Andy Greenberg

If you studied corporate finance or portfolio management 20 years ago, “political risk” tended to refer to a country’s stability in government and the transparency/integrity of its capital markets.

Those considerations still matter, but the deep polarization of government in the United States and other industrialized economies has given added weight to another kind of risk.

Business managers, investors and analysts now must assess the optionality of radically different standards in law, regulation and administration based on who is in power in a given jurisdiction.

THE PROBLEM

An article in The New York Times last month made the case well, at least as it relates to environmental policy:

“Government policies have always shifted between Democratic and Republican administrations, but they have generally stayed in place and have been tightened or loosened along a spectrum, depending on the occupant of the White House.

But in the last decade, environmental rules in particular have been caught in a cycle of erase-and-replace whiplash.

“In the old days, the regulatory days of my youth, we were going back and forth between the 40-yard lines,” said Douglas Holtz-Eakin, who directed the nonpartisan Congressional Budget Office and now runs the American Action Forum, a conservative research organization. “Now, it’s back and forth between the 10-yard lines. They do it and undo it and do it and undo it.”

Economists and business executives say this new era of sharp switchbacks makes it difficult for industries to plan. If there is anything that companies like less than government regulation, it is an unstable business climate…

In the past four months, the Biden administration has strengthened or restored rules that Mr. Trump had deleted, including regulations to cut greenhouse emissions from cars and oil and gas wells; to limit the pollution of toxic coal ash; to protect the habitat of the sage grouse and other endangered species; and to tighten safety controls at chemical plants. All of these rules are likely to be weakened or rolled back once again under a new Trump administration.”

This volatility is of course not limited to the environmental arena. Federal tax and regulatory policy have always featured some oscillation between Democratic and Republican administrations, but the pendulum swings are more pronounced than ever.

For clients of my M&A firm and other private business owners, there is always sentiment in favor of lower taxes and less regulation, but the strongest sentiment may be for greater certainty.

THE DATA

Measuring political risk is big business, but it’s difficult to find metrics that drill in on volatility, as opposed to the stability and functionality of political institutions and capital markets.

The World Bank’s Worldwide Governance Indicators (WGI) project “constructs aggregate indicators of six broad dimensions of governance.” One of the six – government effectiveness – “reflects perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government’s commitment to such policies.”

Here is the data for the world’s 15 largest national economies at five-year intervals through 2022, the most recent year for which data is publicly available. Estimates of government effectiveness range from approximately -2.5 (weak) to 2.5 (strong). Green denotes positive movement from 2012 to 2022, red negative movement.

Over the 2012-2022 period, Canada, Australia, the United Kingdom, Germany, the United States, France, and Spain maintained positive scores but saw a decline in government effectiveness. Among countries with 2012 scores above 1.0, only Japan, South Korea, and Australia improved their positions.

Policymaking Volatility Becomes a Macroeconomic Burden

The New York Times article goes on to cite Costa Gavriilidis, a Scottish researcher who developed a U.S. Climate Policy Index after watching the United States join, leave, and rejoin the Paris climate agreement in just over five years.

“[Gavriilidis’] research shows that whenever the index shoots up to about 50 points, it creates an economic shock of such magnitude that it leads to a 1.5 percent decrease in industrial production, a 0.4 percent increase in unemployment, a 2 percent increase in commodity prices and a 0.4 percent increase in consumer prices, reflecting the fact that producers incorporate the risk of higher production costs associated with uncertain climate policy into their prices.”

This, of course, is a non-diversifiable market risk.

Non-diversifiable Market Risk Translates into Higher Required Returns

Let’s take electric vehicles as an example. Over the next few years, will the United States continue to incentivize their production and purchase? Will there be a return to support for fossil fuels? What will be the federal government’s position on domestic mining of the rare earth minerals that go into lithium-ion batteries? The answers to all three questions depend on political outcomes.

Here are the current five-year Betas for two traditional car manufacturers looking to evolve into battery-operated vehicles, and the two principal electric vehicle market entrants.

Setting aside Tesla, the spread in Beta between GM/Ford and Rivian is about .35. Considering that market-neutral beta is 1.0, that is a substantial swing. The prospect of binary political outcomes is not the only factor contributing to the marked difference in perceived volatility – and thus in required return – but it is clearly one factor dampening the valuations of the publicly traded OEMs concentrated in a new and politically contentious industry.

THE IMPACT ON PRIVATE COMPANIES

Privately owned businesses are not subject to daily public valuation, but they are subject to the same valuation methods. Public comps come into play even more directly if a company’s owner is a private equity fund or other investment company required to do quarterly “mark-to-market” valuations.

What is the impact on private investment activity in businesses affected by policy volatility? There can only be two answers. First, if the impact on required return is moderate, valuations in a given sector decline; and second, if the impact is greater, investors wait until policy direction clarifies.

Between now and the November election, in politically contentious sectors like electric vehicles, the sidelines will be a popular place.

About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. Mr. Greenberg was founder and CEO of GF Data©, the M&A data tracking service, prior to its acquisition by the Association for Corporate Growth in 2022. For more information, visit www.greenbergvariations.com.

© 2024 Private Equity Professional | May 23, 2024

On many episodes of Middle Market Musings, the podcast I co-host with Charlie Gifford, the conversation turns to environmental, social and governance (ESG) considerations in business operations and investments. ESG is also a topic with my investment banking clients, both as it relates to their own firms and to their investable wealth outside of business holdings.

These conversations lead me to wonder, what does ESG actually mean in the world of private capital today – how is it being applied as an investment practice, as opposed to being touted as an organizational aspiration?

Here are a few takeaways from the podcast discussions with private equity fund leaders: (a) The extent to which they are being motivated by genuine concerns about issues like income disparity and climate change; (b) Their protectiveness of the fiduciary obligation to optimize investor returns; (c) Their mindfulness of the importance of these issues in attracting and sustaining younger professionals; (d) The stark difference between the relative straightforwardness of acting on these concerns in one’s own organization and the complexities of applying them as a weighting factor in investment decisions.

“Initial results of this analysis suggests underperformance
of PRI signatory funds.

On the last point, I can’t improve on the comment made on the podcast last year by Gene Fama, the Nobel-Prize winning economist and pioneer in efficient market theory:

“If you say I’m going to invest only in companies doing things that I like, which is a form of consumption rather than investment, that’s fine. You’ve got a perfect right to do that. Where I think people managing these products are not totally truthful is in not saying, ‘Of course that [decision] should be associated with lower expected returns because we’re only considering a subset of the market.’ You can’t do better. At worst you can do about as well, but probably you’re going to do worse.”

Pitchbook recently published an excellent report assessing the impact of ESG objectives in private capital asset classes. The Pitchbook team grounded its analysis in the decision of investment firms to sign or not sign the United Nations’ Principles for Responsible Investment (PRI). These principles, first implemented in 2005, crystallized the concept of ESG investing.

There are six PRI principles with just about all the force in Principle 1 – “We will incorporate ESG issues into ESG investment analysis and decision-making processes.” If a firm is comfortable doing that, the other five principles amount to administration and marketing.

Pitchbook found 2,351 private market general partners as of May 2023 that are mapped to the PRI signatory list. Within that group, performance data was available for 714. Their analysts compare the performance of signatory and non-signatory funds for the vintage years 2010-2018.

Pitchbook concluded: “Initial results of this analysis suggests underperformance of PRI signatory funds. For overall private capital, between 2010 and 2018, there were six vintages for which the median IRR of the PRI signatories underperformed compared with their non-signatory counterparts and only two vintages for which the reverse was true. PRI signatories also under-performed relative to the benchmark, with a median return .81% below it, while non-signatories had a median return .38% above it.”

However, they go on to place several caveats on this conclusion, noting that “these results suffer from several limitations, including that they did not control for geography or fund size.” To take the former as an example, European G Ps tend to under-perform the average and preponderantly signed on to the PRI. In the end, they conclude: “It is evident that other factors controlled for in the regression, including geography, fund size and vintage year, have a much greater influence on returns than PRI signatory status.”

What do I make of this?

Gene Fama’s observation that the addition of non-financial objectives can only reduce financial return stands undisturbed, because actual investment behavior in general is not challenging it.

Most firms committed to the concept of social investing are not following the literal prescription of PRI Principle 1 and including ESG issues “as a weighting factor in investment analysis and decision-making processes.”

It is increasingly common, however, for private equity firms and other investors to target industry sub-sectors compatible with energy efficiency and other social dynamics – but they tend to focus on those with powerful growth drivers behind them.

Two guests of the Middle Market Musings podcast discussed investments their firms have made related to the lithium-ion battery and its use in electric vehicles (EV). In both cases, the investors were adamant that there was no diminution in return expectations. An investment driven by EV technology is not conceptually different from one driven by healthy living diet trends. In Fama’s parlance, both investments are being driven by the consumption preferences of a company’s customers, not by those of the company or its owner.

That is where the center of gravity stands today, but things change.

When Charlie and I talk to our contemporaries, there is respect for social objectives, but also a conviction that people who entrust their money to pension funds and other institutional investors are not looking to have their returns dampened by the pursuit of social objectives, even ones they share. But we all work with younger people who care about these values and may guide financial institutions to look differently at investor obligations and return over time, particularly if there is a widespread sense of government dysfunction in addressing these problems.

About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. He is founder and former CEO of GF Data©, the M&A data tracking service acquired by ACG in 2022. For more information, visit www.greenbergvariations.com.

© 2023 Private Equity Professional | June 21, 2023

I’ve been an investment banker since 1995. Over this period, a handful of trends have defined the sale of a private business – market-clearing auctions, the emergence of the adjusted EBITDA multiple as the primary valuation benchmark, and the widespread use of outsourced financial due diligence.

All of these developments reflected and contributed to what has been a period of elevated valuations, but it is not like any of them were on tablets handed down from a mountaintop.

They all were at a different place 30 years ago:

Auctions
Processes were more targeted, often in arbitrary ways. The universe of financial buyers and their portfolio companies was a fraction of what it is today. Sellers and their bankers relied even more on established relationships. It was harder to get to know someone outside of your geography or personal orbit. Also, and maybe most practically, it was hard to have a hundred buyers when that meant sending out a hundred FedEx packets.

Valuation benchmarks
By the mid-90s, the market had already evolved away from price/earnings ratios to cash flow-based metrics, but there was more reliance on modeling before expressing even a preliminary view of value.  The typical buyer would have frozen like a deer in headlights if a sell-side banker sent over a teaser and said, “We think you need to be at eight times to get a meeting.”

Financial due diligence
Unless specific concerns emerged, buyers tended to rely on their own and their accountants’ review of financial statements and operating data. Quality of earnings has been a phenomenon of the past 15 years, with sellers and their advisors embracing preemptive financial due diligence about 10 years ago.

What has changed in the past generation is changing again.

This is not the case for every business. A pallet manufacturer will be marketed, valued, and sold pretty much as it was back in the day. But a subset of industries are and will continue to see a different kind of process. These industries are characterized by extraordinary projected growth, lofty valuation expectations, and some complexity susceptible to deeper analysis.  The more a business embodies these characteristics, the more the process of selling it is likely to change.

These trends are already underway. The only questions
are who pays for the additional work.

For instance, companies operating in outsourced residential services, cyber security, behavioral health, precision medical devices, branded direct-to-consumer products, and other markets are already seeing the building blocks of contemporary M&A changing in interrelated ways.

More targeted auctions
If you want to sell a business for 15 times, it takes a buyer with the capacity to confirm the case for stellar long-term growth.  As will be noted below, this often costs money.  Processes need to funnel down to the cluster of buyers that like and know the industry but also are able and willing to pony up for consultants and other external resources.

More sophisticated analytics
I don’t mean to suggest that EBITDA multiples will be replaced as the lingua franca of M&A, but for many of these highly valued businesses, buyers are already doing more ground-up confirmatory analysis.

More external due diligence
This has come in two waves. The first is the greater use of external consultants to supplement the buyer, their counsel, and accountant in traditional and emerging areas of due diligence – tax, IT, cyber security, employee benefits, intellectual property, and real estate.

At least one leading investment bank has established a transaction advisory services group to provide some of these services to its M&A clients. It is not new for accounting firms to reach into M&A, but this goes the other way.  It is an interesting move to capture more of the total “advisory spend,” not to mention getting at more fee-based as opposed to success-based revenue.

The other wave involves an array of business models taking advantage of artificial intelligence, behavioral science, and advanced analytics to provide a much denser view of a given company’s value proposition. Two quick examples help make the point.

Think of the relative simplicity of modeling the spending habits of a Macy’s shopper or a Budweiser drinker in 1990 compared to their internet-shopping/craft-beer swigging counterparts today.  One intriguing response is Theta, a firm founded by two business school professors from the University of Pennsylvania and Emory University, that provides “predictive customer value analytics” – a ground-up view of valuation – to acquirers of consumer-facing businesses.

Next think about all of the industry rollups that have gone awry because of improper fit. New Orchard, based in Nashville, provides a SAS offering, the Journey Strategic Platform, that amounts to “quality of culture & operations” analysis – “quantifying, profiling and improving the existing behaviors within a business.”

Final Thoughts
These trends are already underway. The only questions are who pays for the additional work (seller or buyer) – and when (pre- or post-exclusivity).

Based on my experiences as a sell-side banker, I think of two things.  First, the selling client is not looking for additional out-of-pocket expense. Second, over the next few years, more and more of our energy will go into managing complex interactions with buyers undertaking these activities, as opposed to the rote administration of a marketing funnel.

About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. He is also the Founder of GF Data© (now an ACG Company), the leading provider of information on private transactions in the $10 million to $500 million valuation range. For more information, visit www.greenbergvariations.com or www.gfdata.com.

© 2023 Private Equity Professional | February 14, 2023