Many economists are looking to small businesses to lead the economy out of a recession. Can small shops do the same for the buyout market’s current funk?
No universal definition exists of what are variously called small-cap or lower-mid-market buyout funds. Some define them as funds of less than $500 million. Others define them as funds earmarked to acquire companies with an enterprise value of less than $200 million.
For institutional investors, the promise of lower-mid-market funds stems from their strategic position at the less efficient end of the market, where companies are more plentiful and buyers more sparse. Typically they go light on the leverage, and even during tight credit markets they frequently have access to regional and local banks that can help finance deals. Buyout professionals that specialize in this end of the market tend to bring a great deal of operational expertise to the task of building up value during their holding periods. Fundraising statistics suggest that small buyout funds remain highly popular with investors.
In 2008, a down year for fundraising overall, funds with targets in the $300 million to $1 billion size range gathered $29.1 billion, up from $22.7 billion in 2007 and $24.1 billion in 2006. In the first quarter of 2009, the group secured pledges of almost $6 billion, more than double the pace of the larger $1.1 billion to $5 billion target group. The sub-$300-million-target category has also had a respectable run over the past three years, raising $4.2 billion last year, $6.4 billion in 2007 and $8.9 billion in 2006. Among institutional investors with known appetites for small buyout shops are the John T. and Catherine T. MacArthur Foundation; MilitarySuper, Australia’s military pension fund; the Montana Board of Investments and the Virginia Commonwealth University School of Engineering Foundation.
The big challenge for investors, of course, is to find and evaluate small firms, which often set up shop in out-of-the-way places to avoid clashing with rival sponsors. Fortunately, a number of advisory firms have set up funds of funds, both captive and commingled, to solve this problem for investors. Altogether, Buyouts has identified seven advisors that have raised or are in the process of raising about $4 billion, over the past two years, for funds of funds that are dedicated entirely to lower-mid-market buyout funds, in addition to other advisors that include them as part of their broader mandate. Among them are Horsley Bridge Partners, a San Francisco-based shop that reportedly closed on $1.7 billion in June 2008 for investments in small buyout and venture capital funds. Siguler Guff & Co., a Boston shop, raised $600 million for its Small Buyout Opportunities Fund in 2007. WP Global Partners, in Chicago, closed its COREalpha Private Equity Partners II last September with $354 million in pledges from more than a dozen institutional backers, including many international ones. And Chicago-based fund-of-funds manager RCP Advisors recently closed on $300 million for its sixth vehicle devoted to backing U.S. small to mid-market buyout funds.
On the supply side, no one’s sure just how many lower-mid-market buyout funds are out there. But anecdotal evidence suggests their ranks are growing rapidly, even as the buyout market as a whole remains mired in a period of few deals and anemic fundraising. For this article Buyouts has identified 15 lower-mid-market buyout funds, many of them new to our database, which have raised or are trying to raise a total of almost $1.5 billion. Many qualify as new or emerging managers. Among the most prominent is Serent Capital, which closed its inaugural fund about a year ago with $250 million for investments in services businesses. David Kennedy, former president of ServiceSource, and Kevin Frick, former head of McKinsey & Co.’s West Coast private equity practice, founded the San Francisco-based firm in 2007. Limited partners include Harvard Management Co., Horsley Bridge Partners, fund-of-funds manager Adams Street Partners and the private office of the Ziff family.
Among advisors that back lower-mid-market shops, Bowside Capital, founded by entrepreneur Christian Albert, is one of the newest. The firm intends to target funds with less than $100 million used for transactions in specialty manufacturing, distribution or business services. Albert is aiming to hold a first close of Bowside Capital Fund I in June, with a final close of at least $30 million in about a year. Half the vehicle is earmarked for three to five fund commitments, and the other half for five to eight co-investments alongside either funds or fundless sponsors. Backers include family offices, high-net-worth investors and senior partners at established private equity firms.
Albert’s prior experience includes running The Albert Group, which provided management services to investors in lower-mid-market companies and real estate; earlier in his career Albert was also the co-founder of Macsimmum SARL, an IT services and distribution firm headquartered in Paris. There he led the growth of the company for seven years until its sale to a strategic acquirer.
Sub-$100 million funds “really target the sweet spot of $1 million to $5 million in EBITDA companies,” said Albert. They buy at low multiples, add value and grow the businesses, and sell at attractive values, typically after three to five years, he said. But, he added, they are not easy to find. “There is no comprehensive database of small funds, let alone one that properly tracks performance,” said Albert. “I spend a tremendous amount of time networking through limited partners, placement agents and family offices identifying the best ones.”
On the more established side, RCP Advisors held the final close in January on $300 million for RCP Fund VI LP, to be used for backing North American small and mid-market buyout funds. With an average size of $450 million, the funds acquire companies with enterprise values ranging from $25 million to $250 million. Three-quarters of the vehicle will be committed over the next 12 months. The smallest fund RCP Advisors is likely to pledge to is $100 million, although the firm has gone lower. RCP Advisors intends to make 10 to 12 commitments with an average pledge size of $30 million. Sponsors backed by RCP Advisors include Lovell Minnick Partners, which invests in financial services companies and had closed on $365 million as of December for Lovell Minnick Equity Partners III; and Sorenson Capital’s second fund, which closed in early 2008 with $400 million in commitments earmarked for small to mid-market buyout and growth equity investments in the Mountain and Western regions of the United States.
To pick buyout shops, RCP Advisors works to understand why the manager chose a particular investment, and how the firm improved the value of the company operationally, said Charlie Huebner, managing principal with the firm. He likes managers that keep the volatility in their portfolio low, “not going for home runs, but looking to strike the right risk/return balance” by avoiding financial risk. Typically RCP Advisors looks at about 200 managers per year, said Huebner, adding “We have an open-door policy that admits all shapes and sizes.”
About three-quarters of RCP Advisors’s backers consist of endowments, foundations, and public and corporate pension funds; the rest are high-net-worth investors. Backers include AP3 (a Swedish national pension fund); the Chicago Policemen’s Annuity & Benefit Fund, the Florida State Board of Administration and Indiana University. About 75 percent of backers have been U.S.-based, but the firm is moving toward a 50-50 split between U.S. and non-U.S. supporters.
Another fund of funds earmarked for small funds, COREalpha Private Equity Partners II LP, managed by WP Global Partners, is already over 70 percent committed. The vehicle is mostly pledged to buyout funds, but it has also been used to back growth equity, venture capital, co-investments and secondaries, usually managed by U.S. fund managers. The firm is looking at committing more than $200 million over the next 12 months, with average pledges of $25 million, said Greg Oberholtzer, managing director in the New York office. Like RCP Advisors, WP Global Partners backed Lovell Minnick Partners’s third buyout fund.
WP Global Partners seeks to commit to funds that invest in companies with an enterprise value of $250 million and below. The principals are always searching for an area where value can be created, such as in industries that are consolidating, said Oberholtzer. The firm also favors highly operationally focused management teams in the underlying portfolio. These days, WP Global Partners is particularly interested in backing funds earmarked for investments in health care and services.
The appetite for lower-mid-market buyout funds among more diversified funds-of-funds managers also appears to be rising.
Morgan Stanley Alternative Investment Partners’s funds-of-funds team, which last month closed on a $1.1 billion fund, tends to make two commitments per year to smaller and mid-cap buyout funds, which they define as $250 million to $500 million in size, although the team will go below and above that range. “We’re looking for the two best small to mid-cap buyout managers in the U.S. each year,” said Tom Dorr, the firm’s chief investment officer. Past commitments have gone to Housatonic Partners, which invests in buyouts or recaps of small to mid-sized media and communications companies, and which in 2007 closed Housatonic Equity Investors IV with $250 million; and VMG Equity Partners, a buyout firm that raised its first fund of $325 million a year and a half ago earmarked for lower-mid-market consumer product deals.
“We’ve spent quite a bit of time looking at small-cap technology oriented buyout funds, but we haven’t identified one to commit to yet,” said Dorr. “We’ve [also] spent time studying generalist buyout managers in different regions of the country that may have an advantage because of a strong regional presence.”
In December, Chicago-based funds-of-funds manager Adams Street Partners closed on $2.1 billion for its 2009 global program; more than half the capital is earmarked for commitments to U.S. managers of small, mid-cap and large buyout funds, as well as venture capital and turnaround strategies. “We are not carving out a small-cap fund of funds, but having said that, we are seeing good opportunities in that space,” said Hanneke Smits, CIO.
Two areas that Adams Street Partners finds particularly interesting are buyout shops that pursue low-leverage growth strategies and managers with sector expertise, “and that could be any sector,” notes Smits. The smallest fund Adams Street has committed to recently is Serent Capital’s $250 million debut vehicle, which closed in April of 2008 and invests in service businesses. The firm’s pledges average between $30 million and $50 million, irrespective of the size of the fund.
The firm has four dedicated professionals in the U.S. who track buyout funds. “They’re very proactive in terms of engaging with managers that we haven’t backed” before, said Smits. The idea is to meet managers over time and build up a picture about the market as well as the managers and where their competitive strength is. When you do that on an ongoing basis, “you know who the top 10 names are in each space that you want to target for your program, if you’re not in their funds already,” said Smits.
Flying Under The Radar
Be it by a particular industry or a particular region, many of the firms raising lower-mid-market buyout funds are highly specialized.
Two of the 15 LBO fund managers identified by Buyouts fall into the regionally focused camp. New Jersey-based Crystal Ridge Partners provides capital to lower-mid-market companies in the eastern half of the United States and Canada. With $70 million of committed capital, the firm invests in buyouts, recapitalizations and growth equity transactions, taking either control or minority positions. Crystal Ridge Partners invests primarily in the manufacturing, distribution, consumer products, traditional media and specialty services sectors. Founded in 2005 by Don Hofmann and Jack Baron, both of whom previously served as senior partners at JP Morgan Partners, the firm invests in companies generating trailing EBITDA of $2 million to $10 million. Equity investments typically range from $3 million to $10 million.
New Capital Partners, meantime, invests in small-cap and lower-mid-market businesses in the southeastern United States and Texas. The Alabama-based firm closed its second fund with $140 million in capital commitments in March; the fund is earmarked for $2 million to $20 million investments in health care, financial and business services companies with revenue greater than $5 million. Jim Little and James Outland founded the firm in 2000. Both were operators in the health care industry.
Technology is the focus of at least two firms on our list. New York-based Catalyst Investors, whose second fund collected $170 million from 2005 to 2007, invests in media, communications and related Internet services industries. The firm typically invests $5 million to $30 million in expansion deals, acquisitions or recapitalizations; it seeks U.S. and Canadian companies generating annual revenue ranging from $20 million to $100 million. Ryan McNally, Brian Rich and Chris Shipman co-founded Catalyst Investors in 2000 after careers with TD Capital, the private equity arm of Toronto Dominion Bank.
Axia Capital pursues buyouts and recapitalizations of smaller technology firms in targeted industry sectors. Peter Hunter and James Pelusi co-founded the firm in 2003 after long careers as operating executives. The firm is now raising its second fund, Axia Capital Partners II LP, targeting $30 million for micro-cap buyouts of industrial technology companies with EBITDA of between $500,000 to $5 million, said Hunter. The firm is anticipating the fund’s final close in May of 2010.
Services businesses are another popular focus, especially for small shops with more diversified investment strategies. Those fitting this profile include Chicago-based Hadley Capital, which invests in manufacturing, business services and distribution companies generating EBITDA between $1 million and $3 million; Hastings Equity Partners, a Waltham, Mass.-based firm trying to raise up to $100 million for its second fund; Mangrove Equity Partners, a firm founded by ex-Florida Capital Partners executives that typically invests in companies generating revenues from $8 million to $100 million; Atlanta-based Source Capital, which is targeting $50 million for Source Capital Fund I LP to invest in mature, private small-cap companies with EBITDA of at least $1.5 million; and Connecticut-based Woodside Capital Partners, out trying to raise $80 million to $100 million for a fund earmarked to buy companies generating annual revenues between $15 million and $150 million.
Guardian Capital Partners, formed in 2008, looks to make control plays in the services and manufacturing sectors, with an emphasis on industrial companies. The firm, working to hit a target of $80 million, held a first close on $37 million for its debut fund in March 2008. Insurance company MassMutual, advised by Babson Capital Management, is the fund’s anchor investor. The firm, based in Pennsylvania, was founded by managing partners Scott Evans, formerly of Cerberus Capital Management; Peter Haabestad, a former investment banker at Susquehanna Financial; and Hugh Kenworthy, former president of small-cap buyout shop Brynavon Group. Guardian Capital expects to make eight to 10 control investments, writing equity checks of $5 million to $15 million for companies with enterprise values of $15 million to $40 million.