Top trends in middle-market private equity About the author Contents Harris Smith Managing Partner, Private Equity and Strategic Relationships 1 Executive summary

Harris Smith is a Certified Public Accountant and the managing 3 The impact of the credit crunch partner of Private Equity and Strategic Relationships for Grant Thornton LLP. In 1976 Smith started his career in the 7 The explosion of cross-border M&A activity Baltimore office of Grant Thornton. In 1986, he was promoted to partner and in 1989 he relocated to the Southern California office 11 The proliferation of operational partners to head up the Assurance practice. In 1998, Smith was promoted to office managing partner of the Greater Bay Area offices, and in 13 The emergence of sovereign wealth funds 2003 he became the West Region managing partner. In 2008 he became the managing partner of Private Equity and Strategic 16 The middle-market compensation squeeze Relationships. 18 Three hot sectors for investment In his current role, Smith is responsible for the development and enhancement of strategic relationships for the firm and at the 21 The natural evolution of the private equity firm same time, overseeing the services provided to private equity clients. This dual role provides Smith the opportunity to further 23 Conclusion elevate the firm’s reputation and to create relationships with key influencers to deal with challenges in the marketplace and to enhance our brand. With over 30 years of experience, Smith is a member of the firm’s National Leadership Team and the sponsor of Grant Thornton’s Women’s Initiative.

Smith is a director, executive committee member and chairman of the Association of Corporate Growth. He served as president (2003) and director of the San Francisco Chapter of the Association of Corporate Growth beginning in 2000. Smith resides in Los Angeles with Jill, his wife of 26 years, and is the father of twins, Stephanie and Jordan, who are seniors at the University of Southern California and UC Berkeley, respectively.

Acknowledgements The author would like to thank Danielle Fugazy, Lora DeSanto, Pat Fanelli and Bill Haynes for their contributions to this project. Executive summary

This white paper explores seven trends The middle market has been able to hold its own quite well that have recently altered the way the private equity community conducts compared to the big-deal market. business. Some of the issues explored in the white paper are important because of the cyclicality of the private equity The key areas explored are: The first trend is that a cyclical business, while others are emerging • the impact of the credit crunch, market brings change and change trends that may become mainstream in • the explosion of cross-border M&A breeds uncertainty. The subprime the coming years. As these private equity activity, mortgage/housing debacle and its impact trends have gained visibility and affected • the proliferation of operational on credit is the primary trend that has investment opportunity in the middle- partners, triggered the 2008 down cycle. Private market private equity sector, • the emergence of sovereign wealth equity firms are returning to the days Grant Thornton decided to seek a broad funds, where they spend substantially more time perspective on their current and emerging • the middle-market compensation looking for quality companies to invest in, impact, how they developed, what is squeeze, and they are performing more thorough driving them, how widespread they have • three hot sectors for investment, and due diligence rather than jumping in to an become, how they affect market • the natural evolution of the private investment headfirst. participants and what challenges they equity firm. However, contrary to the headlines create for the middle market. that grace industry trade publications, all To explore these questions, a The current environment is not doom and gloom. The middle Grant Thornton team considered many The private equity market will finish out a market has been able to hold its own quite data points, including reviewing year that will be remembered as the one well compared to the big-deal market. Association for Corporate Growth when the record dealmaking streak ended. That being said, there’s no denying that (ACG) and Thomson Reuters surveys, A new era of quiet uncertainty has come there has been a flight to quality, a interviewing private equity professionals over the industry. Gone are the days of contraction in leverage multiples and a about the state of the market, and drawing frenzied dealmaking. 2007 produced the tightening of financing terms. The good upon the expertise and experiences of our third and last year of consecutive record- news is that deals are still getting done. private equity service professionals. breaking deal volume. According to The second trend is that private equity Through many different sources and Thomson Reuters, U.S. buyout firms firms have adapted to the changing original reporting, Grant Thornton completed only about $55 billion worth market by opting to do cross-border compiled the white paper to give readers a of deals during the first half of 2008, deals. Middle-market investment banking better understanding of where the middle making it extremely doubtful that 2008 firms, like Harris Williams & Co. for market is today, how it got there and will reach the $475 billion in deals example, say that they expect to spend where it is heading. completed in 2007. more time on globalization and emerging markets, and they see their clients also doing so in the next year.

Top trends in middle-market private equity 1 With the lines blurring between private equity firms, hedge funds, lenders and bankers, private equity firms are emerging as asset managers.

A third trend is the hiring of The fourth trend affecting the private Lastly, with the lines blurring operational partners, representing equity community is the emergence of between private equity firms, hedge another way private equity firms have sovereign wealth funds (SWFs). Morgan funds, lenders and bankers, private equity been able to transform themselves. Hiring Stanley researchers say SWFs, mainly in firms are emerging as asset managers. operational partners is a recent Asia and the Middle East, poured around This trend has already begun to take phenomenon. While larger firms always $45 billion into a range of companies and place in the larger market, and is now put big-name advisors on their letterhead, assets in 2007 alone. Some analysts believe emerging in the middle market. Many middle-market firms have increasingly SWF assets could reach $15 trillion by believe it is the natural evolution of the been hiring partners who don’t 2015. SWFs are here to stay; they will industry. This white paper explores what necessarily have private equity have an increasing long-term impact on firms are doing to drive this trend, and knowledge, but who do possess expert the marketplace. what some middle-market private equity knowledge in a particular sector. Touting The squeeze on middle-market managers think of it. operational partners is a good way for compensation is the fifth significant trend. firms to woo management teams in As the megafunds have grown even larger, today’s market, where competition for they have hired more talent to broaden quality deals is more fierce than ever. their scope, luring private equity talent Bringing extra capabilities to the away from middle-market firms. This bargaining table can only help firms white paper discusses practices that become more competitive. middle-market firms are using to retain top talent. The sixth trend is that certain industry sectors have remained particularly strong, despite the global credit crisis. The technology, health care and energy sectors continue to present strong investment opportunities and are expected to do so for years to come.

2 Top trends in middle-market private equity The impact of the credit crunch

In August 2007, the credit markets began Figure 1.1 their contraction, leaving the private All North American M&A activity* equity market in a very different place For the years ended Dec. 31, 2001-07, and the period than it had been for the previous five Jan. 1-May 6, 2008, annualized years. Gone are the days of frenzied Deal value in billions Number of transactions dealmaking; back are the days of caution 1,892 and careful due diligence. 1,799 For the next year or so, fewer deals in general are expected to be completed. As 1,371

Figure 1.1 demonstrates, M&A activity 978 967 899 remains down, regardless of deal size. 587 However, M&A activity for deals larger 478 than $500 million has slowed considerably more than smaller deals (see Figures 1.2 2001 2002 2003 2004 2005 2006 2007 2008 and 1.3). In addition, there has been a Annualized decrease in capital put into new private Source: Harris Williams & Co. compiled from third-party sources equity deals. *Excludes minority stake purchases, acquisitions of remaining interest, self-tenders and repurchases

Figure 1.2 Figure 1.3 M&A middle-market transaction activity M&A large-cap transaction activity For the months ended Jan. 1, 2007-April 30, 2008 For the months ended Jan. 1, 2007-April 30, 2008

Deal value in billions Number of transactions Deal value in billions Number of transactions

$30 150 $300 75.0

$25 125 $250 62.5

$20 100 $200 50.0

$15 75 $150 37.5

$10 50 $100 25.0

$5 25 $50 12.5

$0 0 $0 0.0

1/07 2/07 3/07 4/07 5/07 6/07 7/07 8/07 9/07 10/0711/07 12/07 1/08 2/08 3/08 4/08 1/07 2/07 3/07 4/07 5/07 6/07 7/07 8/07 9/07 10/0711/07 12/07 1/08 2/08 3/08 4/08

Source: Harris Williams & Co. compiled from third-party sources Source: Harris Williams & Co. compiled from third-party sources

Top trends in middle-market private equity 3 While private equity deals smaller not disclosed, but the Dealmaker Figure 1.4 Figure 1.5 than $750 million experienced a less sharp Private equity volume Private equity volume estimates the price tag to be a bit over decline in the number of deals than the for deals less than for deals larger than $100 million, which pales in comparison larger-size deals market, total deal volume $750M $750M to Carlyle’s $6.3 billion Manor Care deal is down from a year ago (see Figures 1.4 No. of Value No. of Value last year. The Authentix deal was and 1.5). Overall in 2007, private equity deals (millions) deals (millions) completed using capital from its Carlyle firms put $474.8 billion of capital into U.S. Growth Capital fund, while the 2000 179 $20.1 2000 13 $ 19.8 U.S. deals, marking the third straight year 2001 84 5.3 2001 5 6.2 Manor Care deal was completed using the of record volume. For the first half of 2002 75 6.8 2002 11 21.9 firm’s main buyout fund. This would 2008, a paltry $63.2 billion of U.S. deal 2003 82 7.9 2003 8 13.5 seem to indicate that Carlyle has been 2004 110 15.9 2004 31 56.7 volume was recorded (see Figure 1.6). 2005 137 24.8 2005 29 87.5 focusing more on its growth buyout “It’s still a good time for clean 2006 153 24.6 2006 66 349.1 practice rather than its large buyout fund companies to sell in the middle market,” 2007 140 25.4 2007 53 289.3 for which it is more widely known. 2008 50 6.9 2008 9 13.9 says Mark Jones, a partner with River Other large private equity firms have Associates Investments LLC. “If the Source: Thomson Reuters Source: Thomson Reuters decided to raise dedicated middle-market companies are of real quality, the debt funds for the first time. At the beginning sources are there. In fact, it’s a good time of the year, TPG Capital raised $1.2 for traditional debt players, as well. It’s Figure 1.6 billion to invest in middle-market less competitive for them without all the Private equity deals completed and funds buyouts. And in April, Silver Lake held a raised through June 13, 2008 CLOs [collateralized loan obligations] final closing of Silver Lake Sumeru, its and BDCs [business development 2007 2008 Billions inaugural middle-market investment fund, companies] that private equity firms were Deals $474.8 with $1.1 billion of equity capital using. Mezz guys [mezzanine investors] completed 63.2 commitments. are a lot busier and getting involved in Buyout funds $292.2 “Getting out of your comfort zone is larger transactions these days, but at very raised 133.6 a formula for disaster,” says Jay Jester, a safe multiples. There are opportunities in Source: Thomson Reuters managing director with Audax Group. the middle and lower ends of the market.” “A couple of the megafunds will put some Even though middle-market firms are dollars to work on smaller deals, but best at weathering the storm, deal Most of the decrease in activity has when the market comes back, they will professionals are certainly feeling less come from the large market. As a result of leave. I prefer to focus on the 300 to 400 optimistic. According to the December large-market firms’ inability to access debt formidable middle-market firms that 2007 ACG/Thomson Financial survey, to complete megadeals, many of them really present competition.” dealmaking professionals were less have moved downstream. However, not With larger competitors moving into optimistic about the strength of the M&A all mega-firms are taking the same their turf, a flight to quality and harder- market at the end of 2007 than they were approach. For example, The Carlyle to-come-by debt (see Figure 1.7), middle- earlier at midyear 2007. Thirty-eight Group partnered with J.H. Whitney & market dealmakers are feeling pinched. percent of survey respondents rightly Co., a middle-market buyout firm, to buy expected transaction levels to drop in Dallas-based Authentix, which develops 2008. That was more than double the and delivers authentication and brand number of respondents who in August protection devices. Financial terms were 2007 thought levels would drop at the same time last year. To be fair, last year’s survey was taken when dealmakers were Figure 1.7 Average leverage as a multiple of EBITDA for middle-market LBO deals still in a hot M&A market and the drop- For the years ended Dec. 31, 2001-07 and Q1 2008 off had not yet hit, whereas the May 2008 7-year average: 4.3x 5.6x ACG/Thomson Reuters survey was taken 4.7x 4.7x 4.5x as we continue to be, arguably, in the 3.8x 3.8x 4.3x worst of it. 3.4x

2001 2002 2003 2004 2005 2006 2007 2008

Total debt

Source: S&P Leveraged Loan Review 4 Top trends in middle-market private equity Some private equity firms have set Figure 1.9 their sights on smaller deals, as well. In SF BDC price index two-year performance April, Norwest Equity Partners bought As of May 30, 2008

Shock Doctor, a sports protection Millions equipment company. The property was 200 acquired exclusively with equity provided 190 by Norwest and the management team. 180 The price tag was below what Norwest 170 usually pays for a deal, making it possible to get the deal done debt free. 160 The type of debt available for deals has 150 also changed radically over the past year. 140

There’s been an enormous contraction in 130 the pool of debt buyers for new issuances, 120 particularly among collateralized debt and 110 loan obligations. According to Standard

& Poor’s, in the first half of 2008, 7/28/06 2/23/07 10/05/07 5/16/08 10/06/06 12/15/06 5/04/07 7/13/07 12/14/07 2/22/08 collateralized debt obligations (CDOs) Source: Factset fell for the first time since 2004. What’s more, Lehman Brothers estimated there would be only $30 billion to $35 billion in new CLOs issued in 2008 — a 60 percent Figure 1.10 drop from 2007 levels. Performance of top four BDCs from January to May 2008 As of April 2008, the number of U.S. Total return 1 2 1 3 5 QTD YTD CDO managers on the league tables, (millions) month month year year year which include CLO issuance, was small, BDCs ~500+ million market cap with only five banks issuing deals, ALD Allied Capital -21% -17% -44% -21% 6% -10% -20% according to Thomson Reuters ACAS American Capital -5% -15% -29% 10% 73% -12% -6% AINV Apollo Investment Management 2% 17% -18% 32% - 9% 4% (see Figure 1.8). ARCC Ares Capital Corp. 1% -8% -26% -10% - -5% -15%

Source: Stifel Nicolous

BDCs appear to be out of favor. At the same time that BDCs started Figure 1.8 Collateralized debt obligations for Q2 2008 Depressed valuations of publicly traded on a downward spiral, the Financial BDCs, which were once a strong source Accounting Standards Board (FASB) Name Market No. of Total of debt financing for middle-leveraged implemented the fair value accounting share deals issuance (billions) buyouts (LBOs), are also gone (see rule FASB 157, which requires the BDCs Figure 1.9). to set the value of their private portfolio Citigroup Global 38% 5 $2.3 Morgan Stanley 21% 3 1.3 By the end of May 2008, almost every companies to fair value based on public JPMorgan Securities 21% 3 1.2 single BDC was trading below its book market data or other market comparables. Barclays Capital 10% 1 .608 value as investors anticipated write-downs Many private firms are anticipating write- Lehman Brothers 10% 2 .605 (see Figure 1.10), according to an index of downs as a result of the poor performance Source: Bank Loan Report/Thomson Reuters BDCs compiled by analysts at investment of BDCs due in part to the impact of bank Stifel Nicolaus. A depressed stock FASB 157. price makes it difficult for BDCs to originate new loans, drying up more liquidity in the middle-market debt arena.

Top trends in middle-market private equity 5 In fact, several BDCs are faced with seeing an uptick because of that. There’s Figure 1.11 the prospect of running out of capital in Mezzanine funds raised 2000 through Q1 2008 also been a resurgence of mezz in the the near future. For example, as of press market. But you can’t get the mezz time, if Apollo Investment Corp. Fund raised No. of funds without the senior debt first.” (millions) followed its historic investment pace, the The last result of the credit crunch we BDC was facing the prospect of having 2000 $ 7,488.2 38 will discuss is that it has given strategic 2001 11,130.9 25 less-than-desired investment funds by 2002 2,636 25 buyers a chance to get back in the game. March 2009, according to Stifel Nicolaus’ 2003 5,423.1 28 According to Harris Williams, strategic estimates. Meanwhile, as of press time, 2004 4,613.7 32 buyers remain aggressive for quality 2005 8,958.6 42 MCG Corp. was virtually out of capital, 2006 1,7474 46 assets. The firm has seen a significant while Ares Capital Corp., operated by 2007 17,167.2 44 increase in strategic buyer interest in Ares Management, was looking at hitting 2008 18,186.8 11 recent months. The firm, which has its ceiling by the end of 2008. American historically sold about 50 to 60 percent of Source: Thomson Reuters Capital Strategies had enough funds to its client companies to strategic buyers, last into the beginning of 2009. has sold more than 70 percent of its client “Nearly all the BDCs are trading companies to strategic buyers since below book value, and it’s much more Indeed, the trouble in the credit December 2007. “We expect to see more difficult for them to raise capital,” says markets has turned out to be good for activity from the strategics in coming Greg Mason, a senior equity analyst traditional mezzanine lenders in the months,” says Hiter Harris, co-founder of covering BDCs for Stifel Nicolaus. “The marketplace. As Figure 1.11 shows, the Harris Williams (see Figure 1.14). BDCs would be putting the money to amount of mezzanine capital raised in the work if they weren’t so constrained, but first half of 2008 was at $18 billion, new capital is very expensive, which is $1 billion more than the amount of capital forcing the BDCs to slow their debt raised in all of 2007. The percentage of Figure 1.14 investments into private equity deals. We mezzanine going into deals has increased, In the next six months, what is the greatest expect the BDCs to remain under this as has the equity contribution (see Figure opportunity for liquidity events for your pressure for at least the rest of 2008 and 1.13). Reliable senior lenders are also in portfolio companies? into 2009.” demand these days (see Figure 1.12). As a result of the issues BDCs are Andy Steuerman, a senior managing Sale to strategic facing, mezzanine debt has become more director with Golub Capital, explains, buyer 72% prevalent. “Mezzanine partners that have “We have been very active on the senior Sale to proven out their willingness and side because we continue to raise more financial partnership mindset are at a premium capital and we have stuck by our buyer 22% these days,” says Audax Group’s Jay relationships and supported the firms that IPO 3% Jester. “People aren’t looking for the very have supported us. It’s hard to find a Other 3% cheapest dollar anymore.” reliable lender these days and we are

Source: ACG Thomson Survey

Figure 1.12 Figure 1.13 Average purchase price and equity contribution by sponsor Equity contribution For the years ended Dec. 31, 2000-07, and Q1 2008 For the years ended Dec. 31, 2000-07, and Q1 2008

Senior debt Sub and other debt Equity 50% 9.3x 8.5x 8.4x 45% 8.1x 7.2x 3.4x 6.9x 6.7x 7.0x 3.4x 5.9x 3.3x 3.9x 40% 2.9x 0.5x 2.9x 2.9x 3.2x 2.5x 0.5x 0.6x 35% 0.9x 0.5x 0.9x 0.7x 0.9x 0.8x 5.4x 4.6x 4.1x 4.0x 30% 3.1x 2.6x 3.1x 2.9x 3.5x

25% 2001 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 Q1 2008

Source: Harris Williams & Co. compiled from third-party sources Source: Harris Williams & Co. compiled from third-party sources

6 Top trends in middle-market private equity The explosion of cross-border activity

Figure 2.1 Figure 2.2 Office locations of the five largest private equity firms Office locations of the five largest middle-market private equity firms

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● ● Firms represented Firms represented The Carlyle Group TA Associates Warburg Pincus Sun Capital Partners The Blackstone Group American Capital Strategies KKR Advent International Bain Capital Riverside & Co.

Cross-border M&A has become an Going global is not new. Large-market increasingly vital part of strategic plans for U.S.-based private equity firms started middle-market companies and private opening up offices overseas to pursue equity firms. Large U.S.-based private opportunities in the late 1990s. Today, the equity firms have already proven that five largest private equity firms cover the doing business in different parts of the world with offices (see Figures 2.1). U.S. world often equates to success in today’s middle-market firms have taken this cue rapidly growing global economy. Reasons and have also started expanding globally to go global include the need for (see Figure 2.2). geographic diversification, the availability of good acquisition candidates in places outside the United States, the need to outsource divisions of portfolio Cross-border M&A has become an increasingly vital part companies to places where there are cheaper labor costs, and the continued of strategic plans for middle-market companies and private consumer growth in emerging markets. equity firms.

Top trends in middle-market private equity 7 Figure 2.3 Figure 2.4 Cross-border M&A volume Private equity deals completed and funds raised through June 13, 2008 Rank value in millions Percent of global 2007 2008 Billions $1,500 50% 45% Deals $474.8 $1,200 completed 63.2 40% $900 35% Buyout funds $292.2 raised 133.6 $600 30% Source: Buyouts $300 25%

$0 20% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007*

*Ending June 30, 2008

Source: Thomson Reuters

Figure 2.3 illustrates the proliferation Figure 2.5 Figure 2.6 of cross-border M&A activity over the Where do you expect most cross-border Private equity volume by U.S. firms outside past 10 years. There has certainly been a activities to take place? of the United States decline in U.S. private equity deal flow Western Europe 59% Value ($ billions) No of deals (see Figure 2.4) making overseas activity Canada more attractive. According to the May 38% 2000 $ 27 240 2008 ACG/Thomson Reuters survey, 28 China 28% 2001 21 150 2002 29 126 percent of middle-market firms say their United States 25% 2003 45 185 firms participated in a cross-border deal in Latin America 20% 2004 61 255 the first half of 2008, and more than 55 2005 78 288 India 19% 2006 131 362 percent of respondents say their firm is Eastern Europe 16% 2007 194 486 likely to complete a cross-border deal in Middle East/Africa 11% the next six months. Additionally, more Source: Thomson Reuters than 40 percent of respondents say that Other 25% cross-border deals will become Source: ACG Thomson Survey increasingly more important to their firms over the next few years; 20 percent of respondents believe the best way to “There’s still a market for any kind of weather the current environment in the company anywhere, but the private United States is to diversify equity firms that have the foresight to go geographically. Figure 2.5 shows where to areas where there is higher growth and middle-market private equity firms mitigated risk will do well,” says Michael believe they will be active in the next six Gibbons, a senior managing director at months. Brown, Gibbons, Lang & Co. “A great What’s more, private equity deal number of firms are doing cross-border volume by U.S. firms outside the country deals. We recently did a deal in Hungary reached $194 billion in 2007, the highest for The Riverside Co. and one in ever, and that trend is expected to Germany for Sun Capital. We will continue (see Figure 2.6). continue to see this type of activity.”

8 Top trends in middle-market private equity Figure 2.7 lists select activity by U.S. Figure 2.7 private equity firms overseas since the Select list of U.S. private equity firms that have participated in cross-border activity since the beginning of 2008. beginning of 2008 The list — small, but telling — Firm Funds raised Office opening suggests that firms are rushing to get overseas. However, the two areas in which Acon Investments Mexico and Brazil U.S.-based firms have the most interest are China and India. Developing Bear Stearns Cos. and Chinese bank Citic $1 billion Asian joint venture Securities Co. countries, particularly the BRIC countries (Brazil, Russia, India and China), present Brysam Global Partners new private equity firm unique opportunities to access growing Englefield Capital €1.06 billion new markets. Although Asian investment was once considered principally a means Arsenal Capital Shanghai of enhancing manufacturing potential for Sun Capital Partners $6 billion fund Tokyo products destined for Western markets, the vast markets that these economies JPMorgan Stockholm, Sweden represent cannot be ignored. Although China is geographically smaller than the H.I.G. Capital London United States, its population is three to Morgan Stanley $1.5 billion Asia four times greater: about 1.3 billion. Imagine a potential middle-class Global Infrastructure Partners Hong Kong consumer market equal to the entire Baird Private Equity China population of the United States, and you can easily see why investors view China Morgan Stanley India and other Asian countries as a market Summit Partners €1 billion European private equity fund opportunity rather than simply a place for low-cost manufacturing (see Figure 2.8). Sun European Partners Paris and Frankfurt

The same can be said for India and other Note: As of press time, not all firms raised a dedicated fund in conjunction with opening an office overseas. developing countries. Source: Grant Thornton Research “There has been a lot of buzz around India and China for several years,” says Dennis White, a corporate partner in the Boston office of McDermott Will & Emery LLP and vice-chairman of ACG. “People are very interested in those Competition for good acquisition Figure 2.8 regions, and things are starting to happen. targets in the United States has been fierce What are the reasons for going to China? But there’s still a larger volume of cross- and has become even more so in the new Produce or source goods or services in China border activity in the UK, Europe and environment. Competition has led to for the China market 51% Canada.” McDermott Will & Emery more firms looking at cross-border deals; Produce or source recently initiated an alliance with MWE having an actual footprint abroad is goods or China Law in Shanghai to meet the needs something most firms believe is services in China for the of their clients. “Everyone is looking for important. U.S. market opportunities anywhere they can find 16% them,” says White. Produce or source goods or services in China for other (non-U.S./non-China markets) 8%

Import into China 19%

Other 6%

Source: 2008 AmCham Business Climate Survey

Top trends in middle-market private equity 9 Best practices To support all the cross-border Figure 2.10 “There’s an invaluable benefit of having a activity and globalization, many service Private equity deal volume by all local presence,” says Steve Collins, a providers have also opened offices around private equity firms outside U.S. managing director with Advent the world. Lincoln International opened Value Deals International. “It’s hard enough to get a eight new offices recently: five in Europe, (billions) deal done in a country where you know the latest in Madrid. Meanwhile, 2000 $ 60 1,347 the local customs and laws — forget about Houlihan Lokey opened a Tokyo office. 2001 61 1,058 a foreign country. Not all markets need a Proskauer Rose opened an office in 2002 68 859 local presence, but most do.” Brazil, and Simpson Thacher moved into 2003 101 1,165 2004 145 1,506 White agrees. “It’s easier to do deals in Beijing. Heller Ehrman LLP opened in 2005 204 2,020 the UK than in China,” he says. “There London — its first European office and its 2006 356 2,515 are varying degrees of a presence needed. fourth outside of the United States. 2007 408 3,082 Having a presence on the ground and Kirkland & Ellis LLP opened an office in 2008* 71 791 relationships with local banks and firms Hong Kong and Grant Thornton has a *Ending April 2008 can make all the difference. The customs presence in more than 100 countries: 60 of Source: Thomson Reuters and cultural issues can make a big these member firms have experienced difference in getting a deal done.” local M&A professionals serving clients. Figure 2.11 The opportunity available in Still, the pendulum swings in both Non-U.S. based private equity developing regions is not just for U.S. directions. While there has certainly been fundraising private equity firms. In the past year, a push for U.S-based private equity firms many European-based firms have also to move overseas, many private equity Fund raised Deals (billions) moved into the growing territories. firms located outside the United States 2000 $26 101 Figure 2.9 lists non-U.S. firms that have decided to move in to take advantage 2001 25 89 recently have opened offices in of the weak dollar. Cinven, BC Partners, 2002 17 76 different regions. CVC Capital Partners, Permira and 3i 2003 27 76 Group all opened offices in New York 2004 23 91 2005 66 105 during the past few years. The presence of 2006 91 133 these new offices underscores a deal trend 2007 75 118 Figure 2.9 that has been growing for at least five 2008* 22 34 Select list of non-U.S. firms that have opened years: European private equity firms are offices abroad *Ending April 2008 hungry for North American targets. For Source: Thomson Reuters Firm Office opening/ example, in 2003, European private equity country of deal firms paid $622.7 million for a total of Adveq Beijing 23 U.S.-based companies, according to Impact Champ Private Equity Singapore Thomson Financial. Last year, that Private equity firms and companies that Istithmar Shanghai Candover Hong Kong number grew to $27.7 billion for 63 U.S. support the private equity industry are Bridgepoint Poland targets. expected to continue opening offices all FountainVest China “With the depressed U.S. dollar, it over the world. Most private equity firms Ontario Teachers’ Pension Plan London makes sense for firms to have interest in will wind up being global to some degree. Source: Grant Thornton Research U.S. targets,” says McDermott Will & “The private equity industry is centered in Emery’s Dennis White (see Figures 2.10 the U.S. and grew up in the U.S., but and 2.11). taking it beyond the U.S. is a natural extension of the industry,” says Advent International’s Steve Collins. “There may be a slowdown in the near term, but directionally, cross-border activity will continue to grow.”

10 Top trends in middle-market private equity The proliferation of operational partners

Twenty-two percent of respondents to the When Lincolnshire Management From the largest private equity shops May 2008 ACG/Thomson Reuters survey decided to hire James Binch as a senior like Bain Capital to the mid-market ones cite strategic investors as one of the operating partner and managing director, like Industrial Growth Partners, firms are greatest impediments to dealmaking the New York-based firm was looking for increasingly finding operations people today. Increased competition from someone who was a capable fixer of invaluable to their teams. strategics, coupled with the proliferation companies. After being a seller in the “A lot of firms are adapting an of private equity firms, have made wooing marketplace until mid-2008, Lincolnshire operating partner model,” says Brian management teams into a sale more decided it was time to become a buyer Korb, partner with Glocap, a private challenging than ever, especially for teams again; and having someone to help equity recruitment firm. “And not that plan on participating after the improve the performance of portfolio surprising, we have definitely seen an buyout. Over the past couple of years, it companies made perfect sense. Prior to increase in the hiring of these types of has become more common for private joining Lincolnshire, Binch was president individuals. These partners come with equity firms to hire operational partners and CEO of medical component additional credibility and a network that in hopes of gaining a competitive edge. manufacturer Memry Corporation can add value in a number of ways. They According to the ACG/Thomson Reuters (AMEX: MRY). “What better person to can help with deal flow, apply best survey, about 80 percent of respondents hire than someone who has on-the- practices across portfolio operations and, believe there has been an increase in the ground experience,” says Bill Buttrick, when necessary, they can even parachute number of private equity firms hiring communications director at Lincolnshire. in and run them.” operational partners. While these partners “It’s not primarily the sector experience Another reason for the proliferation are not hired for their expertise with we’re interested in. Rather, we look for a of operational partners is the need for private equity, firms expect them to have manager who is capable of getting on the private equity firms to really showcase expansive knowledge of the sector they ground and figuring out what’s going on their capabilities to sellers, especially in worked in and be able to deliver added at a portfolio company quickly.” this environment. Many dealmakers value to their portfolio companies. Lincolnshire is just one such firm that believe that an operating partner gives has hired an operating partner lately. See them the edge (see Figures 3.1 and 3.2). Figure 3.0 for recent examples of other “No matter how good an idea a firms that have hired operating partners. private equity professional has, the management team looks at a 40-year veteran’s ideas differently because they have sat in the same chair,” says Tim Many dealmakers believe DeVries, managing general partner at that an operating partner Norwest Equity Partners. gives them the edge.

Top trends in middle-market private equity 11 Figure 3.1 Select list of U.S. operating partners hired from January to June 2008

Private equity firm New hire Previous position Private equity focus

Advent International Pam Patsley First Data Corp. Financial services operating partners Arcapita William Miller Boston Consulting Group Strategic performance Arsenal Capital Partners Larry Resnick M&A Executive, Triumph Group Aerospace and defense Arsenal Capital Partners Anthony Giorgio Corporate Development, SYMYX Technology Specialty chemical and materials Blue Point Capital Thomas Cresante CEO Special Devices Blue Wolf Capital Van Walbridge CEO of Mobile Tool International Blue Wolf Capital Walter Stasik CEO of Genesis Worldwide II Calera Capital Paul Walsh EFund Corp. Business and financial services Calera Capital Clyde Thomas eFunds Corp. Business and financial services Calera Capital (Fremont Partners) Michael Murray Head of I-bank with Bank of America CCMP Capital John Bowlin Kraft Foods Consumer investments CCMP Capital Denny Shelton CEO of Triad Hospitals Health care investments DLJ Merchant Banking Neal Pomroy MD with Mercer Management Head of portfolio strategy Doughty Hanson & Co. Adam Black Associate Director KMPG Oversee sustainability matters Fidelity Equity Partners Gray Hall CEO of CeriCenter Inc. Genstar Capital Paul Clark CEO of ICOS Corp. Biotech investments Morgan Stanley James Howland President of Dun & Bradstreet Natural Gas Partners Jack Holmes Syntroleum Corp. Deal generation Navigation Capital Partners O.G. Greene CEO of Burroughs Corp., National Data Corp. Norwest Equity Partners Jeffrey Greiner Founder of Wessels, Arnold & Henderson Technology add-ons Pegasus Capital Advisors Steven Marton President of office products at Newell Rubbermaid Providence Equity Partners Barry Allen VP of operations at Qwest Communications Water Street Healthcare Partners Curt Selquist Johnson & Johnson Welsh Carson Anderson & Stowe Stephen Larned Chief Marketing Officer DigitalGlobe Welsh Carson Anderson & Stowe Daniel Lieber CEO of Union Site Management WL Ross & Co. John Kanas CEO of North Fork Bank Distressed financial services opportunities

Source: Grant Thornton Research

necessary. And it helps to have an Impact Figure 3.2 Private equity firms will continue to hire Does having operational partners give operational partner when you are trying private equity firms an edge when looking for to buy a company. When there’s someone MBA students and investment bankers, investments? from your group who can prove they but they will increasingly seek out have experience, management teams veteran operational partners. They will Yes, it demonstrates appreciate that, and it adds to the chances continue to hire any professionals who knowledge of working with them.” may make them more competitive, even if and experience Additionally, operational partners can it’s outside of what was once considered in certain the normal realm. markets cut to the chase, getting a job done 79% quicker and with less trouble. “Firms “If an operational partner can make a

No, it realize that to stay competitive in this 5 percent to 10 percent impact on one of doesn’t really current environment, they need to extract our businesses, that puts us at a huge make a difference 21% maximum value from their investments. advantage,” says Norwest’s Tim DeVries. They can hire outside consultants, but it “Private equity has matured Source: ACG Thomson Survey pays off to have tactical in-house advisors tremendously, and we all have to do a you can also turn to,” says Glocap’s Brian better job. Every increment helps. Some Lincolnshire’s Bill Buttrick explains, Korb. “You can justify paying someone operational partners help us with contacts “It makes sense to have an operational $1 million a year if they are saving you or give CEOs advice or set a great team in partner. A private equity company may $10 million.” place. All of those things help us perform own 15 portfolio companies and half may superiorly.” run into the occasional trouble. You want the ability to air-drop someone in who can work with current management or in a worst case scenario, replace them if

12 Top trends in middle-market private equity The emergence of sovereign wealth funds

At the beginning of the year, sovereign Figure 4.1 wealth funds (SWFs) became one of the Super Seven Sovereign Wealth Funds most talked-about new trends in private equity. First, as this asset pool continues to SWF Estimated size (billions) expand in size and importance, so does its potential impact on various markets, The Abu Dhabi Investment Authority $500-900 The Government Pension Fund of Norway 350 including private equity. Second, critics are Government of Singapore Investment Corp. 330 concerned that investments by SWFs will Kuwait Investment Authority 250 raise national security concerns, because an China Investment Corp. 200 unspoken purpose of the investment could Singapore’s Temasek Holdings 159 Stabilization Fund of the Russian Federation 158 be to secure control of strategically important entities for political rather than Source: Grant Thornton Research financial gain. However, regardless of how controversial they are, there’s no doubt that SWFs are here to stay. Figure 4.1 lists the Super Seven SWFs, U.S. market conditions, coupled with At the end of 2006, estimates of the so called because all have assets over $100 large sums of capital raised by SWFs, leave investments held by SWFs varied between billion. While these may be the largest of no doubt that SWFs will remain active for $1 trillion and $7 trillion U.S. dollars. the SWFs, it is important to keep in a long time. In 2007, Morgan Stanley According to The Economist, market mind there are currently more than researchers said SWFs poured around capitalization of SWFs is about $2.5 30 SWFs globally. $45 billion into a range of companies and trillion. However, the numbers are The United States is an attractive assets. And Merrill Lynch analysts estimate uncertain because of the difficulty of market for SWFs because of its history that between $3.1 trillion and $6 trillion in counting SWF holdings. The Abu Dhabi of political stability and overall new investment dollars could be pumped Investment Authority, for example, is transparency. Furthermore, the financial into world stock markets by such funds in considered the world’s largest SWF, but expertise in the country is considered the next five years. Some analysts believe experts can only guess at its size, because it second to none, which makes SWFs the assets could reach $15 trillion by 2015. has never been publicly disclosed. more at ease taking on risky investments Estimates range from $500 billion to in financial services companies. $900 billion.

As this asset pool continues to expand in size and importance, so does its potential impact on various markets, including private equity.

Top trends in middle-market private equity 13 Figure 4.2 Recent activity of SWFs in the United States

SWF Amount committed To whom

Mubadala Development Corp. $1.35B/7.5% stake The Carlyle Group Beijing’s State Foreign Exchange Investment Co. $3B The Blackstone Group The Abu Dhabi Investment Authority $7.5B Citigroup Singapore’s Temasek Holdings $9.72B UBS Adu Dhabi Investment Authority 10% Apollo Management Adu Dhabi Investment Authority 5% Sony (SNE) Singapore’s Temasek Holdings $4.4 with an option to buy Merrill Lynch China Investment Corp. $5B/10% Morgan Stanley China’s State Administration of Foreign Exchange $2.5B TPG

Source: Grant Thornton Research

Figure 4.2 shows recent examples of Despite public perception, the private scrutiny being placed on these funds to SWFs making their way into the U.S. equity community largely sees SWF make sure everything is legitimate. If an economy in general and into private equity investments as beneficial. Speaking at a SWF is one of many LPs [limited partners] in particular. conference hosted by The Deal, Gary in a $10 billion fund, how much control do Parr, vice chairman of Lazard, urged the they really have? Perhaps not much.” SWFs raise concerns audience to think about what state U.S. Nonetheless, the fear exists that the It is important to note that most of the banks would be in “if sovereign wealth SWFs are working toward political gain. SWFs do not have board seats at private funds hadn’t been there to step in last When a U.S. private equity firm buys a equity firms, yet there is still uneasiness November. It would’ve been Bear Stearns large U.S. company, everyone knows it’s about their participating in the U.S. private but all over [Wall Street]. It would’ve for the money. The worry is that SWFs equity market. Americans accept foreign been chaos.” might not be in it just for the money. Will investment to a certain degree, especially if He continued, “We shouldn’t be the Abu Dhabi Investment Authority it adds up to more jobs for Americans. For prohibiting this money from coming in. really act like a limited partner if a private example, no one really complains about When you look at the deals they have equity firm is trying to buy a company that Toyota producing cars in the United States made, there are so many constraints on sells an alternative to oil? or cell phone companies opening offices the sovereign wealth funds that there are Another worry is experience or lack and sites in the country. Additionally, it’s many ways to do this without a new thereof. Just as many argued that hedge awkward to complain when SWFs have body of law.” funds didn’t have the sophistication and provided cash infusions to credit-troubled While monitoring SWFs is deemed sticking power of private equity firms, U.S. banking institutions during the past necessary by most in the private equity some now wonder whether SWFs do. year. But the public in general has concerns business, SWFs are believed to be fairly However, that concern doesn’t realistically regarding foreign investors. The most harmless. “The risk isn’t as great as people seem to be the case. “These are not famous example of this was the 2006 are making it out to be,” says Dan Reid, unsophisticated investors,” says Reid. uproar over the proposed purchase of national managing principal, Transaction “They didn’t just come into cash, and several U.S. ports by Dubai Ports World, Advisory Services at Grant Thornton. decide to start investing it. SWFs have which wound up pulling out of the deal in “In fact, the risks are really no different hired many experienced M&A the face of public controversy. than they are from any foreign investors. professionals, and many of the staff have People really need to look at these been educated and trained in the United investments on a case-by-case basis. States. They are making smart financial Believe it or not, there’s already a lot of decisions.”

14 Top trends in middle-market private equity While it remains unclear what exact impact SWFs will have on the private equity community, there’s no doubt that they are here to stay and will be a driving force.

The early results • In June 2008, Treasury Secretary Impact While the end result of what will happen to Henry Paulson worked to alleviate While it remains unclear what exact SWFs investing in private equity is not yet concerns about SWFs. He told the impact SWFs will have on the private known, measures have already been taken: audience at the U.S.-U.A.E. Business equity community, there’s no doubt that Council in Abu Dhabi that the United they are here to stay and will be a driving • In early 2007, legislation was States is open to investments from force. To date, SWFs have invested introduced in California to bar state SWFs. “As we seek to open new primarily in very large companies or pension funds from investing in markets abroad, America will keep our mega-private equity firms. While the private equity firms that are partly markets open at home to investment impact on the middle market has been owned by SWFs from countries with from private firms and from sovereign negligible, that could change in the abusive human rights records. wealth funds,” he says. “We reject future. Just as many large state pension Although the bill never received measures that would isolate us from the funds started investing in large private support from Gov. Arnold world economy.” equity firms before they decided to give Schwarzenegger and was withdrawn, the middle market a try, the same could the fact that such legislation was However, lawmakers are still happen with SWFs and middle market. proposed represents a red flag for concerned about political motivations and “The opportunity is significant,” says SWF investment in the United States. will fight against opening up the United Reid. “There’s a whole new spigot of cash • In October 2007, the Foreign States to the funds. As of publication of flowing into private equity. Over time Investment and National Security this white paper, lawmakers were already sovereign wealth funds will make more and Act of 2007 (FINSA) went into starting to discuss the possibility of more direct investments but right now effect, broadening the president’s and limiting SWFs in the country. they are acting as LPs. The amount of the executive branch’s ability to “This will likely be a topic in capital they have is staggering.” control foreign investment in the Washington for quite some time,” says United States. Grant Thornton’s Dan Reid. • The European Union and the Bush administration are backing an effort by the International Monetary Fund to develop a voluntary code of “best practices” for the funds. • Peter Mandelson, the European Union’s (EU) trade commissioner, has spoken out against certain foreign investment opportunities, such as investing in defense contractors, by sovereign nations.

Top trends in middle-market private equity 15 The middle-market compensation squeeze

It’s no secret that record amounts of industry leaders. The larger the fund, the Figure 5.2 capital have poured into private equity larger the management fee, and the more Average base salary for mid-sized private equity firms over the past five years (see Figure compensation there is to go around. funds ($750M-$2B in assets) 5.1). While small and large buyout firms The Glocap-Thomson Financial Title Average base salary (thousands) alike have raised capital during the past study, the “2008 Private Equity three years, the increasing size of mega- Compensation Report,” shows the 2005 2006 2007-08 Associate $ 88 $ 93 $ 96 funds accounts for most of the private increasing discrepancy in pay between Senior associate 122 148 156 equity capital that currently exists. The large firms and smaller firms. Everyone Vice president 162 181 186 war chests that the mega-firms have knows that smaller firms receive less in Principal 211 238 240 amassed are unprecedented. As a result, management fees, but their staffs aren’t Source: Glocap megafunds have been able to significantly necessarily proportionately smaller. widen the pay gap between themselves Pay increases to junior professionals are and mid-market firms when it comes to smaller at smaller firms, both in absolute Figure 5.3 associates and senior associates, which and percentage terms (see Figures 5.2, Average bonus for mid-sized private equity some view as tomorrow’s private equity 5.3 and 5.4). funds ($750M-$2B in assets) Title Average bonus (thousands)

2005 2006 2007-08 Associate $ 88 $ 98 $111 Senior associate 122 148 161 Figure 5.1 Vice president 179 223 245 U.S. buyout and mezzanine fundraising, 1996-Q2 2008 ($mil) Principal 238 265 306

Source: Glocap Mezzanine funds Buyout funds

$300,000 Figure 5.4 250,000 Average total cash compensation for a 200,000 mid-sized fund

150,000 Title Average compensation (thousands) 100,000 2005 2006 2007-08 50,000 Associate $176 $191 $207 Senior associate 244 296 317 0 Vice president 341 404 431

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Principal 449 503 546

Source: Thomson Reuters Buyouts Source: Glocap

16 Top trends in middle-market private equity According to the study, an associate is For senior associates, the good news Figure 5.5 Figure 5.6 defined as a pre-MBA who generally has is that the numbers, percentage-wise, tell Percentage of Percentage of fewer than five years of total work a somewhat better story. Salary and compensation change compensation change experience, including two or three years at bonus at the mega-firm level are up from 2006 to 2007 from 2006 to 2007 an investment bank. A senior associate is nine percent to $419,000 over 2006. For for an associate for a senior associate defined as having an MBA and between the large firms, compensation is also up Change Change four and seven years of work experience. nine percent to $356,000. For mid-size “The larger funds with yearly firms, a senior associate makes $317,000, Megafund 22% Megafund 9% Large fund 16% Large fund 9% management fees of $100 million plus a seven percent increase from 2006. At Mid-market 8% Mid-market 7% have the cushion to pay up to retain and small-to-mid-size firms, pay is up six Small market 4% Small market 6% attract top talent,” says Glocap’s Brian percent to $277,000. At the smallest Microfund 4% Micrcofund 5%

Korb. “The mid-market firms feel the funds, senior associates should expect to Source: Glocap Source: Glocap squeeze of this comp inflation driven by make $223,000, a five percent increase the megafunds.” from a year ago. However, that’s almost According to Glocap, in 2006, an half of what a senior associate would associate at a mega-firm earned an make at a mega-firm. Impact average of $238,000 in compensation, Advent International hired four new Middle-market private equity firms are including base salary and bonus. That associates in the past year. Steve Collins, a going to have to work harder to recruit same position paid $290,000 in 2007-08, a managing director with the firm, admits it and retain strong talent. 22 percent year-over-year increase. In the is harder to recruit new talent. “The According to Glocap’s Brian Korb, large firm category, an associate makes supply of associates is the same, but the one recruiting tool that mid-market and $238,000 in 2008, equivalent to last year’s demand is three- or fourfold from what it small private equity firms can use to help salary and bonus at a mega-firm and a was. There are big funds out there now retain quality staff is the promise of a 16 percent increase from the previous where increasing salaries doesn’t change faster path to becoming a partner. Some year. However, in the mid-size range, the their bottom line that much. But it isn’t as associates and senior associates might be average associate makes $207,000 in cash easy for smaller funds,” says Collins. willing to take less money with the compensation, up only eight percent A mid-market private equity promise of earning much more when they from 2006. In the two smallest segments, professional who wished to remain off the join the partnership, which can happen a newly minted associate can expect to record agreed that the competition is much more quickly at a smaller firm. earn $172,000 and $157,000, respectively, tough. “I can’t believe what kids coming Small firms also arguably give junior level in base salary and bonus. Both represent out of banking are demanding. It’s not staff a better opportunity to learn the four percent increases from 2006 levels. only the pay, but the options. It wasn’t ropes of the business. always like this, but now they are Some private equity firms have tried choosing between staying in the banking other tactics to retain their staff. A industry, and going to a private equity handful, mostly unsuccessfully, have tried firm or a hedge fund. They have more to raise management fees to produce the options. If there used to be 100 jobs extra cash for compensation. “It’s available to these people 10 years ago, challenging to a certain degree to stay in I would say there are 500 now.” the middle market,” says Korb. “If your success allows you to raise a much larger fund and move out of the middle market, then you run the risk of growing out of your sweet spot. However, if you turn down the extra capital, you risk cutting off the additional resources to hire and retain top investment professionals to Middle-market private equity firms are going to maintain your previous success. have to work harder to recruit and retain strong talent. It’s tricky.”

Top trends in middle-market private equity 17 Three hot sectors for investment

It’s no secret that noncyclical sectors are Figure 6.1 Figure 6.2 the best ones to invest in right now. Sectors that will experience the most M&A M&A deal volume for energy and power deals Grant Thornton has identified three activity through 2008 sectors that are heating up in today’s Rank date Value (millions) No. of deals Energy 20% environment: energy, health care and 2000 $323,516.3 2,186 Financial services 17% technology. 2001 268,721.4 1,819 Health care/life sciences 16% 2002 177,574.0 1,810 2003 147,388.2 2,020 Energy Technology 15% 2004 263,861.4 2,298 Energy consumption in the United States Manufacturing and distribution 13% 2005 376,034.7 2,371 2006 557,518.3 2,774 is projected to rise by 31 percent by 2030, Consumer products and services 8% 2007 616,405.3 3,259 according to U.S. Energy Department Business services 8% 2008* 149,493.6 987 projections. Private equity firms are Retail 1% undoubtedly ready to take advantage of *Ending April 2008 the growth opportunities in the sector. Other 2% Source: Thomson Reuters According to the May 2008 Source: ACG Thomson Survey ACG/Thomson Reuters survey, the energy sector is expected to see more growth than any other sector (see Figure 6.1). Additionally, since the beginning of Impact “We have had 46 preliminary bids of 2008, $15 billion has been poured into the All types of energy deals are seeing interest, some from private equity firms sector, with $10 billion in private equity activity these days, but alternative energy and some from strategics and foreign funds raised for investment (see Figures is certainly garnering most of the bidders, as well.” 6.2 and 6.3). attention. Even Riverstone, which invests The growth in alternative energy is “It’s a great industry to be in,” says in all types of energy companies, believes being driven by high commodity prices as David Leuschen, a managing director alternative energy will grow from about well as regulatory requirements that with Riverstone Holdings. “It’s huge, 20 percent of the deals they now do per didn’t exist a number of years ago. and there’s a large food chain. The year to as much as 40 percent, depending State-by-state renewable portfolio opportunities are growing, there are more on market conditions. standard requirements in the electricity assets to buy and there’s more volatility.” “We are in the process of selling a space, ethanol blending targets in the According to Riverstone Holdings, green company on the West Coast, and it biofuel space, and technologies that were there are about 100,000 energy companies is one of our most intense processes ever,” completely nascent or didn’t exist globally with more than $8 trillion under says Michael Gibbons, a senior managing 10 years ago are starting to approach management. director at Brown, Gibbons, Lang & Co. commercialization.

18 Top trends in middle-market private equity However, while transactions in Health care Impact alternative energy can vary widely, sector The health care industry has become an Private equity firms are working hard to fragmentation is the single attribute that especially popular destination for buyout fill that gap. According to Venture remains constant. “You have a lot of firms to invest in these days. The industry Intelligence, health care private equity highly fragmented services in the energy is generally viewed as a recession-resistant firms reported 19 deals worth sector,” says Grant Thornton’s Dan Reid. safe haven when times are bad. In good $425 million in the first quarter of 2008. “Especially in oilfield services. This times, it’s as appealing as any other Overall, M&A deal volume is still industry was depressed for 15 years prior growth sector. But with the baby boomers increasing (see Figure 6.4). to the last couple of years, and many coming of age, the need for health care Jonathan Goldstein, a managing entrepreneurs are considering exiting or companies continues to grow every day. director with TA Associates, explains, retiring. In addition, we have seen a “We are seeing the aging population “A lot of firms are interested in the health significant trend that children don’t want accelerate faster and faster. So there will be care space,” he says. “It’s considered to take over family businesses anymore, lots of different opportunities in this space recession-proof. And unlike many so these businesses will likely be sold. for the next 10 to 15 years. There will be industries where you can have a short This creates an incredible opportunity to more and more people to be served,” says product cycle, health care companies have roll these companies up.” Jeff Benton, a partner in Grant Thornton’s a longer life span. The pace of change is Another factor driving energy deals is Corporate Advisory and Restructuring not excessively rapid.” the price of oil. As the price of a barrel of group. “There currently exists a In 2007 and the beginning of 2008, oil continues to remain high, spending the disconnect between the amount of plenty of private equity firms began money to find an alternative makes services available and the projected gearing up for health care investments economic sense. “At $110 a barrel, population growth.” (see Figure 6.5). alternative energy becomes feasible and many traditional energy companies look attractive. There’s no question why money Figure 6.4 is starting to focus there,” says Reid. M&A deal volume for health care targets

Rank Value No. of date (millions) deals Figure 6.3 Select energy funds raised from January to June 2008 2000 $148,210.8 1,308 2001 92,281.0 1,231 Firm Fund Amount 2002 103,612.2 1,200 raised 2003 99,707.7 1,536 Avista Capital Partners $2B 2004 168,265.3 1,771 2005 175,235.4 1,986 Alinda Capital Partners Shaw Infrastructure 2006 266,929.7 2,165 and The Shaw Group 2007 265,050.7 2,300 Investments 2008* 75,085.9 649 NGP Energy Capital Natural Gas Partners IX LP $4B *Ending April 2008 Crosslink Capital $400M Source: Thomson Reuters TCW Group TCW Energy Fund XIV $2.6B Energy Investors Funds United States Power Fund III $1.35B Figure 6.5 Tenaska Capital Management Tenaska Power Fund II $1.5B Select health care funds raised January-June 2008 NGP Energy Technology NGP Energy Technology $300M Partners Partners II LP Firm Fund Amount raised (millions) Cadent Energy Partners Cadent Energy Partners Ii LP $475M Water Street Healthcare Partners Second $ 600 Canaan Resources Canaan Natural Gas Fund X $250M Signet Healthcare Partners First-time fund 200 Blue Tip Energy Partners Blue Tip Energy Partners I $160M Galen Partners Galen Partners V 250 Shefa LTD Middle East 15 Hudson Capital Hudson Clean Energy Partners $1B New Spring Capital 150 Riverstone Holdings/ Riverstone/Carlyle Global Energy $2.4B East West Capital Partners Asia 400 Carlyle Group & Power Fund IV Flexpoint Partners 1,200 Beekan Petty O’Keefe & Co. 650 Trust Company of the West TCW Energy Fund XIV $2.6B DW Healthcare Partners DW Healthcare Partners II 133 Goldman Sachs Goldman Sachs $520M Health Enterprise Partners Health Enterprise Partners 63 Concentrated Energy Fund Goldman Sachs Goldman Sachs Healthcare FOF 100

Source: Grant Thornton Research Source: Grant Thornton Research

Top trends in middle-market private equity 19 Grant Thornton’s Jeff Benton has “The tech industry is holding up better observed this development. “People are than most industries,” says Marc Chiang, always going to need health care and director of the Transaction Advisory services,” he says. “Private equity is in a Services group at Grant Thornton. “Clean great position to take advantage of the technology has been growing, and that is a growing demands.” contributing factor. For the largest private However, there are risks. The major equity firms there still isn’t too much one is an increase in the reimbursement activity, but the middle market and the rate, which will most likely be seen after corporates have been active.” the 2008 U.S. presidential election. A The first indication that tech is in change in reimbursement rates will adjust favor is the amount of funds raised to be any company’s earnings, in most cases not invested in the sector (see Figure 6.7). for the better. Another risk includes changes to government regulation. “It’s a Figure 6.7 solid place to invest, but there are traps Technology funds raised investors need to be aware of,” warns 2000-08 Goldstein. Funds raised No. of (millions) funds The second factor that makes tech Technology 2000 $26,051.6 45 strong is that competition for deals has Despite the credit crunch that has 2001 19,031.3 35 eased, due in part to the departure of paralyzed almost every other industry, 2002 8,978.3 19 generalist firms that have been scared off mid-market tech buyout firms appear to 2003 3,341.1 16 2004 5,813.3 22 by the lack of credit. However, for firms be particularly active. Many tech investors 2005 6,023.7 24 that play in the tech space, the lack of believe they are going to see another 2006 25,548.3 26 leverage is common; market conditions vintage year, reminiscent of 2000 and 2007 23,457.1 31 2008* 15,400.0 9 aren’t so far off from what they were 2001, when tech buyouts, on a dollar prior to the past few years. In general, volume, accounted for 14 and 21 percent *Ending April 2008 these companies use less leverage than of all transactions, respectively, according Source: Thomson Reuters your normal buyout. to Thomson Reuters. Already, the “Tech companies are made up of IT numbers are proving the tech investors and people, so lenders have always been right. In the first quarter of 2008, the skittish about lending to the industry,” $19.7 billion in closed tech deals Impact says Nicholson. “We are used to this; accounted for 31 percent of all buyout “The thing about tech is that you always generalist funds may not be. We have transaction deal volume involving U.S. have to be thinking about the future, the always had to look at all the ways to get sponsors. Furthermore, the growth is next thing,” says Chris Nicholson, a a deal done, and sometimes it’s with expected to continue (see Figure 6.6). partner at Vector Capital. “Even a boring less leverage.” tech company needs to be looking ahead. Also helping the tech buyout scene: And just like in the early 2000s, now is a Corporate orphans are easier to buy these good time to be working on the next Figure 6.6 days because companies are looking to Sectors that will experience the most M&A thing so companies are ready when the activity through 2008 shed noncore assets. Though prices have market comes back. Now is the time to fallen nearly as low as they did in the Energy 20% buy: Valuations are low; you can make aftermath of the 2001 tech wreck, now is changes and be ready with a sales effort Financial services 17% still a good time to pick up assets. when things pick up.” Health care/life sciences 16% Furthermore, the industry has matured,

Technology 15% making it easier for private equity firms to

Manufacturing and distribution 13% understand the business propositions. Additionally, because of their maturity, Consumer products and services 8% these firms now have an operating history, Business services 8% making them easier to understand and Retail 1% more attractive to private equity investors Other 2% than ever before. Source: ACG Thomson Survey

20 Top trends in middle-market private equity The natural evolution of the private equity firm

While private equity’s place in the market Figure 7.1 used to be clear, recently the lines between Is raising a diversified set of investment funds the wave of the future for middle-market private equity and other asset classes have private equity firms? started to blur. Many of the large players have diversified their offerings: buying Yes, it only makes sense for private equity firms to be able to show LPs a diverse offering 12% hedge funds, raising middle-market funds and launching new vehicles to capitalize Yes, the large market is already doing it, it’s just a matter of time until the middle market follows suit 30% on the dislocation in the credit markets. There are a number of middle-market No, that’s not what private equity investing is about 40% firms that have also expanded beyond I am not crazy about the idea, but my firm may eventually have to their normal realm. The practice allows do it to stay competitive 18% LPs to look at private equity firms as a one-stop shop, while giving private equity Source: ACG Thomson Survey firms the opportunity to stay active regardless of market conditions. However, the question remains: Can private equity funds be all things to all investors? should we be different? Based on “It’s easy when you can diversify your According to some, just as there has competitive advantage, there’s going to be assets within one firm that you trust,” been a consolidation in the number of an evolution where most of the talent and says one LP. “You just have to be sure that companies that make cars, the same will money ends up in firms having 200 or the firm has the proper infrastructure to happen in the private equity world. more employees and $5 billion or more in support so many different businesses.” Thirty-five years ago, when private equity assets under management. However, as Jack Katz, Grant Thornton’s was really making a name as an asset class, private equity firms grow, there will New York Cluster managing partner and companies were bought cheaply and the continue to be increasing specialization by Financial Services group national new owner could make a few changes industry, stage, geography and other managing partner says, “If a private while generating a profit and a high return factors. For example, even with our equity firm has the track record, it can for the investor. That simply isn’t the case multiple funds in various geographies, set up other funds to remain nimble, anymore. Because of the increased Riverside will continue to dedicate itself especially at times like we are number of private equity firms, hedge to the smaller end of the middle market.” experiencing. For example, more funds and strategic buyers, there is much According to results from the May distressed funds are being set up now, more competition, prices are up and 2008 ACG/Thomson Reuters survey, but those private equity firms may returns are on the decline. while middle-market firms are split on choose to start a different fund in the “It’s natural that over time the private whether diversification makes sense, most future. There are advantages to equity industry will consolidate,” says think asset expansion is inevitable (see diversifying within the same fund. Stewart Kohl, co-CEO of The Riverside Figure 7.1). You can choose between different Co. “Every other industry has, and why alternatives in different industries.”

Top trends in middle-market private equity 21 Indeed, and the bottom line is that Figure 7.2 LPs want solid investment choices. “It’s Can middle-market private equity firms handle raising and putting multiple funds to work? all about generating good returns for your investors,” says one private equity player. Yes, we might have more overhead, but it’s possible 28% “Managers don’t get in trouble for Yes, but it will take a significant ramp-up period 35% suggesting to invest in well-established funds with a good track record, but the No, it just wouldn’t add up. Returns would be diminished with all the extra overhead 26% manager will get fired if the recommended investment results in lost capital for the No, fundraising is too exhausting -- there would be no time to put the money to work 11% LPs. Once you have the track record, raising multiple funds is a good growth Source: ACG Thomson Survey strategy for PE [private equity] funds, assuming that they can execute successfully on the expanded philosophy and don’t compromise what made them successful in the first place.” The trend really started recently with the megafunds, which have built out their businesses in many different directions. It’s clear that the listing of large- where they can invest larger amounts For example, in the past year, TPG has market firms raising multiple funds can go without doing multiple searches and raised $3 billion for distressed investing, on and on. However, right now there are monitoring multiple firms.” $1.2 billion for middle-market buyout just a handful of middle-market firms According to the May 2008 investments, $7 billion for financial following suit. Riverside has successfully ACG/Thomson Reuters survey, despite services investments, and $4.2 billion for raised a buyout fund, a microcap fund and the interest of LPs, raising multiple funds investment in Asia. This is on top of an an Asian fund, all on top of a European won’t be an easy task (see Figure 7.2) for $18 billion fund the firm raised to handle fund. Monomoy Capital Partners closed middle-market private equity firms. its regular private equity investments. an inaugural turnaround fund with “It’s smart from a private equity TPG is not alone. While other $280 million in capital commitments. standpoint,” says River Associates’ Mark megafunds might not have raised as many TriLyn LLC and Investcorp have held Jones. “It broadens their depth and different types of private equity funds, $100 million for a first close on TriLyn- exposure. And you have been seeing some are raising different vehicles Investcorp Mezzanine Partners I, a fund middle-market funds carve out new altogether to keep business robust, even that will make structured mezzanine and funds. At ACG Capital Connections, you if regular LBO business is not. The other high-yielding debt and preferred see a couple of different names at one Blackstone Group raised several new equity deals in U.S. commercial and table, then you come to learn they are all a funds during the past year. Blackstone residential real estate. The Audax Group part of the firm. But it’s a much larger task raised $1.3 billion for distressed investing, also has a private equity fund, mezzanine for middle-market firms. It’s going to take a $400 million CLO vehicle called St. and senior debt funds. Sun Capital a while for middle-market firms to be able James’s Park CDO B.V., seven U.S. Partners has diversified its fund offerings. to offer investors what Blackstone can. CDOs with $4.7 billion, four European The megafunds have the resources. The CLOs with $2.9 billion, and two private Impact middle market is approaching this much mezzanine funds with $2.1 billion. All While turning into true asset managers more slowly.” told, the firm’s new CLO group manages may be the wave of the future, it’s not According to Grant Thornton’s Jack $14 billion across 26 funds in the United expected to happen overnight. “The Katz, the evolution has already started, States and Europe. Additionally, in March private equity industry will continue to and it will just keep on going. “Private the firm acquired GSO Capital Partners, a evolve, and it will take 10 to 20 years for equity has been around for a long time,” hedge fund, for $365 million. This is all in this consolidation to play out, he says. “It goes through different addition to the firm’s $21.7 billion buyout importantly because fund lives are long,” variations and reinvents itself from time fund, not to mention its real estate and says Riverside’s Stewart Kohl. “And there to time. Firms adjust their focus, debt mutual funds. will always be some private equity shops ratios and fund sizes, so this is not that choose to stay small and operate as necessarily so surprising.” boutiques. But most of the large pension funds and other leading private equity investors would really like to find homes

22 Top trends in middle-market private equity Conclusion

It is clear that private equity has entered a Nevertheless, there are factors and different era of dealmaking. With the trends that suggest caution is in order. In proliferation of cross-border activity, the next year or so, the use of SWFs will operational partners and sovereign wealth be carefully monitored, even though most funds, and private equity firms becoming believe the massive amounts of capital all-around asset managers, the industry is they can introduce into the U.S. economy poised for more growth than ever before, would create more benefit than harm. despite the credit crunch. All of these new Additionally, the large-market private trends solidify two key points: Private equity players will continue to put the equity is an ever-changing and maturing squeeze on middle-market players for asset class, and savvy private equity talent, as well as deal flow. Until the credit investors have proved there are ways to markets open up again, large-market firms reinvent the business and create new and will continue to look at smaller deals, exciting opportunities. creating more competition for mid- market and smaller firms than ever before. However, private equity has proved time and time again to be cyclical, creative and ultimately resilient. So when the markets look the toughest, some of the best investments are made.

Until the credit markets open up again, large-market firms will continue to look at smaller deals, creating more competition for mid-market and smaller firms than ever before.

Top trends in middle-market private equity 23 About the sponsors

About Grant Thornton LLP About ACG About NASDAQ OMX

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