Making the Case for the Middle-Market

Tumultuous credit markets are changing the private equity landscape. We’ve seen a falloff in upper and mega-market private equity deals, with some private equity groups exposed by a string of imprudent — and, in some cases, broken — deals. The massive leveraged buyouts that helped boost M&A activity to record levels earlier this year have dropped off dramatically, with Dealogic reporting the value of announced U.S. M&A down 71 percent in November.

In contrast, I’ve seen a different story playing out in the middle-market. Private equity groups are looking for an alternative to large buyouts, making the often overlooked smaller deal landscape an attractive option.

Several voices have been insisting on the health of the sub-$1 billion deal-making market. From my vantagepoint as an advisor to private equity groups across industries such as manufacturing, distribution, healthcare and retail, I’d like to add a few items to the discussion about why the middle market is a viable, healthy and sustainable avenue for creating value and opportunity.

Deals are not dead
Several of the busted LBOs in recent weeks were questionable deals to begin with, or at least were highly dependent on conditions prevailing in the credit markets. This vulnerability to lending conditions isn’t such a stumbling block for mid-market funds. In fact, it’s been a record-breaking fundraising run for private equity groups — which means they have capital on hand that needs to be deployed. Unlike the LBOs of large-cap M&A (which earlier this year commonly featured excessive leverage and loose loan terms), middle market deals are typically sales of privately held companies — usually purchased for operational value.

Middle-market volume has been and remains high. Mid-tier investment bank Robert W. Baird reported a record 456 deals disclosing a value under $1 billion in 2006, for a combined value of $91 billion — up 21 percent from a year earlier. It’s a total that is steadily increasing.

Flexible blueprint for growth
The middle market is dominated by privately held companies, which means there are far more options for structuring transactions. And the highest returning deals are not necessarily the biggest by size.

Also, smaller deals tend to be higher risk, higher return. Ownership horizons in general average far longer than with the big deals — we’ll likely see exit strategies stretch out even longer given the credit market conditions. Putting capital gain first, rather than just attempting to tie up massive amounts of capital, will mean that private equity remains an attractive and viable selling option for smaller business owners — more of whom are becoming aware of their exit options.

Rise of the quality deal
As has long been the case in the middle market, firms seeking high-quality purchases will ride out the storm — in this case, the credit markets. Under tightened conditions, firms are going to feel pressure to perform the “right” due diligence — to account for factors such as management sophistication and accounting personnel in target companies. Lenders are going to be more insistent on this third-party due diligence.

Firms that pay close attention to key deal issues are going to remain healthy. While EBITDA will remain a deal driver, it’s going to be more important to look at margin sustainability, customer concentration, growth potential, earnings and asset quality, and working capital analysis.
I think it’s clear to all industry observers that we’re not going to see multi-billion-dollar Merger Mondays anytime soon. As many have suggested, we’re at an inflection — or at least a reassessment — point in the industry. Emphasis will move to growth equity. We’ll see private equity groups assessing companies for operational value instead of seeking quick-flip opportunities. New targets will get smaller, and as exits get trickier, ownership windows will lengthen and funds will put the focus on turning around their existing portfolio companies.

Even in a slower market, good deals will get done. And as the center of activity shifts to the still-thriving middle market, the private equity landscape will continue to evolve.

Michael J. Grossman is a director with the National Transaction Support Services practice at RSM McGladrey. Leading the practice in the New York office, Michael performs transaction services primarily on buy-side transactions.