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.