Mid-Market Private Equity

Panel Definition of "Middle Market":

• Levine Leichman Capital (Lauren Leichman): Defines as companies with $50M–$500M revenue; sweet spot is $100M–$200M; targets margins of low 20s to 40%.
• Chatham Capital (Brian Reynolds): Defines as $25M–$1B, focusing on the lower end with 70% of portfolio under $100M enterprise value (EV) and 30% under $300M; targets sub-$500M EV.
• MidOcean Partners (Ted Virtue): Defines portfolio companies as having $200M–$2.4B EV; notes definitions vary significantly by institutional investor, GP, and banker.
• Crestview Partners (Barry Volpert): Targets sub-$500M EV; focuses on media, financial services, healthcare, and energy.
• Ferros Capital (Nealon Youngblood): Manages $1B AUM in Dallas/Asheville; focuses on healthcare services and business services.

Market Activity and Deal Flow Trends:

• Refinancing Surge: Strong public equity and credit markets are driving aggressive refinancing activity as companies capitalize on low rates and favorable terms; Barry Volpert notes refinancing is more active than new investment.
• Investment Volume: MidOcean purchased three new platforms in four months; Chatham Capital saw deal flow up 120% year-over-year, concentrated in the first two months of 2013.
• New Deal Scarcity: Despite high liquidity, new deal activity is lower than expected due to an "ebullient" market driving up valuations and reducing attractive opportunities.
• Dry Powder: $370B in dry powder exists across private equity, with 65% (approx. $240.5B) allocated to middle-market funds.
• Recapitalization: Only 12% of leveraged loan and high-yield financings year-to-date are for new deals; the majority are for recapitalizations to deleverage flat-EBITDA businesses.

Liquidity, Hold Periods, and Secondary Buyouts:

• Extended Hold Periods: Average hold periods have stretched from 4 years to 5–6 years due to the 2007–2008 financial crisis preventing exits; funds invested pre- and post-crisis are now harvesting simultaneously.
• LP Pressure: Limited Partners (LPs) are increasingly demanding returns, leading to a trend of fewer, larger commitments to top-performing managers and a "shakeout" of underperforming firms.
• Secondary Buyout Volume: Secondary buyouts now represent 17% of all buyouts; Bain data indicates these offer slightly lower average returns but significantly lower volatility due to experienced management teams.
• Exit Opportunities: Over 6,500 portfolio companies acquired between 2005–2008 are entering the market for potential exit as the hold period normalizes.

Management and Operational Strategy:

• Management Retention vs. Replacement:
  • Levine Leichman invests with management retaining or increasing equity; foreclosure on management equity is rare and considered an investment failure.
  • MidOcean actively enhances or replaces management teams, leveraging a bench of 35 operating executives to add global skills to small businesses.
  • Crestview views management as the "engine" of the company, aiming to double EBITDA over the investment life through financial sponsorship.
• Operational Value Add: Firms emphasize adding value through global expansion, strategic M&A, and governance improvements, which is a distinct advantage over large-cap funds whose management teams already possess these capabilities.

Comparative Performance: Mid-Market vs. Mega-Funds:

• Return Targets: Mid-market funds target net 18–20% IRRs (high teens to net 20), whereas mega-funds often target net 12% as their primary LPs are satisfied with lower returns.
• Competitive Disadvantage: Mega-funds bidding at net 12% can theoretically pay 50% more for the same company than mid-market firms bidding at net 18%, creating pressure on valuations.
• Differentiation: Mid-market firms counter this by leveraging deep relationships, offering "sweat equity" to owners, and focusing on deals where they can create unique value that mega-funds cannot replicate.
• Historical Performance: Data cited indicates mid-market buyout returns exceed mega-fund returns over any reasonable time frame.

Financing Environment and Capital Structure:

• Credit Market Conditions: Debt markets are robust, mirroring 2007 levels with leverage ratios of 6.5x–7.0x for larger deals; terms are user-friendly with no covenants in many cases.
• Capital Source Shifts: CLO issuance returned with $54B in 2012 and $26B in Q1 2013; BDCs are also providing lower-cost financing.
• Market Inefficiencies: A disconnect exists in the small-cap (<$300M EV) market where big banks do not underwrite paper, creating barriers to entry and lower multiples for those unable to access syndicated credit.
• Interest Rate Strategy:
  • Chatham Capital prices deals on a floating rate basis.
  • Crestview is leaning toward fixed-rate debt, citing 7% yields on high-yield bonds as "cheap money" relative to historical cycles.
  • Firms generally aim for conservative leverage (4x–4.5x total debt/EBITDA) to weather potential rate hikes.

Exit Strategy Evolution:

• IPO Market: MidMarket IPOs are deemed impractical for smaller firms ($20M–$40M EBITDA) due to regulatory costs (Dodd-Frank) and transaction expenses; Crestview notes IPOs remain viable only for upper-tier companies with >$100M EBITDA.
• Primary Exit Channel: M&A (strategic or financial) remains the dominant exit; Crestview reports cumulative distributions split evenly between dividends/recaps, public market exits, and M&A, predicting M&A will rise.
• Strategic Buyer Sentiment: Corporations hold massive cash reserves but face pressure to deploy it; carve-outs are attractive to them if the asset is underperforming or dilutive to stock buybacks.

Fundraising and LP Demographics:

• LP Priorities: LPs prioritize distributions, high returns, and organizational transparency (compliance, compensation structures); they prefer fewer, larger commitments.
• Co-Investments: LPs increasingly demand co-investment opportunities to avoid fees and enhance returns; HBS data suggests co-investments within 30 miles of LP HQs perform best, while others underperform commitments.
• Market Shakeout: Firms are expected to consolidate as LPs withdraw from underperforming managers, favoring those with strong track records and the ability to execute at scale.

Macro and Tax Considerations:

• Interest Rate Risk: Firms are managing exposure by purchasing GDP-uncorrelated businesses (Lauren Leichman) or maintaining flexible debt structures; Crestview sees potential benefits in inflation-linked commodities.
• Tax Law Impacts: Year-end transactions saw acceleration due to capital gains rate changes (15% to 24%); firms remain focused on maximizing net pre-tax IRRs for LPs while navigating tax structures for management teams.
• Global Expansion: Opportunities exist for cross-border partnerships, particularly in Asia and Europe where middle-market LBO ecosystems are less mature than in the U.S.

Forward-Looking Statements and Industry Outlook:

• Positive Environment: All panelists characterize the current environment as highly positive, citing strong equity markets, liquidity, and the necessity of private equity for pension funds to hit 8% net return targets.
• Consolidation Prediction: The industry is expected to see a significant reduction in the number of active firms over the next decade as capital concentrates among top performers.
• Sustained Advantage: Mid-market firms maintain a persistent competitive advantage through the ability to buy at lower multiples, borrow less, and provide operational value add that large-cap peers cannot easily replicate in smaller deals.
• Future Volatility: Some panelists anticipate eventual interest rate normalization and inflation risks, but view the current low-rate environment as a window to optimize capital structures before conditions tighten.