US mid-market: Why the middle matters

While the private equity industry has become increasingly adventurous in terms of the geographies and industries it invests in, its bread and butter is still very much the US mid-market.

Though fundraising figures are on pace to be down 5-6 percent on 2016, at $57.1 billion for the first half, mid-market US funds still made up 75 percent of all funds closed so far in 2017, according to PitchBook. They are also raising more quickly, with the time taken for a fund to close going from 15 months in 2015 to 10 months in the first half of 2017.

This level of competition has driven up the price of assets. US mid-market M&A multiples are at an estimated 9.9x in 2017, compared with 9.6x last year and 9.1x the year before. Coupled with an appreciable growth in the leverage that banks are offering – one mid-market GP reported being offered loans worth six times a portfolio company’s profitability – and you have what amounts to a rather frothy market.

High pricing has not yet affected dealmaking. Total deal volume in the US mid-market is in line with last year, and the amount of capital invested up 23 percent compared to the first six months of 2016, according to PitchBook. The data provider defines the mid-market as US-based companies acquired through buyout transactions of between $25 million and $1 billion.

But the situation has accelerated a trend that was already taking place: the move towards increased specialisation as a means of differentiation. This does not just mean focusing on single sectors, such as healthcare or technology, but drilling down even deeper.

The Riverside Company is a mid-market firm that takes both control and non-control positions in businesses of up to $400 million in value. It has an array of highly specialised vehicles such as one dedicated to early stage B2B software-as-a-service (Saas) businesses, in keeping with the fact that IT deals accounted for 30 percent of the market in the first half. With distinct specialisations, the firm feels it can compete on a level beyond price and wastes less time on targets that are not quite right.

“We want to find out early what they really want in a partner and try to line it up as soon as possible,” says Jeremy Holland, head of the firm’s North America origination team. “Or we have a candid conversation internally on whether we should bow out, because it’s in a niche where we haven’t really spent time. If you don’t have that value-add then it’s all about price and that’s really tough. One can argue, does anyone ‘win’ an auction? On eBay, you may have paid more than anyone else but did you ‘win’?”

Fun times for funds of funds
For funds of funds managers with dry powder to deploy, in some ways it is a great market in which to be. There are growing numbers of increasingly distinct suitors doing all they can to get you onboard. At the same time, fund of funds managers still have to negotiate the elevated price environment, which makes choosing the right GPs, who can deploy capital in a timely and productive manner, even more important.

Hamilton Lane closed its last flagship fund of funds Hamilton Lane Private Equity IX in July last year on $516 million, above its target of $400 million. According to Christian Kallen, managing director with Hamilton Lane’s fund investment team in the United States, mid-market GPs are deploying capital at a pace close to the long-term average – nothing to worry about but a little more slowly than two or three years ago. Either way, investing in the right GPs should trump any short-term pricing concerns.

“High prices are nothing new to the industry,” says Kallen. “These days, market-clearing prices are often required to win a deal. GPs need to have a view, a thesis, a strategy of what to do with a company after they buy it. If they can match the strategy and expertise to the right company, then it makes sense to pay those kinds of multiples. Firms that are just buying the market, may be setting themselves up for mediocre returns.”

Exit options
Since 2015, there has been a marked downturn in M&A activity across the US mid-market. According to PitchBook, the first half of 2017 saw $44.5 billion worth of exits across 410 deals, down 15 percent year-on-year by number of deals. This is largely driven by the reduced role of strategic buyers, which accounted for 43 percent of exits in the first half of 2017. This is down from 48 percent during 2016, which was the lowest figure since 2006.

Secondary buyouts are driving the market, as is an increase in initial public offerings. There have been 23 exits through listing in the first half of 2017, worth $6.2 billion – already nearly double the volume and value seen in 2016. Despite this increase, Holland doesn’t envisage significant development of the IPO market. Even if a firm grows to the point of being able to list, a secondary buyout is the preferred option for the time being.

“The extra amount of time, cost and attention that goes to compliance and reporting in that manner does not appeal,” he says.

“Just as importantly, a lot of our LPs would rather just have cash returned as opposed to restricted securities in public companies. And strangely, at this frothy point in the cycle, we are seeing superior valuations achieved in a private M&A process to other financial sponsors or to a strategic buyer.”

The decision to sell in the private market is also driven by political and macroeconomic risk. While the market seems to be impervious to such risks for the time being – for good or bad – GPs have spotted an opportunity to lock in simple cash returns while they can.

“General partners are more open to selling their portfolio companies quicker, after a two-, three- or four-year hold period,” says Kallen. “There’s a very strong market they can sell into right now and get attractive multiples on the way out… It may be a little premature, but they are taking a bit of risk off the table.”

For the time being, GPs are likely to continue to take advantage of high exit multiples by holding assets for less time. While fundraising is set to remain strong by historic standards, PitchBook expects it to decline in the medium term as a growing number of LPs reach their private equity allocation targets. Whatever happens, it will be a long time until another can match the breadth and variety of the US mid-market.