Independently Sponsored: Clearsight Advisors

TONY HILL

Well, Justin, thanks for joining us for this interview. It’s great to have you. Before we get started, tell us a little bit about Clearsight Advisors and, particularly, its new and somewhat unique independent sponsor model?

JUSTIN LOEB

Absolutely, and honored to be included in this series. Ever since I received my first package of Trivest sticky notes, I’ve thought very highly of Trivest’s differentiated approach to private equity B2B marketing, so it’s awesome to be included in one of your newest and most interesting marketing ideas yet!

Clearsight is the leading merchant banking firm exclusively focused on high-end professional services and tech-enabled services businesses. Everything we do revolves around these sectors, and I believe we are unmatched in our depth of capabilities, domain expertise, and track record of success. Historically, we’ve helped entrepreneurs, boards of directors, and institutional investors in these sectors primarily through M&A advisory services. As we’ve continued to grow our team, we’ve sought to expand our suite of solutions to be as helpful as possible to our clients. Given the robust growth in the Knowledge Economy, yet the historically limited capital markets solutions, we saw an opportunity to offer unique growth capital solutions. We focus exclusively on writing sub-$10mm checks, which goes a long way in filling gaps in the private capital markets. Target firms are typically seeking our growth capital for buying out a non-active partner, making investments in key resources, completing add-on acquisitions, and/or product development. We’ve received a lot of interest since we formally launched earlier this year. Additionally, we’ve seen co-investment opportunities from partners in our ecosystem that are looking for us to be the industry expert. Our core business will continue to be providing world-class M&A advisory services, but in order to truly become a one-stop-shop for our sectors of focus, we recognize the need for this specialized investment capability.

TH

Very interesting, and congratulations, by the way. It wouldn’t surprise me if we started seeing more independent sponsors gravitating toward more of a hybrid model like you guys. The optionality and market opportunity makes a lot of sense.

OK, let’s get to the topic du jour: the impact of the general election on deal-making. Justin, you’re based just outside of D.C., which I suppose makes you a Washington insider. We’re excited to get your viewpoints. Let’s start with [pun intended] the elephant in the [oval-shaped] room. M&A volume from 2017 through 2019 was blistering hot, eclipsing 15,000 transactions per year all three years. The last time we saw that kind of activity was in 2007, and we all know how that ended. Do you expect the outcome of the U.S. general election to impact deal-making in 2021 and beyond, or is our course already set regardless of the winners throughout the ballot?

JL

The election has already impacted deal making! We saw a flurry of M&A activity starting at the end of the summer when firms were exploring liquidity events to avoid potential changes to long-term capital gains taxes. As I’m sure you are aware, Biden’s proposal includes a major increase to long-term capital gains taxation for individuals earning above $1 million. We recently published an infographic illustrating the impact that Biden’s proposal would have on transaction proceeds.  We concluded that valuation multiples would need to grow 30%+ under the new tax regime (compared to the same transaction today) in order for shareholders to receive a similar amount of net proceeds in a liquidity event.  There won’t be a comprehensive tax proposal until well after the election of course, and it remains to be seen how much of Biden’s campaign agenda will be implemented if he is elected.

If Biden wins and Democrats maintain control of the House while winning the Senate, I believe you will see a huge amount of exits in 2021. Investors will look to monetize platforms and recognize capital gains in the hopes that new capital gains legislation will not be retroactive, since legislation will likely need until at least the end of Q2 2021 to pass. The maximum capital gains tax rate has only increased once in the last ~30 years. The 2012 American Taxpayer Relief Act increased the maximum capital gains tax rate to 20% and was not retroactive. However, there are certainly many historical examples of retroactive tax increases, especially on income taxes. At the end of the day, I don’t believe this tax would be retroactive. Capital gains taxes really only have one direction to go after essentially plateauing or decreasing over the last 30+ years. The change is coming, but how large of a change and its impact are still up for debate.

TH

Yes, for better or worse, I think you’re right. Let’s drill a little deeper. What differences in terms of M&A volume, valuations, mega deals, strategic versus financial buyers, anything, really…do you foresee between a Democrat versus Republican-led White House and Congress?

JL

I believe most of the trends we will see are not contingent on the outcome of the election; however, the rate at which these trends unfold will absolutely be impacted. If the White House and Congress both become controlled by Democrats, then there will be a significant increase in financial sponsors, and some founder-owned businesses, getting to market in 2021. Although it’s speculation at this point, there is certainly a good chance that any upcoming legislation change will impact later years rather than 2020 and 2021.  There is potential for a retroactive tax increase, but if businesses wait until after 2021 to explore a liquidity event then some form of a future tax increase is inevitable. If Trump wins the election, the rate at which capital gains and other corporate taxes increase will most likely be slower, but the consensus is that corporate taxes are going up regardless. We’d expect less volume of M&A in 2021 under a Trump administration, but likely higher levels of deal volume in 2022. This aligns with PwC’s latest Pulse Survey of 500+ US corporate leaders which illustrated that US companies see changes to the tax code as the top policy risk for businesses, regardless of who wins the election. Business leaders seem to agree that they are going to be the ones paying to offset at least some of the trillions of dollars spent by the US government this year to combat the COVID-19 pandemic.

In conclusion, we expect M&A to slow materially across the board in 2022 and beyond, especially under a Biden administration. Valuations could increase to try to entice sellers to continue to transact despite a more significant capital gains tax burden, but with valuations already largely back to pre-COVID levels, we do not anticipate a material increase. We also believe growing firms will be more willing to raise primary capital, as opposed to selling secondary shares and triggering a capital gains taxable event, to accelerate their growth and attempt to achieve a higher valuation.

TH

And what about independent sponsors? How do you think they’ll fare with regard to origination, capital raising, portfolio management, etc.? Do you expect the size of the independent sponsor community to grow, shrink or stay the same?

JL

I believe the independent sponsor community will continue to grow in comparison to institutional funds. Uncertainty between now and the end of 2021 makes it difficult for investors to have enough conviction to put a lot of money to work. Likewise, the institutional fund model doesn’t give investors a lot of flexibility in how and when they deploy their capital raised, exacerbating challenges over the next 12-18 months. According to Pitchbook, total dry powder stood at ~$1.5 trillion across all U.S.-based LBO funds as of the beginning of 2020. While much of that does not need to be invested in 2021, the flexibility for that dry powder is certainly much lower than what is available to independent sponsors. Independent sponsors have the luxury of evaluating opportunities on a deal-by-deal basis without a bunch of committed capital from LPs sitting around mounting pressure on the institutional investor. The total amount of dry powder available for buyouts has increased every year since the Great Recession, and even if that slows next year, many investors could benefit from having a more flexible timeline.

An important trend as we approach 2021 is the increased specialization of investment criteria across both the institutional fund and independent sponsor communities. The days of a general search for $2mm to $10mm of EBITDA, with strong management teams, good free cash flow generation, etc, are coming to an end. With the growth of the private equity industry and technological advancements facilitating investors’ ability to find targets, specialization will continue to become an important aspect of differentiating and securing deals.

TH

So, what steps is Clearsight Advisors taking to prepare for those eventualities?

JL

Clearsight’s one-stop-shop approach makes us well positioned to prepare for these eventualities. The most important piece of our approach is our exclusive sector focus, since many subsectors have remained relatively unaffected by COVID and continue to make up the fastest growing pieces of US GDP. We respond to the market needs of our clients and prospective clients with a personalized strategic evaluation—we do not offer one size fits all solutions. As capital gains tax changes become likely, we expect the rate of M&A advisory work in our sectors to continue its current rapid pace. We have closed nine M&A advisory transactions since April, and there appears to be no near-term slowdown in sight.

TH

Good to hear you’re getting in front of what sounds like is going to be a bit of a bumpy ride. Most recessions last a year or two; however, the domestic conditions leading up to the imminent/present economic downturn – an unbridled, ten-year economic expansion, seething political polarization, an elusive and rebounding global pandemic – are truly confounding and without precedent. When do you think the dust begins to settle from a deal-making perspective, 2021? 2022? Beyond?

JL

Despite my bullishness on Clearsight’s industry focus areas, I think many other sectors will continue to see little to no M&A as COVID directly impacts their revenues. For these sectors, I don’t see the dust settling until an effective COVID-19 vaccine is widely distributed, and that seems unlikely until late 2021 at the earliest.

The good news is that we are pretty confident the interest rate environment will continue to be very M&A friendly over the next few years. Additionally, private debt capital has matured rapidly over the last decade. Coming out of the Great Recession, as many commercial lenders were pulling back from financing LBOs, the total private debt capital market grew from ~$56 billion in 2008 to ~$240 billion by the end of 2019. The combination of large amounts of PE dry powder, relatively inexpensive and substantial debt capital, and our focus on high-end professional and tech-enabled services businesses positions Clearsight well for the foreseeable future.

TH

As you know, we publish Independently Sponsored on the first Tuesday of every month. In November, that just happens to fall on November 3rd: Election Day. Do you care to make any predictions?

JL

Although the national polls were a bit misleading four years ago, my best guess is that they will be more indicative of the outcome this time around. My prediction is that Biden wins the presidency and Democrats maintain control of the House, while also adding enough seats to the Senate to give them a majority. I believe this would greatly accelerate M&A activity in the near term, but stymie M&A in 2022 and beyond, assuming a good chunk of Biden’s campaign plans regarding tax increases come to fruition. If the polls are correct, I think more uncertainty exists around when a winner will be officially announced and how the current administration will handle a transition. Living in our nation’s capital, I am interested to see how these two questions play out firsthand.

TH

Indeed! If there’s one thing that, I think, we can all agree on these days, it’s to expect the unexpected. On that note, that brings me to my favorite part of the interview: the recounting of a humorous deal-related story. Everyone in the biz has one (probably more). Do you have one for our readers?

Justin Loeb

Unfortunately, the best stories probably aren’t wise to publicize, but I’ll give you a quick one that others who have grown up in the M&A industry might be able to relate to. Early in my career, as a junior team member providing M&A advisory services, I finished up a management presentation that took me to the wee hours of the morning and dropped it off at my Managing Director’s house on my way back home. I was home for no more than 10 minutes when I got the call. My boss was violently ill and couldn’t leave the house, let alone get on a plane in a few hours to head to the management presentation in Houston. Could I, a wide-eyed 22-year-old struggling from lack of sleep, get on a plane in a few hours and cover the MP all day in Houston? Of course! I bought a ticket for the first flight out, got a couple hours of sleep, and was off to save the day! The MP went well, and our client was impressed, but I’ll never forget getting home and being so excited at the prospect of sleeping only to receive that call. It was definitely a coming of age moment in this line of work!

Tony Hill

That might be the best one we’ve had yet, and just the dose of light-heartedness we can probably all use going into Tuesday’s general election.

Justin, I want to thank you for speaking with us today and for your insights—it’s always a pleasure. Congratulations again on the new independent sponsor arm you’ve launched at Clearsight. We wish you a strong close to the year in 2020 and much health and happiness going into 2021.