The US mid-market had a stellar year in 2018, especially in terms of deal activity, but some softness is emerging at the margins. The environment is marked by asset prices that continue to be elevated and by limited partners who are increasingly preoccupied with how mid-market firms will weather an inevitable economic downturn.
Deal activity in the US mid-market reached a decade-high in 2018 for number of transactions and deal volume. There were 3,072 mid-market transactions in the US in 2018, totalling $437.7 billion, up from 2,655 deals totalling $381 billion in 2017, according to data from PitchBook.
However, the beginning of 2019 was slower, due in part to volatility in the public markets at the end of 2018. In the first quarter, GPs closed on 649 deals totalling $75.1 billion. Q2 figures had not been released by the time we went to press but market participants noted activity had picked up and the total figure for the year could be near 2018’s.
A story about selection
“There was definitely a slow start of the year,” says Christian Kallen, a managing director on Hamilton Lane’s fund investment team, adding that it lasted until about March or April. “Then it got back to normal. Can we catch up to the end of the year? I am not 100 percent sure, but everything else in 2019 will look very similar to 2018. If we look at our distributions, it looks pretty close to last year.”
On the exit side, while initial public offerings continue to be nearly non-existent, secondary buyouts are still the most common route in the mid-market. However, GPs are noticing a decrease in the quality of companies that are coming to market. In particular, there are more companies that have been in portfolios for a long time, or businesses that may have had issues in the past or are simply unsound.
“It feels like later stage,” says Vincent Fandozzi, head of North America direct buyouts at Ardian, who focuses on the lower mid-market in the US. “People are trying to use the strength of the financing market and the M&A market to see if they can get something sold. A lot of them aren’t getting sold. It’s a story about selection.”
In this late cycle, investors are willing to pay a premium for strong companies that will be able to weather a downturn. Companies that have strong predictable cashflow and aren’t cyclical are not only being sold easily but are also the ones fetching high exit multiples. Some of these can be found in the healthcare sector, business services and technology, particularly those focused on software.
“In a downturn, everything is going to struggle, but the question is by how much,” Fandozzi says. “GPs may be putting a little bit of a premium on businesses with a safer view on cashflow.”
Kallen adds: “It feels like everyone in the US mid-market is looking for capex-light businesses with recurring revenue and that are easy to scale.”
He notes that the flipside of buying good-quality businesses at high multiples is that GPs are using more leverage to be able to deliver the performance LPs are expecting.
“The positive impact on the operational side gets kind of negated by the financial risk you have to put to be able to buy them,” he says. “But this is where you see a lot of growth.”
Some GPs have been forced to become less conservative than they were about five years ago.
“There seems to be a shift that everyone is now trying to play that kind of market and taking the risk, which obviously will lead to issues down the road at the end of the cycle,” says Kallen. “The question is when the end of the cycle will hit and what is the quality you have to put in the portfolio at that point.”
These are the types of questions that LPs are increasingly asking their GPs, particularly during due diligence. Delivering good returns is no longer solely sufficient.
“I think some GPs think that as long as we put our head down and deliver good returns, everything should be OK,” says Eric Zoller, founder and partner at Sixpoint Partners. “A lot of GPs are delivering good returns today, but good returns by itself today is not a sufficient differentiator.
“Today GPs need to differentiate themselves by their approach to the market, the edge they have into how they deliver those returns, and most importantly perhaps, by demonstrating they can continue to deliver those returns even as the market continues to heat up and potentially even turns down.”
LPs want to know how a GP will manage its portfolio in a downturn and, as a result, GPs with a strong operational focus are getting increased resonance because they are the ones who will have an edge in managing companies in difficult times.
Investors are also focused on managers’ pricing discipline and the interplay between that and investment pacing. They want to make sure GPs are putting the money to work, but they also want to ensure that they are doing so in a prudent fashion by not overpaying.
A split fundraising market
Zoller observes that overall, the fundraising environment for US mid-market funds has become bifurcated between funds that demonstrate they can deliver liquidity early and raise funds easily and those that are taking longer because they can’t demonstrate liquidity.
“It’s because the market is more saturated now than it was in the past,” Zoller says. “LPs may be looking for an exit from the prior fund, and perhaps a deal in the new fund. If you go back to the 2015-18 period, the market didn’t require the same degree of liquidity or portfolio development, and GPs were still successful in raising a new fund with or without new investments.”
GPs are having to wait to launch their fund until they either get an exit or show an additional investment in the new fund. They may also have to offer a fee break or some other special relationship.
Fundraising figures for US mid-market vehicles fell in 2018 and have continued to decrease this year, but good managers that offer strong liquidity have been able to continue to raise swiftly. US mid-market GPs closed on $9.17 billion in the first half of 2019, according to PEI data. In 2018, that figure was $33.65 billion, down from a peak of $50.4 billion in 2017.
The largest US mid-market fundraise in the first half of 2019 was SK Capital Partners V, which closed on $2.1 billion in February. SK Capital focuses on investing in the speciality materials, chemicals and pharmaceuticals sector.
First-time funds also continue to attract interest from LPs as Arcline Investment Management, a firm set up by former Golden Gate Capital dealmaker Rajeev Amara, showed when it closed its debut fund in March on $1.5 billion. The firm’s strategy is centred around buying mid-market industrial businesses.
“Typically, first-time funds or new managers were raising funds with a couple of hundred million dollars,” says Kallen. “You’re now seeing more and more first-time funds and new managers starting with $1 billion. This is definitely new, that you can raise significantly larger funds in a first-time fund than you were able to do five or six years ago.”
While some funds have a one-and-done close on their fund, this is not the case for all US mid-market GPs. LPs’ calendars are filling up even faster than in the past and they are putting their money to work earlier in the year than they used to, making it more important than ever for GPs to make sure they get on LPs’ radars prior to officially launching their funds.
“If you look at 2019, many LPs are already out of capital and are already building their calendar for 2020,” Zoller says.
What the economic environment will look like in 2020 and whether a downturn will have hit by then is still unknown, but it’s clear that US mid-market funds and their investors will have to continue to put a greater emphasis on making sure portfolio companies are ready when it comes.
“The challenge for the GP in the mid-market is really to figure out where we are in the cycle and constructing their portfolio accordingly and making sure they don’t get caught with a portfolio with a relatively high leverage that might get them into trouble if the revenue and EBITDA growth stops,” says Kallen.
“It really comes down at the end of the day to what is going to be the catalyst that makes the cycle enter the downturn, and the macro-economic environment will be the biggest challenge for the mid-market.”