Private Equity: Deploying Capital in the New Normal

After navigating the changes created by the COVID-19 pandemic for the last two years, private equity firms have had to negotiate a new set of challenges as it relates to deploying capital and guiding their portfolio companies. Labor pressures, supply chain disruptions and inflation are just some of the factors that have altered the landscape, and everyone has had to adapt.

At BMO’s annual Farm to Market conference in New York, Michael Cippoletti, BMO Capital Markets Head of Food, Consumer & Retail, moderated a panel of financing experts to discuss deploying capital in the “new normal.”

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  Melissa Barry, Partner, New Heritage Capital

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  Tara Cuprisin, Managing Director, BMO Sponsor Finance

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  Joanna Reiss, Partner, Apollo Global Management

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  Kelly Thomson, Head of Capital Markets, Mubadala Capital

Following is a summary of their discussion.

More than two years after the initial shock of the pandemic, private equity firms face a different type of challenging environment. Barry noted that the conversation among business owners has shifted to thinking about recessionary impacts. “How are these businesses going to fare in an inflationary environment?” she said. “It shakes different folks out of the woodwork as the markets are changing.”

With that in mind, private equity sponsors have turned their focus to corporate fundamentals. “Cash flow generation, the robustness of your business model, the purchase price we pay—all those things that you've read about in college textbooks matter now more than the momentum trade that has been so effective recently,” Reiss said.

Reiss highlighted labor as a particularly difficult challenge for companies today. She noted that even when inflation begins to subside, the pay raises required to attract and retain employees will remain. “We’re never going to be able to fill those roles for the old rate again. How is it possible that we have not entered a permanently higher cost basis in a lot of aspects of our business? Efficiency gains are not likely to exceed that cost pressure, leading to price increases companies just have to take.”

On the positive side, Cuprisin said companies have emerged out of the mode of constantly putting out fires and have returned to focusing on growth again.

“We saw a lot of businesses stop investing in R&D during COVID,” Cuprisin said. “We saw fewer new products come to market, and we saw less innovation and development during COVID. Seeing them start to return to putting new lines in and working on investing in R&D, that's been really interesting. Most of the portfolio activity over the last six months, it’s been add-ons, it’s been cap-ex for new lines, it’s been investing in growth versus dealing with all of the liquidity issues.”

New pressures—including labor and inflation—have tested the mettle of even the best management teams. Noting that the confluence of factors has resulted in an “unprecedented time” for many of New Heritage’s portfolio companies, Barry said the best management teams rely on creativity, focus and flexibility to address these challenges.

“We've gotten very creative in how we offer incentive compensation,” Barry said. “So, rather than saying you were making $15 an hour and we're going to permanently raise it to $18 and we've got to live with that for the rest of our lives, it's how do we offer a productivity bonus that de facto takes you up to $18, but maybe doesn’t live in our cost base forever. Or it’s other incentives for employees, like work from home, extra vacation time, extra intangible benefits.”

Reiss added that the strongest teams in Apollo’s portfolio focus on their top five priorities and remain flexible in a fast-changing environment. “The phrase ‘we’ve always done it this way’ is not a path to success,” she said.

One new path to success has been the focus on environmental, social and governance, or ESG, standards. Apollo Global Management has an impact investing mandate. Reiss said that, to her surprise, the pandemic didn’t break ESG’s momentum. Instead, it’s only resulted in an awakening of how businesses address these issues.

“The companies I own, because they're doing something good for underserved individuals or communities, because they're doing something good for the environment, are structurally advantaged,” she said. “Because every time we're going to compete in the market, my sustainable packaging company is more attractive than the non-sustainable competitor to that brand owner who's trying to tell their own brand story. That is a tailwind that I get the benefit of.”

The same is true of sponsors that don’t have an explicit ESG mandate. As Thomson explained, ESG is part of the new normal in the private equity world.

“I don't think anyone can say that they don't have some sort of mandate,” Thomson said. “If you're trying to get [limited partners] into your next fund, they're going to send you their questionnaire if nothing else. You can make the choice to either have a tick-the-box approach to ESG, or if you're going to be asked about it, you can take the approach of, I might as well actually get real about this.”

All of the panelists agreed that navigating this period of change and uncertainty requires strong relationships among lenders, capital providers and portfolio companies. “Being consistent, being reliable, knowing that you can get a consistent read—and one that you can deliver on—is very important,” Cuprisin said. “It's times like this that those relationships matter the most.”

For Thomson, that means making sure portfolio companies are communicating openly about potential issues, whether it’s supply chain disruptions, rising commodity prices or labor shortages. “What we're asking as an investment committee is to tell us as soon as you think there's going to be a problem,” she said. “I think one of the benefits of having private equity backers is that any one individual company is not the only thing we're looking at. We have the benefit of breadth of visibility. So, whether it's an equity problem or a financing problem, there may be another company in the portfolio that has dealt with a similar covenant challenge or a similar working capital issue. We're just asking everybody to just be even more transparent than they might otherwise be.”

A strong relationship with a committed partner can thrive even in the most turbulent times. As Thomson said, “A good sponsor with a good investment is always going to get a deal done with their debt partners.”