Private Equity in the Mid-Market

Sunil Sharma:

You're going to exit your business one way or the other, voluntarily or involuntarily, right? You're better off thinking about it earlier so you can dictate the terms and have a plan and ultimately have a successful outcome for you.

Narrator:

Welcome to Accounting for the Future, a BDO Canada podcast for financial leaders to navigate change and achieve business growth. We'll uncover the challenges financial leaders may not have dealt with yesterday but will definitely have to manage for the future.

Anne-Marie Henson:

Hi, and welcome to BDO Canada's Accounting for the Future. I'm Anne-Marie Henson and I'm joined by my co-host, Armand Capisciolto. Today we're talking to Sunil Sharma who's BDO Canada's Transaction Services and our private equity leader.

Armand Capisciolto:

Anne-Marie, you and I have had a number of conversations with Sunil on the topic of private equity and even the broader kind of private markets and the opportunities they present for our clients and the companies that we work with at BDO. I know you and I have found these conversations really interesting. And as a result, I think our listeners are going to find the conversation we're going to have with Sunil about this topic very interesting. So, Sunil, welcome to Accounting for the Future.

Sunil Sharma:

Thank you and happy to be here. Certainly, looking forward to discussing this afternoon. In the back of my mind, I have all the snow I got to go shovels. So, this is always keeping me warm for this afternoon until this evening when I got to get out there and do some more heavy lifting.

Armand Capisciolto:

The heavy lifting of talking accounting or the heavy lifting of shoveling snow, I don't know which one is more enjoyable.

Sunil Sharma:

Talking accounting, talking private markets, private capital is easy, fun stuff. The snow is where the real work starts.

Anne-Marie Henson:

Sunil, I thought maybe we could take a step back, which we do pretty often on the show just to make sure that as we're talking through private equity and what's happening with clients, with investors and what you see going on in the near future, we start with the basics of just definitions. We hear a lot about private capital being really interested these days in investing in SMB clients, so small to medium businesses as well as MME, mid-market enterprise. So why don't we start by just giving us a little bit of insight into the size of these different types of companies and what they mean for you and private capital investors.

Sunil Sharma:

Yeah, it's a great question, a great point. I think there's, first of all, a lot of misconceptions generally around where private capital is looking to invest the size and types of businesses that they look to invest in. I think people often perceive private capital to be billion dollar deals and really big transactions, which they can certainly be, but I think it's very relevant that they do look at SMBs, which I think from a revenue perspective if we think about from a kind of zero to $50 million business and MMEs, which are the kind of $50 to $200 million revenue range. And so, when you think about a business that's kind of sub 50 million in revenue, that could be your local manufacturer of sporting goods, right? It could also be your vet clinic.

All these types of businesses, all different shapes and sizes are of interest to private capital are warranting and attracting investment from private capital. Either it can be done through what we'll call a platform investment and that's something that's a little bit more sizable probably on the higher end of an SMB in terms of size or in the MME space. Or it can be a tuck-in, right? So, I'll use the vet example. Again, you know might have a group of veterinary clinics that are 50 million in revenue. They have several locations; they receive an investment from a private equity firm. And then they'll look to build and consolidate and continue to add on. And so, they might go and buy a veterinary clinic that does 1 million in revenue. So, it kind of gives you the landscape and we call that a tuck-in acquisition. So, it kind of gives you the landscape and size of the types of deals private equity funds are looking at.

Armand Capisciolto:

It's interesting, Sunil, as you talk about the tuck-ins, because I think when we talk about the growth of private capital, we sometimes forget about these secondary deals, right? The private equity invested in a larger company and that part of the growth strategy related to that larger company is to acquire other companies. So, you might not be looking at it, "Well, it's not private equity that bought my company or wants to invest in my company," but it indirectly is.

Sunil Sharma:

Yeah, for sure. I mean when you look at the statistics around deals last year, over 80% were deals under 25 million in value. And so, when I think about aligning that to the size of company, that's an SMB, right? And that's over 80% of deals in the year. So, it's a pretty significant portion of overall deal volume that we've seen in Canada over the last number of years. And that's a function of our economy, right? Our economy is driven by SMBs and MMEs. So, it makes sense in that regard.

Armand Capisciolto:

Very interesting. So, sticking with definitions for a little bit before we get into the meat of some of our discussion, I think we've brought up private equity, but we've also talked about private capital. My understanding is private equity is a subset of private capital. So maybe if you can give us a little bit of an understanding of what are the various types of entities that would be considered providers of private capital?

Sunil Sharma:

Yeah, for sure. And you're absolutely right that private equity is one of the subsets of private capital. When we look at private capital more broadly, it's investments in assets that are not available in the public markets, right? So, it's not a public company. It's typically not an owner managed business at that point anymore. So really what's involved there is private equity, you have venture capital is another one, real estate investments, infrastructure and natural resources, and private debt. Those are the kind of main categories of private capital. We're seeing more and more activity and more and more prevalence in Canada is within that private equity vertical specifically.

Armand Capisciolto:

Very interesting. What I was doing, if I think about prior to 2022 and worked with a lot of companies going public, the public markets were going gangbusters in 2020, 2021. As we all know, 2022 wasn't a great year for the public markets. But when I think about the companies that I dealt with in those go-public transactions in 2020 and 2021, a lot of them, they were previously had private capital ownership. A lot of the go-publics were that were part of that exit strategy that the private capital had. So, I guess I was hoping you could talk a little bit about how the growth of the private markets, private capital has compared to the public markets over the last few years?

Sunil Sharma:

The last few years have been an interesting trend in that the private markets and private capital in general since about 2000 has had kind of 10X growth in terms of net asset value or asset under management. When you look at the public markets, they've kind of grown at about three times over that same length of period. So, we are seeing that private capital, it is truly outpacing public market growth quite considerably. I think that's a trend that's going to continue. But ultimately, I go back to what I mentioned earlier and that's because the SMBs and MMEs in Canada, they drive the economy, right? Being a public company is expensive, right? There're a million plus and kind of listing fees and additional costs and regulatory requirements and governance and things of that nature. And so, it is definitely more favorable to be in that kind of private realm.

You don't have again as much volatility. Obviously public markets give you access to more capital, and they certainly have their advantages, but generally we've seen a lot of money flowing into SMBs and MMEs from a private capital perspective expect that to continue. And given the volatilities that we've seen in the public markets in the latter half of 2022 and into 2023, we're starting to see a big trend of take-privates as well. So, a lot of private capital is looking for and seeing value in the public markets, seeing assets that are undervalued and taking them private. So that's something that we have started to see, and I expect to see continue over the course of 2023.

Anne-Marie Henson:

Oh, that's really interesting, Sunil. I know you're in the Toronto area. I'm in Montreal, so we haven't gotten the snow that you're about to shovel yet. It hasn't made its way across the country here. But one thing, you mentioned the $25 million deal size. I heard that a lot of that activity came out of the Quebec area, which is really interesting in terms of just the economy and exit strategies for companies. Armand referred to there being a real slowdown, almost halt, in the IPO market over the past year. Sounds like what you're saying is that private capital transactions remain very active. So, you started talking a little bit about what you expect to happen 2023. Can you talk to a little bit about the trends you started seeing maybe in the latter half of 2022? We heard a lot about valuations going down, companies starting to do mass layoffs and anticipating more in 2023. What do you see in terms of upcoming trends in private capital?

Sunil Sharma:

Yeah, I'll pull my crystal ball out here. I can't say my track record, I'm not batting a thousand in terms of my predictions. But I think to think about where we came from first, we had this pandemic and the world stopped for about three months, March to June. And then ever since then, private equity activity has been... It's been quite hot. It's been a record quarters effectively since June of 2020 onward. Why did that happen at that point in time? You had a significant amount of dry powder. When I say dry powder, capital available in the private markets. You had record low cost of capital, so interest rates were super low. You had baby boomers retiring. So, there was this perfect storm of events that led to a record amount of activity.

And now as we started to get towards the back half of 2022, we started to see interest rates rise overall economic uncertainty. And so, deal activity, especially within the private equity community, did statistically slow down. I think heading into 2023, I don't think we're going to see that level of activity that we saw in 2021 and the first half of 2022. Given the level of uncertainty that's out there given the rising cost of capital, I think overall, generally people are proceeding with caution, but there still continues to be a significant amount of dry powder that's out there. There continues to be baby boomers that are looking to retire. There's a significant amount of wealth transfer that's expected. The Financial Post had mentioned that there's going to be about $2 trillion in wealth transfer upcoming in the coming years. So, there's still factors that led themselves for private equity activity to be active, but we're probably not going to see the record here as we saw in 2021, 2022. But I also don't necessarily see us reverting back to kind of pre-pandemic where there was activity, but it just wasn't as busy.

So, I think it's probably somewhere in between. People still want to get deals done. There's probably a lot of buying opportunities from evaluation perspective, but there are factors out there that are leading people to proceed with caution. And so, because of that, I think there's just going to be a decline in volumes in this upcoming year.

Anne-Marie Henson:

I guess what I'm hearing is private capital is still quite active, perhaps not as much as we've seen in previous years, but still a good strategy to consider for succession planning or if you're looking to exit your business. So, what advice would you have or what advice do you give these days to your SMB or MME clients if that is what they'd like to do, that they're looking to sell their business and they're looking at a private equity exit as an example. What kinds of things are you telling them they should prepare for?

Sunil Sharma:

Yeah, this is a little self-fulfilling because I'm in the business, but the first thing I say is hire an advisor. I think that I truly believe that. I truly believe that hiring an advisor does add value to the process and is worth the money and worth the investment on the part of the seller. Selling your business is not easy, right? It's your baby, it's something you've built over a lifetime. Or even if you're not looking to fully sell and you're looking for a partner to come in and help that next stage of growth, you want to make sure you go through the right process to figure out who your future business partner will be.

And so, it is a lot of work, it's a huge financial decision, a lot of times the largest financial decisions our clients will make. And so, it is stressful, it's emotional. And getting help, there's nothing wrong with that because it will generally lead to a more successful outcome and allows our clients, SMBs and MMEs, to focus on what matters most, which is running their business, right? They got a day-to-day. And so, hiring an advisor to get help to sell their business is really important.

And then the other thing in general I would say as just overall is preparation, right? When you're thinking about selling your business, I also tell people you're going to exit your business one way or the other, voluntarily or involuntarily, right? You're better off thinking about it earlier so you can dictate the terms and have a plan and ultimately have a successful outcome for you. A successful outcome in exiting your business or getting a partner is different for every business owner. But when you're having to do it, call it in that situation where it's involuntary health problems, whatever the case may be, it's obviously more difficult. So, when you can get in a situation where you're controlling the narrative, you're dictating the terms, you're running the process to get the best result for you, that's always great, right?

I was given a piece of advice in my career, have a five-year plan, right? What are you going to do in the next five years? Where do you want to be in the next five years? The same applies to our clients, right? Where do you want to be in the next five years? How are you going to get there? Do you need support? Do you need financing? Do you need a private equity partner? Do you want to sell in five years? Because if you do, don't start it five years from now. Start thinking about it now, start talking to people, start understanding what options are available to you because there's more that's out there that you probably know.

Anne-Marie Henson:

No, I think it's great advice. I think you touched on something that we're accountants or in the financial realm, so we look at numbers and valuations and things like that, but you can't underscore the importance of the emotion tied to selling your business especially if it's been something that you've been doing for your whole career. I guess having an advisor and someone who's a little bit removed from that day-to-day gives you a good sounding board. So, as well as being able to be expert in the negotiation process and what needs to be done at what step and helping you run your day-to-day day, it's also that person who can give you good advice where you might be, I guess, too emotionally invested in the process. So really, really good advice. I like that a lot.

Armand Capisciolto:

It's really interesting listening to, Sunil, your answers to the last few questions. And I always like to plug previous episodes when we're talking to people. We had an episode a while ago, it was actually dealing with the public markets and about raising money in a tough environment which we're really experiencing on the public markets. But you kind of hinted it's tougher even in the private markets now because of rising interest rates and the uncertainty in the economy. But the comment that was made in that episode is when you can do it in a tough market, you're actually making the business more resilient. And I do think advisors help with building that resilience and making decisions, especially getting past those emotional decisions that are really even tougher in a tough market. So, I just wanted to plug that.

I think you actually probably answered my next question a little bit, but what I've seen or what I've observed with some of the clients that I've advised helping them get their financial records ready for a deal is sometimes the time it takes to get their financial records in order has killed the deal. The purchaser, whether it's the private markets or not, has found something else in the time it's taken a company to get it. So, you talk about this five-year plan and thinking about where you want to be in five years. When you're talking to companies, how do you get them to think about that? How do you get them to think that doing something sooner is better? Because often one of the pushbacks that I get when I talk to people about accounting standards and professionalizing their finance department, they're like, "Well, I don't need that. I don't need that right now," but then a deal dies. When you're talking to the companies you work with, how do you convince them that sooner is always better?

Sunil Sharma:

Yeah. It's tough. It's not easy because I can understand their hesitation to make investments that they don't necessarily know will yield a return, right? And personally speaking, I'm a big believer in preparation. I try to prepare in everything that I do and that's in my day-to-day job. When I go to the gym, that's when I play golf, I hit the range all the time, right? I still suck, but all good. So, I'm a firm believer in preparing. When I talk to clients, the one thing that I try to articulate to them is once a transaction's going, time is risk, right? Time is risk for a bunch of different reasons and a bunch of different examples. So, Armand, you mentioned the buyer could find something else, pandemic could happen as we've seen. So much stuff can happen that can get in the way that's even completely unforeseen, right?

And so when it's time to get to market, when you're ready to sell your business, you're ready to hit the on button and get going, you want to be able to go really as quickly as possible, still, again, going through a process and making sure that you're dotting your I's and crossing your T's and making a decision that you're comfortable with. I'm not insinuating and should ever be rushed. But where you can do preparatory work to make the eventual process as seamless and as quick as possible, it's only to your advantage. It increases the certainty to getting a deal done. It minimizes the risk to your business during the process, which is probably the number one deal killer, right? You take your eye off running your business, all of a sudden you have a failing business because you're focused on selling it, right? And that's not something that's interesting to people.

It preserves value. If you know that there's issues in your business that you can clean up, you can make sure you're not having any valuation kind of deterioration after the fact. If you know that there's issues, let's say you don't have time to clean them up, but at least you can control the narrative and spin a weakness into an opportunity and do those types of things. So, I'm a big proponent of preparation and thinking about these things earlier. Again, you don't need to do them all five years from the time you want to sell, but there's ways to do it in advance of the actual sale process, which we find tends to yield, and we have case studies on it, better resolved, right

Armand Capisciolto:

You obviously prepared for this session because that was a fabulous answer. Thank you.

Anne-Marie Henson:

No, it was fantastic. I know we've talked a lot about preparation for an exit, preparation for the sale in order, maximizing your proceeds, your valuation, minimizing pain and delays and minimizing risk ultimately. But there's also when you get to the other side of the sale, so you've now sold your business to private equity, the ownership structure, the requirements, the reporting completely change. And so, can you, I guess, tell us a little bit about those changes? So, the preparation mentally from a resource perspective from going from an owner managed business to now being a portfolio company of a fund or a private equity group.

Sunil Sharma:

Yeah. Life certainly does change, right? And change is never easy. But generally, and again, when you think about it, people think all the change is going to be negative, right? A lot of owner-managed businesses, they look at their sales, they look at cash. Cash is clean. You're always looking at your bank account, making sure that it's full, right? These are obviously things that private equity funds are interested in understanding of the investments that they make, but there's just more formality around it, right? So, an order manager might print his or her sales report at each month and take a look at it, right? Maybe they didn't do it the next month, but they did the following month. So, you have more timely reporting. I think what's important is more accurate reporting. That's all-powerful information to make decisions on running your business, right?

I think where people have maybe a misconception is to say, "Oh, well now I'm being asked to do all this stuff from a financial reporting perspective because of my new partner or the private equity fund or whatever the case may be," but that PE fund is also able and willing to make investments in IT to get you that reporting to get you a chief financial officer or a more robust accounting function so you can have that information so you can ultimately make better decisions to run your business because that's ultimately what they're aiming to do, right? So again, there used to be the notion that private equity funds were slashing and cutting. That may be true to some degree for some funds, but I'd say overall the view is to actually create, maintain and create value. They're willing to make investments to do that in your business. Ultimately, that should be exciting, I think, to most owner managers because now they have better data to make decisions on how to run their business so they can get to that next level of growth, right?

Anne-Marie Henson:

Yeah, no, that's great. And I love that, looking at the positive aspect of it because I do think there's a big fear or concern that once a private equity group comes in and buys you, you are now accountable to these new owners and they're just going to look at slashing costs, right? So, save on payroll, save on infrastructure and technology and things like that. That's likely not the case, right? If they buy a company, it's because they want to create value and ultimately make a gain themselves once the private equity decides to exit or sell that company. So, from what I've seen in the past, and maybe this isn't the case for all private capital, but there seems to be that there's a limited time that private equity will hold an investment or a portfolio company. So, what are the types of exit strategies of private equity when they're ready to sell that business or to divest?

Sunil Sharma:

Yeah. And you're right, that sound private equity, we could probably do a whole other podcast on the evolution of private equity and what the landscape looks like. So maybe that's part two. I think I just invited myself to the next one, I guess.

A typical private equity fund will hold their investment for five to seven years, and then they're looking to return capital to their investors and realize return. And so how do they do that? One, they can sell to a corporate or strategic acquirer, right? They can sell to another private equity fund who will see that there's still value that can be created out of this business and look to replicate and build upon what the existing fund has done. And then depending on where the capital markets are, they could go public. We've seen a number of private equity held assets go public, in particular, Neighbourly Pharmacy is a group that was held by a Canadian private equity fund. Dental Corp is another one. Both went the public route. Obviously, that will be driven by factors where public markets are and if they think they can actually extract value of going public. But those are the typical three primary avenues a private equity fund will look at when they're making an exit.

Armand Capisciolto:

So interesting, Sunil. A couple of things I just wanted to grab that you said in the last little bit is, one, the exit strategy. The exit strategy could potentially lead to going public. Going public, as you mentioned earlier on, is a whole different level of financial reporting and governance and all that. And having the finance function to get ready for that is really important.

But the one thing I really love that you talked about when Anne-Marie was asking about being a portfolio company, you talked about adding value. And to add some of that value is actually investing in IT, investing in data, investing in that finance function. And why I grab onto this, and this has been a theme of this podcast in almost every single episode, is that the finance function isn't just about compliance. It's not just about getting financial records available, seeing your financial statements to a banker. It's also about good information. And having that good information allows the company to make better decisions to grow the value of the company. I just wanted to grab onto that because I get excited about accounting, and I love when we can tie accounting to adding value. So, thank you for that because I just wanted to grab onto that comment a little bit.

Sunil Sharma:

Yeah. I mean, even when we look at our business and I think about our transaction services business, I'm often looking to see where are we generating revenue. There's so much data around our business and how we manage our business. And as accountants, I wish sometimes we did a better job of tracking data and having stuff made available to us. Because in the world that we live in now, what do they say? "Men lie. Women lie. Numbers don't," right? And so, there's a lot of data that's out there that can help you form your future decisions and then unlock value, right? A lot of business owners, accountants included, they sometimes overlook that stuff and don't make the unnecessary investments that are required to get that extra level of data and better decision making.

Ultimately, when a private equity fund is looking to create value, that's certainly one avenue that they'll look at, right? And that's why we continue to see a trend of deep data analytics using data to make decisions, artificial intelligence, all that stuff starts to compound itself and leads to some pretty interesting results. So yeah, there's a ton of different strategies private equity funds will use to create value. Investing in technology and investing in data is certainly one that's at the forefront.

Anne-Marie Henson:

That's really awesome and we definitely need to have you back for a part two. So, Sunil, really appreciate your insight and your expertise on this topic. So, myself, Armand, and our audience really appreciated your time.

I'd also like to thank you, our listeners, for tuning in today. This has been BDO'S Accounting for the Future. Please let us know if you found the topic interesting and useful and remember to subscribe if you liked it. We'll see you next time.