SPECIAL REPORT: THE US MID-MARKET

You won't hear many middle-market GPs bemoaning the demise of the covenant-light loan. Many of them have never seen one.

The Bacchanalian excesses of the debt market were enjoyed primarily by the small oligopoly of mega-firms at the largest end of the private equity market. “It was really the $200 million debt packages and higher that were driving the covenant-light and high-yield market,” notes George Cole, a managing director at media and communications investment firm Veronis Suhler Stevenson and comanager of VSS Structured Capital, a mezzanine fund that invests in companies with an enterprise value of $25 to $100 million. “At the lower end, things have been more consistent. The mid-market has generally been bank-debt driven. When banks are underwriting and owning the paper, you've always seen more traditional structures.”

A consistent message heard across the US mid-market is: we're open for business. And while there exists no single definition of “mid-market ”, the definition du jour seems to be: the market that has not been shut down by a credit crunch. While there is some anxiety over a tighter debt market, mid-market GPs say they feel safe in their respective niches. And while the world waits to see if the bloom is off the megafund rose, the US mid-market is enjoying some welcome attention on the deal front from foreign buyers, and on the fundraising front from LPs, many of whom want to ensure they are not overallocated to giant deals.

No one disputes that a change has rippled through the financing market for buyouts. Ted Carroll, a principal of Noson Lawen Partners, a small, New York-based buyout firm, says that his firm pursues “old fashioned” investments, although, he adds: “Anything with syndicated debt became a squabble fiesta in early August.”

Further up the deal-size spectrum, Jean-Pierre Conte, chairman of San Francisco-based private equity firm Genstar Capital says he has seen debt pricing in his market go up more than 200 basis points, with debt multiples coming down. But Conte welcomes this change. “My sense is that the investment environment is going to get more challenging: banks will be more selective on credit approvals; sellers will want more certainty of closing and LPs will be more selective on GP commitments. I think that's when you'll see the higher quality players differentiate themselves from the pack in a meaningful way and the marginal players will drift.” Ted Virtue, the chief executive officer of New York- and London-based MidOcean Partners, observes: “Leverage, even in the mid-market, is going to come down for a lot of deals. But there is plenty of liquidity available for middle-market deals.”

As evidence, Virtue notes that his firm both acquired and exited deals in early September. Virtue credits the “wide array of sources” of debt financing for its current, relatively healthy deal market. “Regional banks, [business development companies] and certain hedge funds are still actively looking for good mid-market clients,” he says.

As buyout deal sizes move below the megafund range, there is less of a need to “have a massive syndication”, notes Troy Noard, a managing director at Chicago-based Frontenac Company. That said, Frontenac finds itself “having to do a little bit more of the work now. Whereas we might have had one lender show up and say, ‘We'll syndicate it later,’ we're now bringing together several parties to do a club.”

Cole's colleague, Veronis Suhler Stevenson's co-CEO and managing partner Jeffrey Stevenson, confirms this dynamic, but warns of pricing increases. “At the lower end of the mid-market, you can do club deals where a handful of banks underwrite and hold their positions,” says Stevenson. “We're seeing deals and doing deals at that end of the market. The change really has been in pricing, which has widened dramatically by several hundred basis points. That is working its way through to the purchase price.”

Stevenson, too, is unperturbed at the market's tightening. “We've come off an incredibly frothy environment where debt multiples were too high,” he says

A number of GPs say that perhaps the most predictable result of a financing-market reset is reluctance from sellers to accept the new market. Noard says his firm has lately expended much energy in educating family-business sellers about the realities of the debt market. “We've tried to be creative in saying, ‘Look, financing is not what it used to be, the price may come down a bit but there are other ways to bridge that gap.’ We're seeing a lot more seller notes, seller paper, earn outs.”

EUROPE COMES CALLING
Mid-market firms nervous about being able to exit portfolio companies at rich valuations are taking heart from a trend toward more acquisitive strategic buyers and, notably, European buyers.

In general, GPs report that strategic buyers in the mid-market are flexing their muscles. “On the sell side, we've seen strategic buyers a lot more prominently in the market than we have 12 months prior,” says Noard. “Strategic buyers recognise that they have cash, and that they have very little financing risk. Strategic buyers also say, ‘We can close in two weeks, and it will take private equity bidders 30 to 45 days to come up with their financing.’”

A recognition of competitive advantage is also at play among some European corporations, says Brian McKay, a managing director and head of European Corporate Finance in investment bank Houlihan Lokey Howard & Zukin's London office. The drop in the dollar plays some role in this, says McKay, but European buyers are very interested in the US mid-market quite independent of foreign exchange rates. “We're seeing a number of our corporate clients looking to the US for growth, particularly through acquisition,” says McKay. “Over the last three of four years, European companies have really been repairing their balance sheets, and there's been a swing toward the seeking of international growth.” US mid-market private equity portfolio companies are prime targets for this growth hunting, says McKay. “European corporates have been proactively approaching US private equity firms for deals. All things being equal, time is better spent looking at assets held in fund portfolios, because by definition these businesses will become available.”

McKay says he currently is advising a leading European corporate client who is pursuing a portfolio company owned by a US fund. This client is in a particularly strong position at present. “Since the credit market problems, this corporate has found himself to be the last man standing in terms of being a credible buyer,” says McKay. “Everyone else was an LBO buyer who needed LBO financing.”

LP INTEREST PIQUED
While mid-market GPs feel confident on the deal front, the best of them should have reason to feel particularly confident on the fundraising front. Increasingly, limited partners, even the largest ones, are finding reason to carve out greater allocations for a part of the market that has traditionally been viewed as more attractive, but more of a hassle to access. Dana O'Brien, a New York-based managing director and head of the new co-investment business of Paul Capital Investments, the fund of funds affiliate of Paul Capital, says his firm has a particular interest in the mid-market, relative to the megafund market, and has the statistics to support this. O'Brien and his team have determined that over the past three years, US buyout funds to have raised funds of less than $1 billion in size have together raised only 24 percent of the total capital in the US private equity market. And while growth in the billion-plus fundraising market has ballooned in recent years, in the sub-billion market fundraising growth has been all but flat. “There is really a imbalance between supply and demand for capital in the middle and lower end of the market,” says O'Brien, who also points out that leverage multiples in the sub-billion fund market “did not get out of whack” compared to the growth of leverage multiples in the mega-fund market.

O'Brien argues that many investors are under-allocated to the lower end of the market, in part because many of these firms lack an institutional brand name and infrastructure, and – a perennial problem – because small funds do not allow large LPs to write large commitment cheques.

Small-market hassles aside, more LPs are now proactively seeking GPs in the $500 million to $1 billion fund range, says Doug Jarrett, a partner at New York placement agent BerchWood Partners. LPs perceive that the more attractive opportunities at this end of the market are with GPs that have driven returns based on operating expertise and access to deal flow rather than heavy leverage. “A number of investors are reserving allocations for reups with larger funds, but also for some of the smaller middle-market groups.”

Brian Gallagher, managing partner of Chicago-based fund of funds Twin Bridge Capital Partners, confirms this trend: “We believe the recent turmoil in the markets has led many limited partners to put increased emphasis on the lower mid-market where there are more companies available at reasonable prices and the relative returns are more attractive.”

That's the kind of market intelligence that can warm a middle-market GP's heart, no matter how cold the debt markets.