The fact that private equity has recently appeared in tabloid headlines does little to make the job of private equity investors easier, particularly when investors are looking to achieve sizable returns in a market that has become unforgiving.
Following the financial crisis, large buyout funds have generally fallen out of vogue as limited partners find themselves under increased pressure to meet the return hurdles for their portfolios, without using outsized leverage to create those returns. This has created an opportunity for midmarket buyout managers who have started receiving attention from investors seeking to diversify portfolios away from the leverage lurking in larger buyout funds and trying to avoid the higher correlation those funds have to the public markets.
Midmarket buyout investing is particularly interesting for a number of reasons, including attractive acquisition multiples; reduced competition for smaller nonauctioned businesses; opportunity to add value and scale; and strong exit opportunities. Many of these companies targeted by midmarket buyout managers operate in highly fragmented industries and are entrepreneur-founded, and/or family-owned businesses undergoing generational change. They present significant opportunities for midmarket buyout managers to create value through consolidation and professionalization of business operations, which make them attractive acquisition targets for strategic and larger financial buyers.
Many limited partners believe that managers with turnaround and operational expertise are best positioned to benefit from the current environment. As such, the premier funds will be those that have demonstrated their ability to navigate extremely challenging markets and add value to their companies.
Some trends have developed that we believe are likely to continue, and a few new twists may make 2012 a bit different. The financial crisis drove many large firms to "return to their roots," that is, to invest in smaller deals requiring less debt. This manifested in the increase of unusually large portfolios of some megafunds, some of which had in excess of 70 companies. This shift from portfolios consisting of large companies to large portfolios consisting of midmarket companies created competition for large midmarket deals from buyers that had previously hunted much bigger game. This was not welcome news to managers focused on the higher end of the midmarket, and subsequently, pricing was driven up from a 2009 trough of 6.6 times Ebitda multiples to more than 8 times. Now, however, as debt becomes more readily available, larger firms might return to their core market, easing some of the competitive pressures in the middle market.
LPs have seen growth in fund offerings that focus on certain sectors such as energy, financial services and healthcare, which are better served by specialists. The complexity of regulation and change occurring in these markets requires constant involvement and insight into the changes that are likely to occur during the life of an investment.
In addition, LPs have also taken advantage of firms spinning out of more established middle-market managers that have moved up the food chain in both deal size and company profile. The desire to focus on smaller transactions, coupled with the opportunity to establish their own franchises, has led to the establishment of new firms that have been well received by investors.
With popularity comes scarcity, however, and the most successful midmarket firms have found themselves many times oversubscribed, even during what's been one of the most difficult fundraising periods in history. Limited partners will continue to face competition accessing top-tier funds as well as identifying and diligencing next-generation managers.
Considering that over the past 20 years returns for the midmarket have outperformed the rest of the private equity market by anywhere from 200 to 350 basis points, it's easy to see why there is growing interest in the midmarket buyout segment.
However, a word of caution to the midmarket manager: More than a few managers have succumbed to the hubris that follows successful fundraising and have damaged great franchises. Meeting investors' expectations is the best way for managers to ensure that there will be more capital for them in the future.
Kelly Williams is a managing director and global head of the customized fund investment group at Credit Suisse Group. She is founder of the Private Equity Women Investor Network and a member of the board of the Robert Toigo Foundation and the advisory board of Export-Import Bank.