Private Equity Insights: Q1 2024, Charging Through the Storm

[00:00:00] Sean Mooney: Welcome to the Karma School of Business, a podcast about the private equity industry, business best practices, and real time trends. I'm Sean Mooney, BluWave's founder and CEO. In this episode, we have a great discussion about what happened during Q1 2024 in the world of private equity, why it happened, and how this informs what will happen during the remainder of the year.

[00:00:33] Enjoy.

[00:00:41] Today, we have a very interesting episode. We're going to talk about what BluWave is seeing through the first quarter of 2024, by virtue of analyzing the thousands of projects that come into BluWave from the best business builders of the world, the private equity industry. And so you think about this, if you think about a large population of really, really proactive business builders, like.

[00:01:05] The investors, it shows us when we take all this data together and form pictures into it, what's happening and what will happen. And it kind of makes sense, right? It's a statistically significant portion of the private equity industry that's using this engine here. And it paints this really interesting picture.

[00:01:21] And one of the things I've been most surprised about is over time, the predictions we're making, what we're seeing it's time and time again, been kind of spot on correct. And so we'll see how long this remains predictive, but thus far, We've been pretty impressed. And if we jump into this, one of the things that I was doing coming into the first quarter and really not even related to this, I tend to go down rabbit holes.

[00:01:46] I think is probably many of you already know about me and, or maybe do the same. And one of the things that I was recently doing was studying the American history and the American West. And one of the deep dives I went into was one of this great iconic animals of America, the buffalo, which is otherwise known as the American bison.

[00:02:09] And one of the things that I thought was really fascinating as I was studying this kind of beautiful, amazing creature is that it has a very unique tendency that distinguishes it amongst almost all other animals in that when a storm comes, particularly you can envision these winter storms or these.

[00:02:28] Kind of violent storms that head across the plains of the West, and we appreciate that intimately living in Nashville, because they pick up speed all the way across the West, and then they run right into the hills of Nashville and crash right in. And so there's no such thing as a drizzle here, but that's a quick aside.

[00:02:44] As I think about the buffalo, what was interesting though, when these storms come across, whether it's a winter storm or a summer storm, they very uniquely do something that other animals don't. And what that is, is I think many other animals. recoil, they seek shelter, they run away from the storm. The American buffalo does something different.

[00:03:03] They run towards the storm innately understanding that the fastest way to get out of the storm is actually to run in the same direction of the storm. And that's your most certain path. That's the most obvious path. And they're so robust and they're clever and they're smart. They make it through the storm faster than anyone else.

[00:03:20] So while all their peers and the planes are kind of still struggling and languishing in this really, really terrible weather, they're outside of that bad weather by the time it comes through. And when I was reading this, it really struck me. It kind of reminded me of our clients, the private equity industry, as you've listened to us talk about this, if you've read our prior materials, they run towards the storm and go through it.

[00:03:43] And they have been going through this storm that we've all lived in really since COVID. And I think they've been beneficiaries of it. Their portfolio companies have been beneficiaries of it. The employees of their companies have as well. And so the takeaway here as we look through this Q1 2024 report is that private equity for the last couple of years at least have been running through this storm and now they're seeing the clouds part and they're picking up speed and going even faster as they have these clear skies that they're entering into.

[00:04:17] The quick headline, as we look at our Q1, 2024 data is we are now entering, we believe the first phase of the next six to eight year growth cycle. We know this because the private equity industry is taking action in mass that suggests that they're seeing the same things. So let's go through the why we believe this to be true based upon four things.

[00:04:44] Number one is we look at all the noise within the macroeconomic data. We see more good things happening than bad things with increasing velocity and increasing magnitude. First GDP continues to grow, grow above expectation. Second inflation's cooling. The last mile is stubborn. I think we all knew it was going to be stubborn and it's still got a ways to go.

[00:05:10] At the end of March in 2024, it was three and a half percent, March, 2023, 5%. So let's not lose track within all this noise of just the big picture. Next. Unemployment continues to be low. So first quarter of 2023 was 3. 5%. In Q1 of 2024, unemployment was 3. 8%. And that's still low, but that's actually good that it's going up because it means the labor markets aren't overheating as much.

[00:05:39] So I view that as a positive measure. The next thing is if we look at the consumer sentiment indexes, particularly the university of Michigan index, that index continues to grow. So Q1, 2023 is at 62. Two. At 4. So cutting through all the noise and just looking at the basics, the economy is doing pretty darn well.

[00:06:04] And so that one gives us comfort that after the last 24 months of really a fair bit of malaise, things are getting better. I personally think the Federal Reserve will come back to us in a year from now and say, Yeah! Actually, a lot of the economy was really in a recession. We just didn't want to say it.

[00:06:26] And why would they say it? Because then it would just cause a recession to get even worse. And so as we look at the data, I actually do think a lot of the economy has been in recession, particularly in certain sectors. And those sectors that are under malaise are actually starting to get better. And so let's talk about that.

[00:06:43] The other thing that we're seeing is that the private equity industry is starting to meaningfully invest in previously. out of favor cyclical sectors that were impacted by these economic motions and movements that we've been talking about. And so let's talk about that. First quarter of 2024, we've seen a 62 percent increase in due diligence activity In the manufacturing sector, this is a staggering increase in activity for any sector, but particularly manufacturing, which has been suffering.

[00:07:18] And how do we know it's been suffering? Because for at least the last 12 months, and even more, the producers manufacturing index. Which measures manufacturing output in the United States has been contracting. Well, since the first quarter of 2024 started, it's actually been expanding. The private equity industry is really good at looking 12 months ahead, 24 months ahead.

[00:07:43] And so what this aligns with is they started leaning into manufacturing. Before everyone really has even acknowledged that the producers manufacturing index is Is starting to show that the manufacturing world is coming out of the recession that it's been existing in, or at least the last year, the other area that was striking to us when we looked at our data, that was informed by the project demand from these private equity investors is the healthcare sector.

[00:08:09] So healthcare investing is up 49 percent in the first quarter versus the same quarter in 2023. Now, what does that tell us? The healthcare sector has been really negatively impacted by inflation. Okay. And why is that? Well, most of the healthcare sector, their revenue is capped by reimbursement rates set by the federal government, but their labor costs are variable.

[00:08:34] So they have fixed revenues with variable expenses. When you have a lot of inflation and the federal government isn't reflecting that inflation in your reimbursement rates, your margins get really impact. And so the healthcare industry has been hurting over the last 12, 18, 24 months. Well, what are we seeing now?

[00:08:51] We're seeing the private equity industry get more involved in bringing health care to new places where it doesn't exist before and, or it exists in a way that's subpar. And so they're coming back into another out of favor industry. So, one, if you're seeing an industry that's known for acting 12 to 24 months ahead of everyone else, they're leaning into ones that everyone else is kind of running away from.

[00:09:13] The next thing that we're seeing from the private equity industry by virtue of our data is a striking increase in the amount of value creation activity involving technology. Now, for those of you who have been through many cycles, this will make a lot of sense. The number one thing that gets canceled during every down cycle by virtually every business are large technology projects.

[00:09:38] Particularly those involving things like ERP systems, CRM systems, et cetera. They're usually in most cases said, we'll do this next year because there's large dollar projects that consume a lot of time, but also a lot of cash private equity firms preserve cash during down cycles. As soon as the cycle increases, what private equity firms typically do.

[00:10:02] As I channel the gray hair in my head and prior cycles, then they finally tell their CFO, their CMO, their CTO. All right. The ERP is back on because they still know they need it, but they delayed it because it's huge dollars. And they want to preserve cash because cash is the fuel to get you through a down cycle.

[00:10:19] And so what was striking to us in the first quarter is we saw a surge in activity with PE firms bringing large technology systems back in place that were previously deferred during the down cycle of this last economic cycle that we've been living through. So, this is another thing that foreshadows resurgence in the economy because the PE firms are saying, alright, back on, let's put the cash to work, we don't have to think about safety, we're thinking more about success and the balance of those two.

[00:10:50] The other thing that's driving that to be fair and candid is the PE industry is really thinking about the future and the AI future that is coming to bear really on the entirety of the world very soon. And if not already, and so they're starting to lay in the way that they do things very, I think purposefully, deliberately, they're laying the groundwork.

[00:11:12] So we're seeing lots of activity with data quality, data visualization, data analytics, That will someday enable neural networks and yada, yada to come through. But right now they're like, let's get the basics. But both of these involve large amounts of cash sums that are really about the optionality of the future and not surviving.

[00:11:30] And so that's another really interesting kind of foreshadowing that we think is important. The next thing that we think is really important that shows why private equity firms are collectively without even maybe acknowledging it or understanding in this case by case basis. That we're coming out of this recession is an ongoing and significant investment in people.

[00:11:55] And so human capital activity accounted for 46 percent of all BluWave project activity in Q1, 2024, and a staggering 53 percent of value creation projects in the first quarter. Both of these were also higher than the prior comparable Q1 in 2023. What becomes really interesting is when we peel back the onion within our data.

[00:12:18] And so as we geared into the nature of the human capital that was being engaged with through the BluWave engine here, it was decidedly mixed towards two things, more senior level people and more growth oriented people. So as we looked at the prior data and looked at the nuances behind the project activity, a lot of the activity was around bringing in quote unquote wartime generals.

[00:12:41] Who could navigate through choppy waters. It was kind of mid level replacements that were really about the continued tightness in the labor markets today. In the first quarter, as we look at the nature of the mix, it's really more about bringing in the growth minded executives. Who are about once again, success more so than safety.

[00:13:01] And so this is a very important mind shift and mix change that's happening that other business leaders outside of the PE ecosystem should really take a look at and say, wait a minute, something's here. They're not only these Buffalo's going through the storm, but they're picking up speed. They're running even faster.

[00:13:19] And if you don't want to get left behind, you got to be thinking about these same things. And so those are the four big things that we're really seeing that or jumping right out of the data. If you want to get a copy of the report, you can request one at our website, which is www. BluWave. net. We'll also include a link to request a report in the episode notes.

[00:13:39] So let's talk next about what we think is going to happen in more detail in some of the predictions that we had made earlier in this year. So for those of you who have been reading our materials, listening to our podcast, you'll know that in the second half of each year, we make predictions about the next year.

[00:13:54] Those are really informed by the same data that we're talking about here. And let's kind of go through those one by one and really hold ourselves accountable to see how we're doing. So if we look at 2024, we talk about the economic rebound taking place and really entering the next six to eight year market cycle.

[00:14:12] Everything that we've talked about here suggests that we are still on track. It's not going to be one of these all gas, no breaks, Ben Bernanke in 15 year mega cycles. I think it's going to be like what we used to go through before 2007. We are six to eight year cycle that normally ebbs and flows where money may get cheaper, but it will not be free for a sustained period.

[00:14:33] You know, the nineties are popular once again, with a lot of, uh, certainly my kids, we've probably gone back to that kind of nineties, early two thousands kind of posture within the federal reserve. The next thing that we predicted was that private equity sponsors were going to start selling. And really the reason that we think that has to happen this year is that the age of the portfolios are getting quite high.

[00:14:56] And the limited partners are pressuring the general partners because they need liquidity earlier in the, kind of the quasi recession that we were in, it was a, what's called a denominator effect issue where all the other assets were kind of declining in value. And private equity now is kind of like Ted was up above others.

[00:15:13] And I said, well, we can't put any more in there because you're better than others. Even though that you've outperformed others, you're still outside of our pre ordained buckets of allocation. Well, what transitioned after that is the private equity firms kind of held on to assets. Because they only get to sell these companies once.

[00:15:29] And so their behavior is rational. But at some point, the private equity firms are going to have to sell really because the LPs are compelling them to do so. And we think about that one. It's really too early to tell. We haven't seen it yet. However, if we talk with the different investment bankers in our ecosystem that are friends and contributors to our insights, we're hearing that pitch activity is meaningfully, meaningfully up.

[00:15:55] Going into the end of the first quarter and entering the second quarter. So more to come on that we may or may not be right. The third big prediction we said is now's the time to buy the bottom and hit the accelerator. Private equity firms have always done better than the rest of the economy because they look past this proverbial storm that we've spoken about.

[00:16:16] Well, what are we seeing? Private equity firms are accelerating into the manufacturing industry and the healthcare industry that were previously out of favor, and I think if you ask, most people are out of favor. But beyond the visible, and you look back behind the BluWave curtain, we're seeing them by the bottom.

[00:16:36] And so think about that if you're a business builder. They're not only managing their portfolio companies to accelerate, but they're also putting their money behind new deals in these areas. The next area that we talked about for predictions for 2024 was deal makers realizing that AI is a tactic, not a strategy.

[00:16:54] And so if I are once again, date myself going back to 1995, when the internet was made actionable by. Company called Netscape before you had to almost be like a coder to access the internet. Then they came up with this thing that anyone, including people like me could use in my limited technical capabilities.

[00:17:10] And suddenly the entire country was internet, internet, internet's your strategy, we're going to be an internet investment bank, we're going to be an internet, uh, MBA or, you know, all those types of things. Then they realized, you know, a strategy is a tactic. It makes the delivery and transmission of information faster and more efficient.

[00:17:28] The dissemination of information faster and more efficient. Well, AI has come out and what it was last year was still this year. It's a strategy. Everyone's going to do AI. The robot overlords will take over and blah, blah, blah, blah, blah. No, what it is, is it's a tactic. It makes the synthesis of information.

[00:17:46] Faster, more efficient, more effective. So it's the next step in that information value chain that's going on. And what you're seeing is now there are applications that are developing. They're embedding those into the applications you already use. So AI is going to be most impactful when it's made to do one thing really well.

[00:18:05] That's coming. We're seeing that every day with all of these applications coming out. And then the other thing as part of a strategy. We're seeing the private equity firms do a lot to get the precursor steps right, data quality, data analytics, data visualization, get all that right, and then they're going to have neural networks next.

[00:18:22] And so once again, you can see as part of a strategy, it's a tactic within a strategy, the private equity industry is mobilizing on that. I'd encourage other great business builders. To do the same. The last big prediction we made in 2024 was follow the data. We're predicting that data scientists are going to be the hottest new hire in PE firms.

[00:18:44] So we believe that if you think about the private equity industry, and certainly when I came up, the valued skillset was the ability to. Form hypotheses, gather large troves of information, being able to test those hypotheses and then use brains to take imperfect information and come to a more perfect conclusion.

[00:19:06] Well, what's happening in the meantime is the data sets are getting bigger and bigger and bigger within every M& A process and frankly more available. They were just never available at these magnitudes during probably the history of commerce. And now they're becoming available to every company. And so what that means is the private equity firms.

[00:19:24] Like every other business, candidly, they're going from a world of arithmetic and algebra to calculus. And what that means is Excel and algebra are not going to be as useful or as valuable in themselves as they will be when coupled with Python and SQL and Snowflake and these emerging analytical tools that make the ability to make conclusions and correlations and predictions much easier for mere mortals.

[00:19:56] And so we still believe data scientists are going to become part of the standard operating procedure for private equity as a role, not the. And so you will still have people that come from investment banking and accounting and consulting. But the private equity industry is really good at using the word and not, or, and so there will be someone on those teams that is also a data scientist as part of the different skill sets within the organization.

[00:20:23] And this follows the natural evolution that private equity has actually been taking for the last 20 years. And so I think this is going to be a big case. What we are seeing as we look at this prediction. Is that there are early movers that are taking big advantage of this right now. And so we haven't seen the groundswell, like we saw with human capital and before that BD and ops teams, but we're starting to see the green shoots kind of emerge from the soil of private equity here.

[00:20:53] And so there are early movers that are taking advantage. One great example is Blackstone who's accumulated a really top notch team of more than 50 data scientists so far. And then I'm sure there's more to come. And so this is something that I think is still quite nascent. Those who are interested in getting it ahead of the pack, I would very clearly and very quickly, at least add one data scientist, every private equity team that's in the market right now.

[00:21:19] If I were to start a new private equity firm, if I ever were to come back, I probably wouldn't be invited back. But if I were to come back, there are two hires that I would add a hundred percent to the team that I would be interested in forming. One would of course be data scientist. The next one would actually be director of marketing.

[00:21:36] I think that's a subject for a another episode, but those are the two that I'd hire, but the first one I would make would be a data scientist in addition to the people with investment banking skills and consulting skills and operating skills that form this world of, and not or in private equity. So that's what we're seeing so far in the first quarter of 2024.

[00:21:58] Or. We've talked also about what we think is going to happen and unfold during the rest of 2024. There are certainly a number of things that we need to keep an eye on for all of this to take place. And the things that we set forth in our fiscal year 2023 end of year insights report, I think are still spot on right now.

[00:22:18] And so geopolitics are something that we also want to look at very carefully. There's turmoil in Eastern Europe, the Middle East, Asia. There's a major election cycle in the U. S. So there's a lot of change and consternation and friction going on in the geopolitical world. Part and parcel of that, oil and gas.

[00:22:37] I think we've got to really look and make sure we watch what's happening there. Prices have moderated pretty meaningfully since the peaks in 2022, but they've been quite erratic lately. There's still a lot of kind of gamesmanship going on with OPEC plus that everyone wants to see if oil and gas substantially re inflates, we're going to have to obviously take a look at overall inflation, understand how that complicates, you Fiscal policy, also the notion of federal stimulus that we've heard so much.

[00:23:06] The next thing we want to keep an eye out for is the U S consumer. Uh, as we talked about the beginning of this episode, U S consumer staying amazingly robust, but if they flip into savings mode, that could also really slow things down fast. And then if you complicate that with inflation from a whole host of other measures that sustains, otherwise that could cause trouble, lastly, the thing that we're keeping an eye out is commercial real estate, and we all know what's going on there.

[00:23:30] There's been a lot of investment. There's been lower utilization within commercial office space. Thanks to the hybrid work postures. There's a lot of debt that's coming due. The interest rates are higher. All of this could cause a lot of issues, not only for commercial real estate developers and managers, but also for local regional commercial banks that have high exposures to these areas.

[00:23:52] And really what we'd want to see there is whether or not you get contagion, kind of like what we saw the same time last year when there was a, I think a walk on the banks. That was started by Silicon Valley Bank and then cause some consternation throughout the rest of commercial banking sector. So everything else staying kind of common course and direction.

[00:24:12] We believe we're coming out of this last quasi down cycle that we came through entering the next one. But let's all keep our head on the swivel for a variety of reasons that we set forth here, just as you would during any point in time, because the hardest thing in the world is to predict the future.

[00:24:30] We live in a three dimensional game of chess, and it's not only doing things in a vacuum, but there are going to be other variables that impact how the game unfolds. So, Let's get excited about it. Let's play to win, but let's also make sure that we're being mindful that there are other factors at play that could change how this game unfolds in front of us.

[00:24:49] Hopefully this is helpful to each of you. These are our two cents that we just give to the world. And we hope this is valuable as you set forth your plans, strategies, and tactics into 2024 and beyond.

[00:25:10] That's all we have for now. Hopefully this has been helpful in terms of instructing what we're seeing, what the best business builders in the world are doing, and some of the things that you can actionably add to your toolbox to do the same. Special thanks to our listeners for joining today. Please continue to look for us anywhere you find your favorite podcasts.

[00:25:30] We truly appreciate your support. If you like what you hear, please follow, rate, review, and share. It really helps us when you do this, so thank you in advance. In the meantime, if you need to be connected with the world's best in class, private equity grade professional service providers, independent consultants, interim executives that are deployed by the best business builders in the world, or anything else, please give us a call or visit our website at BluWave.

[00:25:54] net. That's B L U W A V E. net and we'll support your success onward.

Private equity insights for and with top business builders, including investors, operators, executives and industry thought leaders. The Karma School of Business Podcast goes behind the scenes of PE, talking about business best practices and real-time industry trends. You'll learn from leading professionals and visionary business executives who will help you take action and enhance your life, whether you’re at a PE firm, a portco or a private or public company.

BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.