US mid-market 2019 September 2019 • privateequityinternational.com
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Senior Editor, Private Equity Toby Mitchenall [email protected], +44 20 7566 5447 Senior Editor, Private Equity, Americas Isobel Markham [email protected], +1 646 380 6194 US mid-market 2019 Senior Special Projects Editor Graeme Kerr [email protected], +44 20 3862 7491 ISSN 1474–8800 • SEPTEMBER 2019 Special Projects Editor James Linacre [email protected], +44 20 7566 5465 News Editor Adam Le Intelligent portfolio construction [email protected], +44 20 7566 5437 Insight Co-investment portfolios can create Senior Reporters outperformance while also mitigating risk Carmela Mendoza over multiple market cycles 13 [email protected], +44 203 640 7512 Rod James 2 Breaking through [email protected], +44 20 7566 5453 Key trends European entrants to the US upper Asia Reporter LPs want to know mid-market GPs are Alex Lynn mid-market buyout arena need to stand [email protected], +852 2153 3148 picking and prepping businesses that will out, says Ardian’s Thibault Basquin 14 Reporter survive a recession Preeti Singh Going global [email protected], +1 646 565 5312 Editor’s letter GPs are becoming more creative and more global in their approach 16 Contributors Appetite remains for booming Amy Carroll, Claire Coe-Smith, Marine Cole, Rob Kotecki and Vicky Meek mid-market 6 Managing Editor, Production: Mike Simlett Head of Production: Greg Russell Production Editors: Daniel Blackburn, Adam Koppeser Analysis Copy Editor: Eric Fish Head of Design: Miriam Vysna Senior Designer: Lee Southey 8 Designers: Denise Berjak, Glen Reynolds Trade war trade-offs Head of Marketing Solutions, Protectionist policies are affecting supply Private Equity Group: Alistair Robinson chains, creating both winners and losers, [email protected], +44 20 7566 5454 say Baker McKenzie’s Michael Fieweger Subscriptions and reprints and Mark Mandel [email protected] Customer Service Thought leaders [email protected] CEOs and CFOs give their two cents on Editorial Director: Philip Borel Continuing to create value seven issues affecting the market from Director, Digital Product Development: Firms are working harder to drive growth asset prices to technology 10 Amanda Janis late in a fund’s life, says Investec Fund Director of Research & Analytics: Dan Gunner Finance’s Tom Glover 18 Managing Director, Americas: Colm Gilmore Managing Director, Asia: Chris Petersen Mid-market economics Group Managing Director, Brands and Markets: Delivering top-line growth 20 Paul McLean Setting up offshore funds Chief Executive: Tim McLoughlin As popular destinations stiffen regulations, TMF Group’s Anastasia Williams discusses the impact on GPs 22 Databank For subscription information visit Dealflow continues to rise 24 privateequityinternational.com Last word Pritzker Private Capital’s Paul Carbone on life since his firm’s split from its parent group 28
September 2019 • US Mid-Market 1 Key trends LPs want to know mid-market GPs are picking and prepping businesses that will survive a recession
he US mid-market had A story about selection a stellar year in 2018, “There was definitely a slow start especially in terms of deal of the year,” says Christian Kallen, activity, but some softness a managing director on Hamilton is emerging at the margins, Lane’s fund investment team, adding writes Marine Cole. The that it lasted until about March or April. Tenvironment is marked by asset prices “Then it got back to normal. Can we that continue to be elevated and by catch up to the end of the year? I am not limited partners who are increasingly 100 percent sure, but everything else in preoccupied with how mid-market firms 2019 will look very similar to 2018. If we will weather an inevitable economic look at our distributions, it looks pretty downturn. close to last year.” lot of them aren’t getting sold. It’s a story Deal activity in the US mid-market On the exit side, while initial public about selection.” reached a decade-high in 2018 for offerings continue to be nearly non- In this late cycle, investors are willing number of transactions and deal existent, secondary buyouts are still the to pay a premium for strong companies volume. There were 3,072 mid-market most common route in the mid-market. that will be able to weather a downturn. transactions in the US in 2018, totalling However, GPs are noticing a decrease Companies that have strong predictable $437.7 billion, up from 2,655 deals in the quality of companies that are cashflow and aren’t cyclical are not totalling $381 billion in 2017, according coming to market. In particular, there only being sold easily but are also to data from PitchBook. are more companies that have been in the ones fetching high exit multiples. However, the beginning of 2019 portfolios for a long time, or businesses Some of these can be found in the was slower, due in part to volatility in that may have had issues in the past or healthcare sector, business services and the public markets at the end of 2018. are simply unsound. technology, particularly those focused In the first quarter, GPs closed on 649 “It feels like later stage,” says Vincent on software. deals totalling $75.1 billion. Q2 figures Fandozzi, head of North America direct “In a downturn, everything is going had not been released by the time we buyouts at Ardian, who focuses on the to struggle, but the question is by went to press but market participants lower mid-market in the US. “People how much,” Fandozzi says. “GPs may noted activity had picked up and the are trying to use the strength of the be putting a little bit of a premium total figure for the year could be near financing market and the M&A market on businesses with a safer view on 2018’s. to see if they can get something sold. A cashflow.”
2 Private Equity International • September 2019 Kallen adds: “It feels like everyone in “The market is the US mid-market is looking for capex- more saturated Big numbers light businesses with recurring revenue now than it was in Facts and figures from across the and that are easy to scale.” the past” US mid-market He notes that the flipside of buying good-quality businesses at high Eric Zoller multiples is that GPs are using more Sixpoint Partners leverage to be able to deliver the performance LPs are expecting. “In a downturn, “The positive impact on the everything is operational side gets kind of negated by going to struggle, the financial risk you have to put to be but the question is able to buy them,” he says. “But this is by how much” where you see a lot of growth.” Vincent Fandozzi Ardian 3,072US mid-market deals in 2018 (PitchBook) $437.7bn Value of deals in 2018 (PitchBook)
Exits in 2018 999(PitchBook)
More risk-taking Some GPs have been forced to become less conservative than they were about five years ago. “The challenge for “There seems to be a shift that the GP in the mid- everyone is now trying to play that kind market is really to of market and taking the risk, which figure out where obviously will lead to issues down the we are in the cycle road at the end of the cycle,” says Kallen. and constructing $10bnTexas dealflow 2018. The highest by state “The question is when the end of the their portfolio (PitchBook) cycle will hit and what is the quality you accordingly and have to put in the portfolio at that point.” making sure they These are the types of questions don’t get caught that LPs are increasingly asking their with a portfolio GPs, particularly during due diligence. with a relatively Delivering good returns is no longer high leverage” 69% solely sufficient. Proportion of mid-market managers with confidence in the “I think some GPs think that as long Christian Kallen global economy. The lowest level since 2016 as we put our head down and deliver Hamilton Lane (National Center for the Middle Market)
September 2019 • US Mid-Market 3 Insight
good returns, everything should be OK,” attract interest from LPs as Arcline says Eric Zoller, founder and partner Investment Management, a firm set at Sixpoint Partners. “A lot of GPs are up by former Golden Gate Capital delivering good returns today, but good dealmaker Rajeev Amara, showed when returns by itself today is not a sufficient it closed its debut fund in March on $1.5 differentiator. billion. The firm’s strategy is centred “Today GPs need to differentiate around buying mid-market industrial themselves by their approach to the businesses. market, the edge they have into how “Typically, first-time funds or new they deliver those returns, and most managers were raising funds with a importantly perhaps, by demonstrating couple of hundred million dollars,” they can continue to deliver those says Kallen. “You’re now seeing more returns even as the market continues and more first-time funds and new to heat up and potentially even turns managers starting with $1 billion. This down.” is definitely new, that you can raise LPs want to know how a GP will significantly larger funds in a first-time manage its portfolio in a downturn and, fund than you were able to do five or as a result, GPs with a strong operational six years ago.” focus are getting increased resonance While some funds have a because they are the ones who will have one-and-done close on their an edge in managing companies in fund, this is not the case for difficult times. all US mid-market GPs. LPs’ Investors are also focused calendars are filling up even on managers’ pricing faster than in the past and discipline and the interplay they are putting their money between that and investment to work earlier in the year pacing. They want to make than they used to, making sure GPs are putting the money it more important than ever for GPs to to work, but they also want to make sure they get on LPs’ radars prior ensure that they are doing so in a to officially launching their funds. prudent fashion by not overpaying. “If you look at 2019, many LPs are already out of capital and are already A split fundraising market building their calendar for 2020,” Zoller Zoller observes that overall, the says. fundraising environment for US mid- What the economic environment market funds has become bifurcated will look like in 2020 and whether a between funds that demonstrate they downturn will have hit by then is still can deliver liquidity early and raise unknown, but it’s clear that US mid- funds easily and those that are taking market funds and their investors will longer because they can’t demonstrate have to continue to put a greater liquidity. Fundraising figures for US mid-market emphasis on making sure portfolio “It’s because the market is more vehicles fell in 2018 and have continued companies are ready when it comes. saturated now than it was in the past,” to decrease this year, but good “The challenge for the GP in the Zoller says. “LPs may be looking for an managers that offer strong liquidity have mid-market is really to figure out where exit from the prior fund, and perhaps a been able to continue to raise swiftly. US we are in the cycle and constructing deal in the new fund. If you go back to mid-market GPs closed on $9.17 billion their portfolio accordingly and making the 2015-18 period, the market didn’t in the first half of 2019, according to PEI sure they don’t get caught with a require the same degree of liquidity or data. In 2018, that figure was $33.65 portfolio with a relatively high leverage portfolio development, and GPs were billion, down from a peak of $50.4 that might get them into trouble if the still successful in raising a new fund with billion in 2017. revenue and EBITDA growth stops,” or without new investments.” The largest US mid-market fundraise says Kallen. GPs are having to wait to launch in the first half of 2019 was SK Capital “It really comes down at the end their fund until they either get an exit Partners V, which closed on $2.1 billion of the day to what is going to be the or show an additional investment in in February. SK Capital focuses on catalyst that makes the cycle enter the the new fund. They may also have to investing in the speciality materials, downturn, and the macro-economic offer a fee break or some other special chemicals and pharmaceuticals sector. environment will be the biggest relationship. First-time funds also continue to challenge for the mid-market.” ■
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Editor’s letter
New York Hungry for more 130 West 42nd Street Suite 450 New York NY 10036 of the mid-market T: +1 212 633 1919 London 100 Wood Street London EC2V 7AN T: +44 20 7566 5444
James Linacre Hong Kong [email protected] 19F On Hing Building 1 On Hing Terrace Central Hong Kong T: +852 2153 3240
Private Equity International he US mid-market’s praises do not get sung often enough. As the biggest beasts and Published 10 times a year by PEI Media. To find out more about smallest minnows capture attention, the companies in the middle keep powering PEI Media visit thisisPEI.com forward. Private equity mid-market dealflow was up $57 billion in 2018 compared T © PEI Media 2019 with 2017. A deal count of 3,072 was more than 400 greater than the year before. Taking the National Center for the Middle Market’s definition of mid-market No statement in this magazine is to (companies with revenue of $10 million-$1 billion), it is a sector that has accounted for be construed as a recommendation to buy or sell securities. Neither some 60 percent of job growth in the US over the last eight years, with revenue in the last this publication nor any part of it year that was 6 percentage points higher may be reproduced or transmitted than companies in the S&P 500. Private in any form or by any means, electronic or mechanical, including equity-owned mid-market companies were “ Companies with photocopying, recording, or a significant part of that. by any information storage or strong cashflows retrieval system, without the prior The question is whether this strong permission of the publisher. performance can last, and there are plenty and which are not Whilst every effort has been of voices calling for caution. Some GPs made to ensure its accuracy, the publisher and contributors accept are responding by going global, looking viewed as cyclical no responsibility for the accuracy to expand portfolio company activity of the content in this magazine. across the Atlantic where once they would are attracting a lot Readers should also be aware that external contributors may have focused on domestic buy-and-build of attention ” represent firms that may have strategies. an interest in companies and/or their securities mentioned in their Within the US, there is a greater contributions herein. emphasis on selection. With concerns that the market is into the late cycle, investors are paying a premium for companies that are expected to fare better in a downturn. Cancellation policy You can cancel your subscription at any That has created a two-tier market, in which companies with strong cashflows and time during the first three months which are not viewed as cyclical are attracting a lot of attention, whereas others are of subscribing and you will struggling to be sold. GPs note there has been a decline in the quality of companies receive a refund of 70 percent of the total annual subscription coming to market. fee. Thereafter, no refund is Fundraising stalled at the start of the year as these concerns took their toll, although it available. Any cancellation request needs to be sent in writing to has since recovered. Investors have been sweet on the US mid-market for a long time now the subscriptions departments and developed a taste for it. Although they are increasingly looking to the horizon, their (subscriptionenquiries@peimedia. appetite is still strong – it is just that their palates have become more discerning. com) in either our London or New York offices.
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KEYNOTE INTERVIEW
Trade war threats and opportunities
As protectionist trade policies impact supply chains of mid-market American businesses, private equity firms are both winners and losers. Baker McKenzie partners Michael Fieweger and Mark Mandel discuss the impact on pricing and portfolios
What impact is the US reopening of NAFTA and termination of SPONSOR protectionist legislation having participation in multi-lateral trade talks. Q BAKER McKENZIE on mid-market private equity The other is national security, which is transactions today? manifested in increased scrutiny of and ac- Mark Mandel: The trade war began last neighbouring nations have gained an advan- quisitions of technology companies and in- year when the President responded to the tage as a result. There are no clear winners creased scrutiny of IP transfers, particularly huge trade deficit with China by imposing or losers, it simply depends what the supply in areas like 5G. It is not always clear what tariffs on billions of dollars’ worth of Chi- chain of each business looks like. If you’re goals the administration is pursuing and, as nese products. He also opened a now com- a private equity firm that owns a company a result, it is not clear as to what may or may pleted renegotiation of the North American that manufactures in China you are having not be an acceptable solution to the trade Free Trade Agreement by imposing import issues, but if you own a portfolio company in sanctions imposed by the administration. tariffs on both Canadian and Mexican goods a neighbouring country it’s a bonanza while Trade sanctions driven by the promotion as part of that renegotiation. trade negotiations continue. of trade policy and national security inter- The number of goods and businesses est have differing effects on private equity impacted is staggering, and those private Michael Fieweger: There are two com- investments. Enhanced national security equity portfolio companies that are buying peting goals behind US foreign trade poli- reviews for example are impacting mid-mar- products from China as part of the supply cy. One is the promotion of the President’s ket deals, largely removing Chinese buyers chain have seen costs go up, while those mercantilist America First trade policy, from the market and creating concern that source goods in Vietnam, India or and includes the imposition of tariffs, the from other foreign buyers and limiting the
8 Private Equity International • September 2019 Analysis
market for the services provided by high producers because they are not subject to tech companies. higher tariffs, we have crafted provisions That impacts the calculus as you go into “Enhanced national that provide that if a tariff were to be technology deals in areas like software or imposed on a product, the seller would software services, because one has to con- security reviews have to pay damages to the buyer. The sider whether there are aspects of the busi- parties negotiate a formula that applies to ness that could be subject to limitations on are impacting mid- determine damages. the transfer of technology, which maybe Either the parties can share the pain or were not an issue in the past. Or, are those market deals, largely the seller can bear all of it. We have seen businesses likely to be the focus of potential this in the form of indemnification on pur- backlash legislation from other countries in removing Chinese chase price provisions. We have used these the future? provisions a lot since the beginning of the buyers” trade wars. Which sectors and types of Right now, private equity firms are try- Q portfolio company are feeling MICHAEL FIEWEGER ing to get to a view on what is the new nor- the greatest impact, and why? Baker McKenzie mal, and once they feel comfortable, they MF: There are some sectors that are seeing will start to operate their businesses under less activity. A client was looking at a deal that construct. It may affect how they put where the end markets are tied to the agri- money to work. In the short term, until the cultural markets. Interest in the target was trade wars are resolved, they may shy away very low, because US farmers are being hit from businesses that have more exposure badly by the tariffs being imposed in China. to tariff risk. However, deals are still get- Sectors hit hard by the trade war like agri- ting done and private equity funds still have culture are a tough place to play these days. with companies with complex supply chains, money to deploy, so they can price the risk Across industrials it has not been easy, there may be some value to be added by repo- into the deal or negotiate the indemnifica- because notwithstanding the intent to ben- sitioning supply chains moving production tion or purchase price adjustment provisions efit US manufacturing, the supply chains of and sourcing out of China into other South- to limit the risk. even heavily US-centric companies are be- East Asian countries. If the fund and manage- ing negatively impacted. Most middle-mar- ment are willing to put in the work there may What advice would you give to ket US industrial companies have supply be opportunities where the targets have been Q any mid-market firms that are chains which are heavily dependent upon negatively impacted by the trade wars. concerned about this? trade with China, Mexico and Canada. There is also a calculation to be made MF: The protectionism and the trade war The presence of existing tariffs and con- about whether this all dies down through are not going to go away any time soon, so stant threat of new tariffs creates significant the hold period. In some of those sectors the advice is to be thoughtful about their risk when looking at a US manufacturer. being hit hard, there is a buying opportuni- impacts when you are making investments Clients are looking carefully in those situ- ty because this will hopefully be resolved by and when you are addressing issues with ations at how much pricing power the com- the end of your hold period. your portfolio companies. panies have and their ability to pass on the There are both negative and positive increased input costs to customers. MM: These policies have created oppor- impacts, and that discussion needs to be an Technology is being impacted in certain tunities but they are not without risk. We item on the board agenda. segments, but overall that market remains are in a period of transition, because it is Attention needs to be paid to the impact pretty strong, particularly in the middle mar- likely that the policies are going to change. on supply chains, earnings, contracting with ket where a lot of investments in technolo- The trade wars could be resolved like with customers and suppliers, and how acqui- gy-enabled services do not see a lot of impact NAFTA or they could expand in intensity sition and partnering opportunities might from the tech transfer focused sanctions. and scope. be created. Some of the best private equity On a macro level, we are seeing a de- Nevertheless, we are still seeing some firms are looking at this as an opportunity, a cline in cross-border investment and people private equity firms purchasing companies way to distinguish and a way to use thinking are putting money to work closer to home. that manufacture in these neighbouring around these challenges to create and un- Asian investments into the US have really countries. They are betting in the medium lock value. dropped off. A lot of that can be attributed term the tariff wars will be resolved favour- Companies need to be thinking about to the trade war, but it is also really expen- ably. how they plan for a prolonged trade war and sive to come into the US at the moment as a what the knock-on effects might be, not just foreign fund and outbid local players. What can private equity firms in the US but also elsewhere in the world. Q active in the market do to The political circumstances that have result- How do you see the policies mitigate the impact of protectionism ed in us getting to this point are not unique Q creating opportunities? and regulatory uncertainty? to the US, so we should not necessarily ex- MF: If you are a private equity fund that is MM: In the context of private equity funds pect this to blow over resulting in free and operationally-focused and used to working buying companies that are lower-cost open markets everywhere. ■
September 2019 • US Mid-Market 9 Analysis
On the minds of industry leaders
How are mid-market CEOs and CFOs managing the long-lasting expansion of their industry, with its high asset prices, sophisticated LPs and cutting-edge technology?
Our mid-market panel
Nathan Brown Managing director, Wind Point Partners
Omar Hassan Principal and CFO, Cloverlay
Heramb Ramachandran CFO, XPV Water Partners
Brian Ramsay President, Littlejohn & Co
Alex Slusky Founder and CIO, Vector Capital
Béla Szigethy Co-CEO, The Riverside Company
Ted Virtue CEO, MidOcean Partners
What is the biggest challenge facing as a value investor with unique distressed and special situations ca- Qyou in the next few years? pabilities. Heramb Ramachandran: Supply and demand. There is an abun- Ted Virtue: With all the capital that has moved into PE, we need dance of private capital and a finite amount of deals. Valuations re- to remain disciplined to where we have a knowledge-based advan- main high, and I don’t see this reversing any time soon. tage. We need to continue to have the best knowledge, networks and Brian Ramsay: Sourcing new deals at a reasonable valuation will management resources in the sectors where we invest. continue to be our biggest challenge over the next few years. Since Omar Hassan: It’s talent retention. This means we have to build the great recession, a winning PE strategy has been to buy great an attractive culture beyond compensation. So we treat everyone like companies for whatever it takes to prevail and then benefit from ex- owners here, and make sure everyone feels their contribution matters. panding multiples on exit. Nathan Brown: The biggest challenge is to continue developing This approach has become a very crowded trade, however, and best practices that allow us to succeed as the market continues to PE buyers have started to stretch their definition of ‘great’ to in- become more competitive. We meet quarterly to assess how we can clude companies with more complex stories. This will at some point improve in all areas of firm activity: deal sourcing, CEO recruitment play to our strengths, so even a mild economic softening or financial and assessment, value-creation plan development and deployment, market hiccup should lead to interesting opportunities for Littlejohn and others.
10 Private Equity International • September 2019 Analysis
Are you diversifying? Q OH: We’re a relatively new firm that launched in 2015, and we feel LPs would like us to stay true to our core competencies. BR: For nearly 25 years, our focus has been to deploy capital in situations that can benefit from some sort of transformation. We started with control private equity, then added expertise and solu- tions in special situations and distressed debt. More recently we have built teams to invest in performing credit and more highly structured capital solutions. When an opportunity arises to use that knowledge to support a business transformation, we want to be able to say yes. TV: MidOcean diversified into credit in 2009, where we now manage over $8 billion in assets across a number of strategies in corporate debt. These credit strategies stem from our specialised experience and expertise in the mid-market, drawing on the strong industry-focused network of contacts our team has built up over close to two decades. We now manage two long/short credit strate- gies, several long-only mandates and a number of customised credit vehicles, in addition to a fast-growing CLO business. NB: We have been investing in three core sectors over the past 20 years, which has given us diversification. However, we’re constant- ly analysing the market trends within those sectors and shifting to where we see the most opportunity. Lately, we are focused on mar- kets and business models that are high free cashflow and recession resistant.
How is the relationship between Q GPs and LPs evolving? OH: They’re more sophisticated, and looking for a continuous col- laboration with GPs. We’ll have periodic updates with LPs about our pipeline and discuss things we’ve passed on that might still make sense for them in a different area of their portfolio. LPs aren’t just clients; they’re partners. Béla Szigethy: It’s constantly evolving for the better, meaning great- er transparency in both directions: LPs being clear about what they want and GPs being transparent about what we expect to deliver. BR: For the last several years, LPs have been looking to deepen their connections with PE firms they view as priority relationships. This might mean committing larger dollars to a smaller number of GPs, seeking co-investments with trusted firms or supporting the growth of PE firms by allocating to their new strategies. NB: GPs and LPs are finding more ways to collaborate and add val- ue to one another. LPs have become more sophisticated on how to leverage their experience and network to bring ideas and new capital to GPs. We’ve benefited from LPs bringing us deal ideas, referrals to executives and secondary opportunities. Alex Slusky: The days of only spending time with LPs around fund- raising are gone. We are in constant communication with our LPs and we often approach them early if we are pursuing an especially large deal that we may not otherwise be able to complete on our own, or seek a complex financing package. They’ve become true partners to our business.
September 2019 • US Mid-Market 11 Analysis
Are you launching a secondaries process to provide Qliquidity to investors? NB: We closed a secondaries process on a 2006 vintage fund last year. We had three portfolio companies remaining and had recent- ly recruited new CEOs and developed a new value-creation plan at each company. We were able to get an attractive offer from a new investor that ended up being a win-win-win-win solution for the original LPs, the new LP, the GP and the portfolio management teams. We don’t see a need to launch another process in the near future as we are seeing some early liquidity events on our more recent funds and hope to What issues keep you awake at night? manage those to a 10-year life. QBR: The biggest risks to deals and portfolio companies right BS: We have provided investors in older funds some assistance in now are geopolitical. The ever-widening political divide in the US finding buyers for their positions. We would like to do more here, and many other countries is fuelling alarming policy initiatives from since investors in general are seeking liquidity more often. both ends of the political spectrum. While we have contingency plans in place, we are obviously limited in our ability to mitigate these risks. BS: With a broad portfolio, lots of folks tending to their own com- panies, somebody doing something stupid along the way is always a concern. Compliance-related issues and headline risks can really hurt an investment. NB: We’re benefiting from this strong market, so we’re currently sleeping well! We have tried to build a portfolio that will perform well in a recession, so that we can continue to sleep well. But each recession has different characteristics and it likely will provide chal- lenges that keep us up at night when it comes. AS: Rarely does a month go by when I don’t read about another large pool of capital increasing its allocation to private equity. They look at What is a trend that doesn’t get how PE has outperformed other asset classes over the last 20 years. Q enough attention? This flood of money is depressing returns and distorting incentives TV: Over the past 15 years, virtually every mid-market PE fund across the entire industry. has transformed from a generalist fund to a sector and geograph- ic-focused fund. Sector knowledge is now table stakes to effectively source and operate successful companies. NB: We have seen the need for minority equity or preferred equity increase in the mid-market. We have accessed capital from other pri- vate equity funds to meet this need in our own portfolio. OH: The use of operating partners might face greater scrutiny. There’s room for conflicts of interest and perhaps LPs are paying too great a share of the cost. I expect more transparency around these fees in the future. BR: While great companies get pre-empted at jaw-dropping mul- tiples, an asset that has even a little hair on it may find that nobody shows up at auction. The leverage markets are similarly bifurcat- ed. Some bank deals are two times oversubscribed at record tight How is artificial intelligence spreads, while for others, the underwriters can’t find a bid. In this Qchanging things? environment, some of these ‘busted’ deals are worth a closer look. ■ HR: AI is a potential game-changer in the sourcing of deals. The sweat equity devoted to building up a pipeline that currently might take months and years could potentially be replaced by data-mining bots with real-time analytics. OH: AI’s chief contributions are going to be the back and middle office, where it can address recurring tasks. To me, it’ll be acost reduction exercise. BS: Each of our portfolio companies is in some way benefiting from AI. I would love to see our own firm use AI to help make better investment decisions. We have a broad universe of companies and experiences for an AI algorithm to draw upon. Can’t wait!
12 Private Equity International • September 2019 Analysis
Building a mid-market co-investment portfolio
Guest comment by David Smith and Oliver Schumann
Intelligent portfolio construction can create outperformance and simultaneously mitigate risk over multiple market cycles
ver the last decade, co-investment selection’ and co-investments generally out- fund mitigates risk by 67 percent versus that funds have continued to develop perform investments not offered for co-in- of a randomly-selected buyout fund (ie, a Oand professionalise as the early ap- vestment by private equity managers. This co-investment fund posts an increase in low- proach to making individual co-investments outperformance is primarily attributable to er decile TVPI of 67 percent). often led to unsatisfactory returns. Here, we the lower costs of a co-investment fund ver- make the case for taking a global, actively sus those of a typical mid-market private eq- Anticipating change managed and well-diversified approach to uity fund (ie, approximately half the annual An experienced co-investment team adds building a mid-market co-investment port- management fee and carried interest). Over value by capturing trends that take account folio. We show that this approach leads to this 30-year period, outperformance appears of market cycles, deliberately over- or un- outperformance while reducing risk over more frequently than underperformance der-weighting a portfolio by region, sector, multiple market cycles when compared with and, on occasion, it can be substantial. transaction size and/or structure. For exam- conventionally built portfolios. We call this Intelligent portfolio construction also ple, emerging from the last crisis, there were ‘intelligent portfolio construction’. provides far greater downside protection good opportunities to invest in mid-sized than would be typical of a randomly select- industrial businesses with international ex- The secret of success ed buyout fund constructed by a single fund pansion potential, particularly in Asia. Independent academic research on the top- manager. To explore this, we conducted Later in the economic cycle (2014-16), ic of co-investment has shown that a key advanced proprietary simulations on 268 the co-investor was offered the opportuni- success factor is the presence of a dedicated private equity funds with vintage years of ty to invest in transactions with high-value primaries platform with a broad and deep 1995-2010 and their 4,739 underlying port- creation potential, especially in software network of several hundred top-performing folio companies and found that, by using the and services. More recently (2016 onwards), private equity fund managers. The scale of spread between the median and lower decile co-investors have looked for transactions co-investment dealflow derived from this measures of total value to paid-in capital that provide a higher degree of downside network permits the adoption of intelligent (TVPI) as a measure of risk, a co-investment protection to safeguard against increased portfolio construction. volatility. These examples reflect trends that This expansive network complements experienced co-investment managers have the skillset co-investment managers should “An experienced followed over the last decade or so. have to enable proper, comprehensive as- Academic research and advanced simula- sessment of the characteristics of target co-investment team tion studies confirm that investing in a glob- companies and their management teams. al, well-diversified and actively managed The intelligent portfolio construction ap- adds value by co-investment fund can be an attractive way proach encompasses multiple diversification of generating outperformance, mitigating factors, including geography, sector, pacing/ capturing trends risk over multiple market cycles. ■ vintage and lead investor. Empirical analysis of more than 1,000 that take account David Smith is senior managing director of co-investments among over 13,000 private Capital Dynamics’ co-investment team. equity transactions completed from 1981 of market cycles” Oliver Schumann is managing director of to 2011 shows there is no so-called ‘adverse Capital Dynamics’ co-investment team.
September 2019 • US Mid-Market 13 Analysis
KEYNOTE INTERVIEW
Making the mid-market breakthrough
There may be plenty of opportunity in the US upper mid-market buyout arena, but there’s also a lot of competition. European entrants need to stand out from the crowd, says Ardian’s Thibault Basquin
As the private equity industry becomes in- tions we’ve completed over the past 10 years, SPONSOR creasingly global, not only are US firms es- 30 percent have been in North America. Our ARDIAN tablishing themselves in European markets, US team is leveraging these foundations to but increasingly European firms are expand- build out our investing opportunities here. ing operations in North America, particu- Why did Ardian Buyout decide larly in the upper mid-market. Yet breaking Q it was time to establish a team And how are you seeking to do into this space is not for the faint-hearted – in North America, particularly given Q that? it may be one of the most active segments of the level of competition? We are selectively focusing on identifying private equity globally, but it’s also fiercely North America is a very interesting and large cross-border transatlantic opportunities with competitive. market and we know this because it is not new a European angle, and that makes us substan- In the autumn of 2018, private invest- to us. Ardian has been in the market for 20 tially different from our US peers. We will ment house Ardian expanded its flagship years through our secondaries fund of funds take majority stakes in upper middle market European direct control buyout fund into business and our infrastructure team, so we companies with the goal of helping them the North American upper mid-market. have already developed strong networks. grow and diversify internationally. Our focus Thibault Basquin, head of Americas invest- However, over the past 23 years, our di- is on companies with an enterprise value of ments for Ardian Buyout Fund, explains rect control buyout team has also built out around $400 million to $2 billion where we what it takes to strike a different note in the many European businesses globally, including can provide equity cheques of a minimum market. in North America; of the 130 add-on acquisi- $200 million.
14 Private Equity International • September 2019 Analysis
Given North America is a key destination their proceeds into the company – in order to What about Ardian itself? for our European portfolio companies, it’s keep usually between 20 percent and 40 per- Q How do you apply sustainable invaluable having a local team on the ground cent of the share capital. That is powerful be- practices within the firm? to strengthen our expansion opportunities in cause it signals to employees, customers and This is fully integrated in our firm and en- this region. And vice versa, we have locally suppliers that the family is very much com- compasses everything we do, from leveraging empowered teams in six offices throughout mitted to the company’s continuing success young talent via our millennial committee, Europe that can really help North American and creates a strong alignment of interest. which feeds back to our board on what we companies accelerate their European expan- should be doing, through to ensuring we sion strategies. We also have deep relation- You mentioned sustainability. promote equal opportunities in our firm. ships with the key European corporates and Q Why is it important to you? We established the Ardian Foundation, families and we want to build on our reputa- This has become more important as the shift which is focused on promoting education tion for being the family business partner of towards private capital looks set to continue and social mobility, 10 years ago – that has choice. In our sixth buyout fund, for example, increasing. It’s true that it’s a hot topic now, so far had over 200 beneficiaries and around 60 percent of the deals we did were first-time but we’ve been working on applying sustain- 30 percent of our staff are involved with it. buyouts primarily completed alongside fam- able principles for more than 10 years. We Also, as a firm established by a female lead- ilies. were an early signatory to the Principles for er – Dominique Senequier – female partic- Responsible Investment. We have a duty to ipation in our organisation has always been Which sectors do you see as all our stakeholders to behave in a responsible important, and we established a women’s Q attractive in the US market? and sustainable manner. It’s an area where Eu- club a year ago to support the development There are a number of attractive sectors, but rope has really taken a lead and, because our of our staff. we have a long track record and strong expe- firm has been committed to sustainability for We also run initiatives such as a disabil- rience in the food value chain, and health and so long, we believe we can bring something ity employment week. We have the Ardian wellness. These are also sectors that fit neatly different to North America. Green Challenge as well, an employee-led with our sustainability agenda. Our commitment has to be holistic, so initiative, which aims to reduce waste in our For example, through several add-on it’s at the heart of what we do on a daily ba- organisation, including reducing packaging acquisitions we have helped make Kersia, sis, from managing our investment portfolio and water and energy consumption. which provides biosecurity solutions, one of through to the way we operate as a firm. Since Lastly, our firm is majority-owned by our the largest groups globally focused on food 2008, with the management’s agreement, we employees, with around 70 percent of em- safety. In health and wellness, we invested have also shared a portion of the capital gains ployees invested in the management compa- last year in Inula, a major natural remedies we make from investments with all employees ny. As with our portfolio companies, we want business. in portfolio companies. You have to consider to ensure that all employees have the oppor- the contribution all employees make – not tunity to share in the value they create. Can that also help to mitigate just management and owners – to creating Q high valuations? value in a business. Since we launched that And how will this approach It can, although we are prepared to pay good initiative, we’ve distributed more than €48 Q develop in the future? prices for good quality assets and families are million to over 20,000 employees. We now have a 10-year track record of view- generally well advised and have a clue about ing our organisation and our portfolio com- what their company is worth. Valuations are How else do you work with panies through a sustainability lens and it’s high and will remain so for some time to Q portfolio companies when it clear that this has contributed to our growth; come. There is so much private capital avail- comes to sustainability? maximising financial returns and creating able in the market and not much sign of that In 2015 we were one of five French private sustainable value for stakeholders are not slowing down. equity firms to launch the Initiative Climat mutually exclusive, they are intertwined. 2020, which aims to reduce carbon emissions Now, we believe we need to quantify How are family businesses in majority-owned portfolio companies for more precisely the impact we have so we Q different when it comes to which the subject is considered material. have decided to measure this using the UN’s private equity investment? Since 2009 we have created, in conjunction Sustainable Development Goals. When you invest in a family business, you with management teams, an ESG roadmap We’re working to develop a method of need very good soft skills and a history of for each of our portfolio companies – that’s measuring and reporting how portfolio com- relationship. When a family business has more than 100 businesses. Roadmaps are panies manage their operations on a daily ba- been very successful in the past, the owners monitored and updated every year. sis, what their impact is on the supply chain, and managers clearly know how to run their Portfolio companies find this very useful their customers, and their products and ser- business. Private equity’s role is usually about as it enables them to communicate progress vices. transitioning, reinforcing management teams, both internally and externally, and they can We’re continually looking for ways of implementing a tailor-made value-added gov- see the impact of what they are doing. It improving what we do and as pressure in- ernance and professionalising processes and helps us because we can provide easy, almost creases on the private equity industry to systems. It’s important to tread sensitively. instant access to ESG KPIs to LPs, who are demonstrate sustainable returns, we want to When we invest in family businesses, we increasingly seeking more information on continue to be at the forefront of develop- also ask the owners to reinvest a proportion of sustainability. ments. ■
September 2019 • US Mid-Market 15 Analysis
GPs go global to create value
A high purchase price environment is forcing US mid-market GPs to become more creative and global in their approach, Marine Cole finds
urchase price multiples remain the thesis and what you’re going to do with high overall in the US mid-mar- the company.” ket even if, depending on the Managers try to get ahead of auctions by company and the sector, they analysing other GPs’ portfolios and identi- may be topping out. It is still fying companies that are likely to come to common to see companies trade market. They either buy the company be- Pat 20x EBITDA, mid-market private equity fore it reaches an auction process or study investors say, a phenomenon often driven by a particular asset closely to be able to move widely available leverage at a low cost. quickly and be in a lead position once it hits For several years, US mid-market GPs the block. have focused on buy-and-build strategies, purchasing high-quality platform compa- Taking a global view nies, which often come at high valuations, US mid-market GPs are also taking advan- and averaging down their costs with smaller tage of global opportunities. Firms, particu- add-ons at lower valuations. The reliance on larly those in the lower mid-market, have add-ons to create value has only gathered historically been heavily centred on North steam in the past year. America. This is in contrast to the Europe- that have global clients and proximity to GPs are also holding companies longer an mid-market, which has a deeper interna- them is key. and relying on dividend recaps to boost re- tional mindset, in part due to the fact that it Basquin moved to Ardian’s New York turns to LPs or are, increasingly, using the is a sum of different markets. office in 2018 after spending 20 years in the secondaries market to lengthen the hold In the US, “people are a bit shy to cross firm’s Paris headquarters to focus specifical- period of a company through GP-led trans- the Atlantic”, says Thibault Basquin, head ly on transatlantic opportunities for the GP’s actions, such as transferring assets that need of Americas investments for Ardian Buyout mid-market portfolio. His role includes more time into a continuation vehicle. Fund, which focuses on the upper end of the looking for add-on acquisitions in North Along with such strategies, GPs are also mid-market. “In Europe, they have to.” America for European portfolio companies being more selective about the auctions However, this is changing slowly. “More and assisting North American mid-market they participate in. They are avoiding large and more, US mid-market companies are businesses in their expansion into Europe. auctions as much as possible and instead willing, or will be willing, to expand outside Ardian is not the only firm with global try to take part in the smaller ones. This is of their existing territories,” Basquin adds. ambitions for its mid-market segment. In one route Ardian has taken for example, ac- “It’s a question of maturity of the market. recent years, many European mid-market cording to Vincent Fandozzi, head of North Because the US market is very large and is firms such as London-based Bridgepoint America direct buyouts at the firm. deeper and more mature than the European (which owns Private Equity International’s “We’re being more selective about what market, it’s true the US market offers plenty publisher PEI Media) have also set up offic- we’re looking at and we’re focusing on of consolidation and development opportu- es in New York to find US add-ons for their smaller processes,” he says. nities. Having said that, in some sectors, you European businesses. “We’re also looking at much more com- will need to have a global presence.” Taking a global outlook for portfolio plex situations that you have to work a lit- This is true for software companies, companies can help US mid-market GPs tle harder at to understand where the value healthcare companies, manufacturing com- boost growth, create long-term value and creation is. It means you have to diligence panies, food chain-related companies and, make a company more appealing to sell. It a little bit more, roll your sleeves up around generally speaking, companies in sectors can also help them avoid cyclicality.
16 Private Equity International • September 2019 Analysis
make sure we will have local production. You can also try to put in place local financ- ing, one of the issues being the local rate of the financing for sure, but there are ways to be creative.” Another risk for US mid-market firms with businesses that are more global is the recent trade tariffs that have been imposed by the US and then in turn by other coun- tries in retaliation. While the trade wars, in particular with China, have not significantly affected the US mid-market directly yet, GPs continue to see it as a concern. For now, there’s un- certainty as to the extent of the impact. “You see it here and there,” says Chris- tian Kallen, a managing director on Hamil- ton Lane’s fund investment team. “One or two portfolio companies in some funds have margin compression, but it’s more a short-term intake than anything else.” Fandozzi at Ardian also notes that it has In the global financial crisis, it was clear affected a couple of companies, but they “More and more, that different countries reacted to the down- have adapted to the changes. For example, turn at different speeds due to variations some of its businesses are sourcing out of US mid-market in supply chain, local regulatory consider- China where higher tariffs have been im- ations or even political behaviours. Being posed, and instead of selling those products companies are willing, more geographically diversified makes a in the US, which would be more expensive company more stable and more resilient, a due to the tariffs, they are selling globally. or will be willing, to key strength at this point in the cycle. “The The question remains whether it is go- company will be perceived as less vulnera- ing to be a temporary nuisance or a perma- expand outside of their ble,” Basquin says. nent challenge. Even if it is challenging for a US “Eventually it will all be pushed to the existing territories” mid-market GP to expand its business glob- consumer through higher prices and will ally, it can take advantage of foreign buyers not have a meaningful impact on the com- interested in North American add-ons to pany for the medium- to long-term as com- THIBAULT BASQUIN sell its portfolio companies to. panies are reacting to it through cost saving Ardian Buyout Fund and price increases,” Kallen says. Mitigating risk “The big impact will be if people believe However, taking a global approach and ven- that there’s permanent trade uncertainty. turing into new markets isn’t risk free. US People will stop investing and will stop GPs need to deal with different cultures, spending, and this might be the catalyst regulations and political systems. They also or the trigger for an economic downturn, have to manage currency risk. and it would have a much broader impact “It’s a critical topic,” says Basquin. “One on private equity and the economy as a way to mitigate currency volatility is to whole.” n
September 2019 • US Mid-Market 17 Analysis
KEYNOTE INTERVIEW
Creating value later in a fund’s life
Firms are having to work longer and harder to achieve attractive returns, but sourcing capital to drive growth late in a fund’s life can be challenging, says Tom Glover, head of fund finance, Investec North America
It is widely considered that The objective is often to create compa- SPONSOR we are nearing the top of the nies that both appeal to strategic buyers and Q INVESTEC FUND FINANCE cycle. How is the US mid-market have increased organic growth and margins, responding? all of which can have a big impact on multi- We are in the longest-ever period of eco- more pervasive and substantial – as we have ple expansion at exit. It comes as no surprise nomic expansion, yet US stock indices have been seeing in the leveraged finance market then that hold periods are lengthening. traded down from recent all-time highs, we as well. So, when people are quoting multi- are struggling with a trade standoff with ples on deals now, they are likely to be based Does this mean that the China, the yield curve has inverted and the on more substantially adjusted EBITDA Q traditional fund structure is Fed is cutting rates as an economic insur- than would have been the case five years unsuitable for modern value creation ance policy. These factors taken together ago. When you take that into account, entry needs? would suggest that the top of the cycle is valuations have continued to climb. Private equity firms operating within tra- near or even in the rear-view mirror, but the ditional fund structures continue to deliver unanswerable question is how long this ex- What impact is that having on strong investment returns. But the ways in pansion will continue. Q how sponsors approach value which value is being created now inherent- In terms of the US mid-market M&A creation? ly require both more time and more capital environment, valuations remain high, but With high entry valuations and many firms throughout the hold period. It is not un- multiples have actually been hovering near modelling lower multiples at exit, sponsors common for a sponsor to reserve an amount today’s levels for over five years. Following have to work harder and longer to deliver equal to 50 percent or more of the purchase the Great Recession, acquisition multiples attractive private equity returns. price as development capital. spiked in 2014 and have since remained We are seeing sponsors deploy larger According to Hamilton Lane data, near- range-bound. amounts of capital – relative to initial plat- ly two-thirds of private equity assets are What the data doesn’t show, however, form cost – in sophisticated and aggressive now taking longer than five years to exit. is that EBITDA adjustments have become buy-and-build strategies. This extended value creation process has
18 Private Equity International • September 2019 Analysis
implications for funds themselves. Platform tal structure. And the third is to accelerate ing to these continuation vehicles to help companies acquired in year five of a fund’s distributions to LPs where value has been cost-effectively grow value. life may not be ready to exit until year 12 or created but not yet harvested. beyond. Fund lives are generally extending How else is the industry well beyond the stated 10 years – frequently How does NAV financing tie Q innovating in response to this to 12 years and even to 14 or 15 years. Q in with GP-led secondaries, challenge? Managing larger reserves of undrawn another significant development for We are seeing increased interest from both capital well beyond the investment period of creating value later in a fund’s life? GPs and LPs in evolving the limited part- a fund’s life also poses challenges for private We see NAV Financing as an important tool nership agreement to allow for longer dura- equity managers. Portfolio companies can along a continuum of options that GPs have tion investment activity. Probably the most require even more capital than expected, de- to help them drive value in the later stag- common evolution we see in the LPA has pleting reserves and putting the firm’s value es of a fund’s lifespan. GP-led secondaries been greater flexibility around recycling creation playbook at risk. are another of those tools and their use has provisions, allowing early exits and cumula- exploded over the past few years. We think tive fees and expenses to be rolled back into So, what financing options do NAV Financing will as well. the fund for continued investment activity. Q sponsors have when undrawn Fundamentally, these GP-led secondar- Longer investment periods are becom- capital runs low? ies provide new options for LPs in late-life ing less rare. We are seeing six-year invest- Until recently, the financing options avail- funds. In a GP-led transaction, remaining ment periods a bit more frequently. There is able to funds low on uncalled capital were portfolio companies are rolled into a con- a lot of talk about longer fund lives, as well. generally limited to LP co-investment at tinuation vehicle. New investors – typical- We are seeing funds raised with 12, 15 and the fund level and holdco PIK financing ly secondary funds – bring fresh capital to even 20-year fund lives, although those ma- at the individual portfolio company. These drive further value creation in these portfo- turities remain far from the norm. financing solutions have a number of disad- lio companies. vantages. The portfolio continues to be managed What impact would a downturn They deliver permanent or longer-term by a knowledgeable GP who is incentivised Q have on both the demand for financing, when a short to medium-term to build value over a finite further time- finance late in the life of a fund and solution is required. They provide fund- frame. Existing LPs can either roll their its availability? ing at the cost of equity, when substantial stakes into the continuation vehicle to par- Private equity’s need to drive value doesn’t unused debt capacity exists at the fund ticipate in that potential upside creation or stop in softer economic conditions. In fact, level. They require expensive prepayment cash out. Investec Fund Finance has become we know economic downturns can provide premia, when debt – if it were available – a leader in providing efficient debt financ- compelling opportunities to generate value would provide more reasonable redemption for those with access to reasonably priced provisions. capital. But traditional financing sources We are now offering a bespoke solution, often dry up then. So the challenge for pri- known as NAV Financing. Our capital is vate equity is to be creative in finding incre- structured to match the duration of the fi- mental capital to take full advantage of the nancing need rather than being permanent, opportunities that dislocations can provide. so it is inherently less expensive. When pric- ing our capital, we take into account the full “Until recently, the What other opportunities excite equity value of the remaining portfolio of Q you in the years ahead? assets, so we offer a more efficient financing financing options Selling perpetual minority stakes in private solution than has previously been available. equity firms is not new but is seeing acceler- available to funds low ated activity. Investec’s fund finance practice How is the US mid-market was launched more than 12 years ago, pro- Q responding to this alternative? on uncalled capital viding loans at the management company When GPs learn about what we at Invest- level. We are extending our longstanding GP ec Fund Finance have to offer, the response were generally limited expertise to provide efficient debt structures is often “I have a terrific use for that” or “I to support minority stake sales. We are also wish I had known about that two years ago to LP co-investment providing a range of GP financing alterna- when I was dealing with XYZ situation”. tives to private equity managers who are re- Generally, our clients are using NAV Fi- at the fund level and ally looking for a less expensive and intrusive nancing one of three ways. alternative to the sale of a permanent stake. ■ The first is to drive further value crea- holdco PIK financing tion within portfolio companies through ac- Tom Glover previously held leadership cretive M&A or injections of growth equity. at the individual positions in investment and corporate The second is to protect a portfolio com- banking at BMO Capital Markets, Merrill portfolio company” Lynch, Deutsche Bank and Goldman Sachs. pany experiencing a short-term setback and He is an employee of Investec USA Holdings requiring equity to right-size its debt capi- Corp.
September 2019 • US Mid-Market 19 Analysis
The mid-market economy: Can strong growth continue?
Guest comment by Thomas Stewart and Doug Farren
Mid-market companies have powered the US economy, but the National Center for the Middle Market sees concerns rising
When we set out to study the US mid-mar- Private equity plays a substantial role in ket eight years ago, we knew it was im- the mid-market. More than a quarter of the portant; it accounts for a third of private mid-market has PE ownership, and those GDP, so it must be. What we didn’t fully companies do very well. According to our understand is that the 200,000 companies data, mid-sized companies in private equity with revenues of $10 million-$1 billion that portfolios grow about one-and-a-half or two make up the mid-market are the most dy- percentage points faster than the mid-market namic part of the US economy, too. They as a whole and add jobs at a similarly higher account for about 60 percent of job growth, rate. Indeed, private equity is itself a contrib- they consistently deliver top-line growth utor to the dynamism of the mid-market. that’s higher than big or small companies, Mid-market private equity investors and they’re resilient. They have survival tend to be more interested in sponsor- rates comparable with big companies and a ing growth than in financial engineering. lot more runway for growth. Private equity plays a role in many family Just in the last 12 months, for exam- business transitions, or it comes in to help ple, mid-market company revenue grew a strong company scale faster than it other- on average 8.5 percent, compared with 2.2 wise would. Private equity isn’t just present percent for the companies in the S&P 500. in the mid-market; it makes its presence felt. That’s a bigger than usual difference, but it’s the kind of thing we see every quarter when Signs of change we measure mid-market performance. Will the mid-market continue to post these The employment picture is similar: 6.4 extraordinary gains in revenue and employ- percent for mid-market, 1.0 percent for ment? Like everyone else, we have been por- small business, and 2.3 percent for big busi- “There is no bad time ing over data trying to understand whether ness. We estimate that over the last eight this long economic expansion will continue, years, mid-market companies have delivered to buy good companies; flatten, or fade. OurMiddle Market Indicator, about 60 percent of net new private sector which surveys 1,000 executives each quarter, jobs. capital is cheap; and gives us a unique view into what these lead- But this story is relatively little known. ers are seeing, saying and doing. Partly that is because 85 percent of some sellers may be They see strong results, but also storm mid-market companies are private, so there clouds. The revenue figures we cited above are few stock market stories to tell. Big busi- more anxious than are near-record numbers. Only a handful of ness titans and upstart entrepreneurs get all companies – about one in 20 – say business the news ink, while family businesses and they should be” is deteriorating. On the downside, tariffs private equity firms often stay below the ra- are hurting retailers, wholesalers and most dar, doing the work. manufacturers, and a small but growing
20 Private Equity International • September 2019 Analysis
number say the business climate is deterio- Looking ahead in that number would be worrisome. Part- rating and demand is weakening. But over- What do these insights tell us about the ly cloudy or partly sunny, it’s hard to know all, business is good. economy? The physicist Niels Bohr joked: what the business forecast should be. That They say they’re going to be cautious. “It is very hard to predict, especially the fu- mixed message has implications for PE Mid-market executives are prudent, pay-as- ture,” but in the next quarter we’ll be look- firms. First, don’t let economic ambiguity you-go types even in the best of times, but ing closely at three areas. The first is hiring. tie your hands. Uncertainty paralyses the their wariness is growing. Every quarter, we As a rule, mid-market companies hire unprepared, but it should energise the ed- ask executives what they would do with an in response to growth rather than in antici- ucated. There is no bad time to buy good extra dollar: whether they would invest it or pation of it. They always forecast fewer job companies; capital is cheap; and some sellers save it. In the last six months, the number increases than they make. A year ago, for ex- may be more anxious than they should be. who say they would put it by has jumped ample, they predicted a 4.8 percent increase Second, an unsettled economic environ- from 29 percent to 37 percent. Private equi- in headcount, but delivered 6.4 percent. If ment increases the value of the rigorous, ty-owned companies are even more savings companies start hewing to their forecasts data-driven management that the best PE oriented. They also say that their confi- and holding the line on hiring, that will be firms bring to companies in their portfoli- dence in the economy, while strong, is not a sign that business is slowing down. The os. We don’t mean loading companies down as strong as it was a year ago. second is investment: Will the aggressive ex- with debt, rather, more hard-nosed work- But what they do has not changed, not pansion plans stay in place? Or will leaders ing capital management and more empha- at this point. For example, in the last 12 delay, diminish, or discontinue them? sis on lean operations; all the blocking and months, 19 percent added a new plant or The third number we will watch close- tackling of good, efficiency-oriented man- facility. Over the previous four quarters, ly is the mix of winners and losers. In the agement, will be even more valuable if the that number was 17 percent, 21 percent, 20 last 12 months, 68 percent said overall per- economy falters. In rough seas, you want a percent and 20 percent. Looking forward, formance improved, 26 percent said it was tight ship. ■ executives’ expansion plans (to enter new unchanged and 6 percent said it deterio- markets, open new facilities, and introduce rated. In the last two quarters, we’ve seen Thomas Stewart is the executive director of new products or services) are actually more about a five-point shift from ‘improved’ to the National Center for the Middle Market. aggressive than they were last year or the ‘unchanged’, but the ‘deteriorated’ number Doug Farren is the managing director of the year before that. has stayed essentially the same. An increase National Center for the Middle Market.
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September 2019 • US Mid-market 21 Analysis
KEYNOTE INTERVIEW
Where to set up offshore mid-market funds
Popular offshore fund destinations are requiring more ‘substance’ and stiffer regulations. TMF Group’s Anastasia Williams discusses what this means for US mid-market GPs who have begun to hunt for deals and investors globally
Private equity’s expansion means different If we take a broader view SPONSOR things for different players. For managers in of the state of offshore TMF GROUP Q the US mid-market, it is driving asset pric- fund destinations, what does the es skywards and keeping GPs on the fund- landscape look like to you at the raising trail to make the most of the good According to Anastasia Williams, head moment? times. According to Bain’s Global Private Eq- of private equity, Americas at TMF Group, This trend towards more substance require- uity Report 2019, mega-funds are frequently this requires more discipline and considera- ments and stiffer regulations hasn’t just ap- launching their own mid-market vehicles as tion from mid-market firms as to where they peared in the last year. For the last decade, diversification plays. domicile funds. These GPs do not have the regulators around the world have come to This leaves many US mid-market firms resources to staff up in three or four coun- understand that private equity is an impor- looking for investors and deal opportunities tries from scratch. And, given the trend tant asset class and one worth their atten- beyond their borders – and that requires towards more substance requirements and tion. That doesn’t mean all the reforms are utilising more, or different, fund structures. tighter rules in places like the Netherlands there to scold the industry. Many have been But private equity’s success has also prompt- and the Cayman Islands, they cannot merely designed for greater clarity and consistency, ed stricter regulation, and that means even hop to another jurisdiction, because tighter even if that means less room for interpre- friendly jurisdictions are demanding boots regulations will eventually appear there too. tation. on the ground for locally domiciled vehicles. Yet that does not mean there are no oppor- In some cases, things are better than ex- These jurisdictions still compete for funds, tunities, as new jurisdictions, such as Ontar- pected. Brexit concerns haven’t eroded the but have tightened regulations. io, are becoming competitive. appeal of domiciling funds in the Channel
22 Private Equity International • September 2019 Analysis
Islands, despite concerns about what the of directors, and the need for those natural UK’s EU exit would mean for these neigh- “Middle-market persons to register as a corporate vehicle bouring jurisdictions. So far, it’s been busi- before conducting security investment busi- ness as usual. firms will need to ness. Yet there’s little doubt we’re witnessing For middle-market firms, this means greater substance requirements for private pick and choose a few more time and cost in setting up struc- equity firms that choose to structure funds tures, but it remains to be seen if these re- abroad. jurisdictions that make forms will prompt GPs to look elsewhere. In the wake of the OECD’s efforts to The Cayman Islands still offers a relatively crack down on base erosion and profit the most sense for their friendly regime for US firms. shifting, jurisdictions around the world are working to balance the need to stay friendly likely LP base” Are there any alternative to foreign managers with the need to meet Q jurisdictions that are becoming new global standards of transparency and more attractive because of the global oversight. This project has led to some of trend towards stricter regimes? the greatest changes in how managers are We hear from fund attorneys and other taxed in a generation. market participants that Ontario is increas- We see the Netherlands as a bellweth- ingly popular. There’s a shared language and er territory. In 2018, it passed several new culture, and an understanding of how US requirements for foreign investors, includ- private equity works, which might be a real ing employing a greater proportion of local asset for a middle-market firm reaching past staff, defined wages for those staff, and local its borders for the first time. office facilities that vastly exceed a simple because these LPs need to invest in a cor- In light of stricter regulations, other mailbox. porate structure. And precisely because they factors, like culture, may matter more than The era of simply having an empty shell are less regulated than other fund structures, they ever did. in some other country may be over. Now greater due diligence by LPs is required. In the coming years we expect a great- managers need people on the payroll. We er convergence of standards. With less and expect it’s only a matter of time before other There have been some recent less difference among jurisdictions, man- jurisdictions, like Luxembourg, follow suit. Q reforms in the Cayman Islands, agers may be less inclined to shop around a popular destination for fund for some ideal place, or to craft increasingly What’s the state of play in structures. What do they mean for complex structures in pursuit of a particular Q Luxembourg? Are there any mid-market GPs? tax benefit. That tax benefit might not be proposals in the works? In June, the Cayman Islands passed the Se- enough to warrant the complexity and the Luxembourg is the biggest fund centre in curities Investment Business (Amendment) cost that inevitably comes with it. Europe and the second biggest in the world, Law, which introduces a regulatory regime Mega-funds will be able to deploy the re- largely because of its high compliance stand- for ‘excluded persons’. sources, both in staff and outside expertise, ards, which are so appealing to LPs. This These excluded persons used to be ex- to juggle structures in multiple jurisdictions. popularity isn’t just among EU investors. A empt from registering with the Cayman Is- But middle-market firms will need to pick lot of US LPs like these regulated funds. But lands Monetary Authority. This exemption and choose a few jurisdictions that make the this also creates a burden for GPs. was in place for those financial services firms most sense for their likely LP base. Luxembourg offers a less regulated op- catering to high-net-worth or sophisticated There was one firm that found a great tion called a reserved alternative investment investors, who were expected to perform ad- deal of support in the UAE and ended up fund. These grew from just 75 in 2016 to equate due diligence. establishing a fund structure there for those 325 in 2017, and reached a total of 575 in This reform will now require most ex- key LPs. 2018. RAIFs are flexible, and provide pri- cluded persons to register and comply with Just as middle-market firms are focusing vate equity investors – whether they are GPs greater reporting requirements. In essence, on a particular sector to generate proprie- or LPs – with an excellent fund-structuring the amendment creates two new classes of tary dealflow and expertise, they may need vehicle. excluded persons: those who will need to to focus on a few key jurisdictions that make There is also a short time to market the register with the CIMA, known as regis- the most sense for them, and their future. RAIF, which is not subject to any authori- tered persons, and non-registerable peo- There may be little use in hopping to Po- sation or ongoing supervision by Luxem- ple, who do not need to register or obtain land for a few tax advantages that evaporate bourg’s financial regulator, the CSSF. How- licences but who will still need to submit to in a few years as that regime catches up with ever, the RAIF still needs to be managed by oversight by the authority for anti-money where the Netherlands is today. an EU AIFM. laundering purposes. It might be far better to commit to some GPs need to double-check that the RAIF In addition, the amendment puts in jurisdictions that may be slightly stricter, but makes sense. For example, if firms are look- place governance requirements for exclud- more reliable in the long term. Middle-mar- ing for commitments from German insti- ed persons. These include the appointment ket firms just don’t have the luxury of globe- tutional investors, the RAIF won’t qualify of at least two natural persons to the board trotting indefinitely.■
September 2019 • US Mid-Market 23 Databank
Straight down the middle
Mid-market revenue growth is strong and dealflow continues to rise – driven by the volume of B2B deals and value of B2C
Dealflow by sector, B2C has rebounded strongly ($bn)
500
400 Materials and resources
IT 300 Healthcare
Financial services
200 Energy B2C
B2B 100
0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Dealflow by region, the Mid-Atlantic accounted for the greatest share in the US for the first time since 2009 ($bn)
500
400 West Coast
South-east
South 300 New England
Mountain 200 Midwest
Mid-Atlantic
100 Great Lakes
0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: PitchBook
24 Private Equity International • September 2019 Databank
8.5% 41% 69% Year-on-year mid-market Proportion of mid-market Proportion of mid-market managers revenue growth companies expected to add jobs have confidence in the global economy – the lowest level since end-2016
Source: 2Q 2019 Middle Market Indicator – National Center for the Middle Market
Exits by sector, B2B passed $50bn for the third time since the financial crisis ($bn)
250
200 Materials and resources
IT 150 Healthcare
Financial services
100 Energy B2C
B2B 50
0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Exits by region, Mountain region reaches the summit ($bn) 200
West Coast 150 South-east
South
New England 100 Mountain
Midwest
Mid-Atlantic 50 Great Lakes
0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: PitchBook
September 2019 • US Mid-Market 25 Databank PE on the map
Texas leads the way in 2018 dealflow and exits by value, Illinois though California comes top by volume
US PE mid-market 14 deaflow and exits by state, 2018 Wisconsin 7 8 (no of deals) 10 13 Number of deals 7 Number of exits Washington Montana Top 5 dealflow by value North Dakota Top 5 exits by value 1 1 4 3 Minnesota Oregon 1 Idaho 7 2 South Dakota 1 1 Wyoming 1 Nebraska Iowa 3 Nevada 1 1 4 Utah 8 2 Colorado 13 2 3 $4.53bn Kansas 1 Missouri California 3
36$9.2bn 6 3 Oklahoma 1 2 Arkansas 11 New Mexico 3 Arizona 1 California
$10.4bn39 4 Louisiana Texas 3 28 Texas $10bn 34 Dealflow 2018 $12.6bn $438bn 3,072 Total dealflow value Total number of deals Source: PitchBook. State-level figures do not include re-distributed values
26 Private Equity International • September 2019 Databank
US PE mid-market dealflow and exits, by state, 2018 ($bn) State Dealflow Exits Alabama 0.00 1.00 New York Alaska 0.00 0.00 Arizona 1.35 2.03 Arkansas 0.12 0.08 $7.48bn24 1 California 9.24 10.40 New York New Hampshire Colorado 2.07 4.53 Connecticut 1.54 2.18 2 Delaware 0.00 0.00 $6.12bn18 District of Columbia 0.63 0.00 Florida 3.09 6.65
Pennsylvania Georgia 1.69 2.80 10 13 Guam 0.00 0.00 Hawaii 0.33 0.98 12 District of Maine Massachusetts $4.11bn Columbia Vermont Idaho 0.11 0.34 Illinois 2.61 3.40 9 1 Indiana 0.06 1.38 Iowa 0.28 0.27 Rhode Island 1 Kansas 0.84 0.94 5 Kentucky 2.37 1.72 Michigan Louisiana 0.38 0.65 Connecticut 6 9 Maine 0.00 0.00 6 Maryland 0.64 0.83 Massachusetts 1.22 3.37 Ohio New Jersey 12 10 Michigan 0.84 1.27 1 Minnesota 1.08 2.41 Indiana 7 8 Delaware Mississippi 0.54 0.00 West Missouri 0.40 0.00 3 Virginia Montana 0.00 0.05 Kentucky 5 Nebraska 0.00 0.08 5 5 Maryland Nevada 0.70 0.87 5 North Carolina 3 New Hampshire 0.18 0.21 Tennessee Virginia 6 7 New Jersey 2.98 2.12 7 6 New Mexico 0.22 0.00 3 New York 7.48 6.12 North Carolina 1.97 2.57 North Dakota 0.00 0.19 Alabama 10 3 South Carolina Ohio 2.29 3.62 2 Oklahoma 1.32 0.81 10 Oregon 0.74 0.19 3 Florida Georgia 14 Other US Territory 0.00 0.00 $3.1bn Pennsylvania 4.11 3.40 Puerto Rico 0.70 0.00 Florida Rhode Island 0.00 0.51 1 South Carolina 0.46 1.69 Mississippi 23$6.7bn South Dakota 0.00 0.00 Tennessee 1.86 1.60 Exits 2018 Texas 10.01 12.57 Utah 0.90 1.36 Vermont 0.00 0.00 Virgin Islands 0.00 0.00 Virginia 0.58 1.19 Washington 2.54 2.78 $209bn 999 West Virginia 0.00 0.00 Total exit value Total number of exits Wisconsin 2.74 3.83 Wyoming 0.10 0.00
September 2019 • US Mid-Market 27 Analysis Q&A Paul Carbone, president and managing partner of Pritzker Private Capital, on life since his firm’s split from its parent group
Pritzker Private Capital, which invests on process proved to be very cumbersome, and behalf of the Pritzker family among others, we realised we needed to move with more separated from Pritzker Group Private Cap- certainty and speed. We decided to form a ital in February last year. Led by president club with select other families and raise a and chief executive Tony Pritzker and pres- committed capital pool for co-investments. ident and managing partner Paul Carbone, The Pritzkers are the largest investors in the PPC raised a committed capital pool of $1.8 pool, and we retain complete discretion over billion in 2018. It invests in North American the investments. mid-market companies, focusing on manu- facturing, services and healthcare. What changed after Almost a quarter of the average family office Q the split? What has surprised you this portfolio consists of private equity funds and Everything at PPC remained the same. Q year? direct investments (%) A The same team, the same ideology and The pricing in the markets – I just PE funds PE direct investments approach of investing in and growing our didn’t think we would be here. Valua- companies. We are still investing in fam- A 0 5 10 15 tions continue to be very high and we didn’t ily, entrepreneur or management-owned foresee this when we were thinking about Europe mid-market businesses that care about their 2019, because everyone was talking about the business post-close, and care about their leg- economy and potential slowdown. North America acy and employees. That said, we are in no hurry to make We often say we are the third option investments. This year we acquired Valicor Asia-Pacific versus private equity firms and strategic in- and intend to acquire another one or two; vestors. We are a family pedigreed firm with but even if we don’t, we are not concerned. Emerging markets longer duration capital and are very cog- nisant of legacy, an issue that is close to the Why did PPC separate from the kind of companies we want to partner with. Source: UBS/Campden Wealth’s 2018 Q Pritzker Group? Research Global Family Office Report Up until now we took majority positions The decision to separate was driven by in the companies we acquired. Now we have A several considerations. For one, while expanded our investment criteria to take we were building great companies and writ- substantial minority positions as well. ing meaningful cheques to those companies, “We often say we This came [about] because we have our money was staying in the ground longer. been in discussions with family businesses We didn’t think it was prudent from a risk are the third option that are looking for capital and partners but and diversification view to continue with are unsure about what they want. Do they that strategy, even if the Pritzker brothers are versus private equity want to sell minority or majority positions? enormously wealthy. How do they want to structure partner- At the same time, we had other family of- firms and strategic ships? Expanding our criteria allows us to fices that wanted to partner with us. For one initiate legitimate dialogue on their needs deal that required substantial investment, we investors” and how we can help execute their strat- invited capital from other families, but the egies. ■
28 Private Equity International • September 2019 The Definitive Guide to Carried Interest
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