It's big, and almost every private equity firm operates in it, yet it's strangely un-competitive. Everyone understands what it is, yet no-one can define or quantify it. It's national, but it can also be pan-European. It has legions of good growing companies and offers the most transactions, but there are few advisors and no auctions. Though one thing's for sure: it's much, much bigger in the US.
It is, of course, the mid market, whose riddle has long puzzled many industry participants. The contradictions of this market are so manifest that to imply homogeneity would be misleading.
There have been attempts to quantify and define the mid market. However, while the term is one of the most widely used in the private equity glossary, it is significant that neither the BVCA nor the EVCA feel able to use it as a workable definition in their statistics. The BVCA has taken a step in this direction with 'mid-MBOs', now defined as deals backed with £2m-£10m of equity, as opposed to 'large' transactions with more than £10m of equity. However, these BVCA definitions, even though updated in the last five years, are already at odds with general industry usage.
This lack of clear quantification is hardly surprising. Definitions of this 'market', in terms of deal size, range from £2m to £100m of equity, or enterprise values of £10m to £300m. UK mid market funds range in size from £60m to over £1bn and in the US there are numerous 'mid market' firms managing funds capitalised in excess of $2bn.
Success leads to scale
Ultimately, the struggle with definition is a consequence of the remarkable extrusion of the whole private equity industry over the last fifteen years. The growth in the industry has seen a concomitant increase in the scale and ambition of its participants. Thus the most successful mid market investors of the last decade – groups such as Candover and Cinven – are now undertaking very different investments to the £5m-£10m of equity they put into buyouts in the early 1990s. This shift has added to the problems surrounding the mid market – its active participants have not been constant, indeed its historical leaders have all but exited the market. This is shown very markedly in the chart below.
|General Investment Trend of Private Equity Firms 1996 – 2001|
Perhaps a more useful way of looking at the market is to sidestep the statistics and look at the characteristics. Certainly the mid market in which Inflexion operates has some very clear qualitative themes.
Our experience at the smaller end of the UK mid market is that it generates a large volume of transactions and therefore the opportunity for selectivity.
Quality and Quantity
As the chart below shows, the vast majority (75 per cent) of UK buyouts have an enterprise value of £5m-£50m, while the low standard deviation reveals the consistency of this transaction volume – not surprising given that 98 per cent of UK companies have turnover of up to £100m (Source: Bureau van Dijk /Jordans). In short the investable universe is large and transaction flows are very consistent. The choice for a private equity firm operating in the £5m-£50m segment is therefore broad.
|UK MBO Market 1997 – 2001|
By contrast, the chart also reveals that dealflow in the large buyout arena is both scarce and much less consistent, with a standard deviation of around one third of average annual deal volumes. Additionally, given the number of large funds seeking investment opportunities in this size range, transactions are hard fought over. We also know this to be the case anecdotally: tight auction processes with limited access to management and parallel datarooms abound. The once coveted exclusivity agreement is becoming devalued as each auction is essentially a contracts race, with the participants, and their investors, either nursing the bill for the abortive costs of the also-ran or potentially living with the 'winners curse'.
However, the controlled auction on a ferocious timetable is much less prevalent at the smaller end of the mid market. Consequently due diligence is conducted at an appropriate pace and with full access to both management and information: a process which very much reflects the competitive dynamics of the mid market.
The most significant cause of auction-intolerance is the combination of a fragmented funding market and plenty of opportunity. However, a secondary factor is the refusal of private equity firms in the mid market to bear large abort costs. Fee income on smaller funds just cannot support substantial aborted transaction costs that are an inevitable by-product of participating in auctions.
This difference in transaction process is so pronounced and important that one could almost usefully define a sub-set of the mid market, the 'sub-auction' market. The opportunity for a GP to take time to sift the numerous opportunities for investment is a luxury not afforded to the larger buyout groups. The relative lack of competitive tension for transactions, and refusal of disciplined mid market groups to emulate their large buyout colleagues and be tempted to bid-up valuations because deals are scarce, has on the whole, maintained a very constant and sensible cap on valuations.
Given the scale of the investable universe, and the relative paucity of advisory fees, coverage of the market by advisors is incomplete. It also takes many different guises and is more in the nature of an introduction. Proprietary, unadvised dealflow may be a myth in the larger buyout market, but is very much a reality at the smaller end. However, a commitment to research is expensive and requires long-term horizons. As a consequence, it is perhaps not best suited to groups comfortable to be reliant on their one-time colleagues in the accounting firms for dealflow.
A wealth of investment opportunities at generally sensible valuations creates an attractive backdrop for selective private equity investing. It also results in a more constant flow of closable investments. Buyouts require leverage and while cautious, banks are still more than willing to lend 2.5 – 3.5x EBITDA. That level of leverage does not help much if the investment is valued at 8x EBITDA, but at 4 to 5x (which is the average pricing we are seeing on mid size buyouts), it is plenty. In short, smaller mid market focused groups can invest in the down swings much more actively than the larger groups, and thus take full advantage of good purchasing opportunities.
It is also important to recognise that the value creation process itself is distinctive in this market. There are certain decidedly 'mid market' ways of making money, and private equity firms need to understand these and structure their businesses and resources accordingly. Additionally there are certain industry sectors where mid market companies can make a difference or indeed be the principal beneficiary of change.
In our experience, returns in the mid market come overwhelmingly from earnings growth in the underlying investee companies. Our track record spans 33 mid market investments made between 1990 and 2002, 70 per cent of which are buyouts and 65 per cent are fully realised. It is therefore a reasonable surrogate for sub-£50m enterprise value investing. Earnings growth has accounted for two thirds of our returns over the last decade, and we suspect, will be at least as important in the coming decade.
These differences should not be surprising. Classic mid market investment theses would include growth buyouts, where a mid-size company is well placed in a growth market, and roll-outs and build-ups, where leverage is often present to enhance the returns to equity, but earnings should grow faster. Equally, the institutionalisation of companies is another mid market value creator – upgrading management and information systems, introducing true shareholder value disciplines before selling to the natural trade acquirer – again, this in our experience results in more marked uplifts in profit and cash generation.
The academic debate about the definition of the mid market will no doubt run and run, and its contradictions will continue to confound the statisticians. The answer to the riddle lies not in its numeric definition however, but in the qualitative aspects, the themes and the opportunities. Identifying these is where an understanding of the mid market lies. Taking advantage of them is what will define its most successful participants.
Simon Turner is Joint CEO of Inflexion, a London-based mid market private equity firm. He can be contacted at firstname.lastname@example.org