investments under immediate pressure around debt servicing and covenant compliance.

Will Southgate, investment director, Rutland Partners, the mid-market special situations investor.

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