Middle-market memo on M&A

The tightening of the credit markets and the resulting sharp decline in high-leverage megadeals has generated strong interest in middle-market transactions -- a trend that is expected to continue at least throughout 2008.

Middle-market transactions are projected to remain in focus because they do not depend on syndicated debt, according to PricewaterhouseCoopers' transaction services group's midyear mergers and acquisitions forecast for 2008.

In addition, three regulatory factors may drive an increase in middle-market deals -- and possibly all deals -- before year's end.

Continue reading below

According to the report:

-- The possible increase in the capital gains tax, which may motivate private equity firms to cash out wholly or in part by fourth quarter

-- The new business combination accounting standard, FAS 141(R) -- Business Combinations, which will no longer allow certain transaction costs to be capitalized into the purchase price, instead requiring them to be expensed

-- Changes in how companies account for noncontrolling interests or minority investments, FAS 160 -- noncontrolling interests in consolidated financial statements, which may cause firms to take control of their minority interests before being required to record them in equity and lose gain and loss recognition for transactions with a parent.

As private equity firms deploy more capital in the midmarket, and because middle-market deals are unique, getting the right fit and the right experience can be critical to success. Four basic issues make these deals unique.

Social issues. Midmarket deals frequently involve founders or family operators who are key to a private equity target's success and growth. It's important to match the financial expertise of the investor with the operating expertise of the owner-operator with sensitivity, whether it involves the introduction of a new finance officer, the addition of debt to the target's balance sheet or the creation of incentive-based compensation plans where there were none.

Changes in senior management also require a sensitive touch. These changes are often characteristic of the midmarket deal, and implementing any of them suddenly and without a clear understanding of the benefits could spell disaster.

Structure issues. Middle-market targets may be organized in a way that is not tax-efficient for investors. Therefore, understanding the use of creative and flexible flow-through structures for making an investment, such as LLCs, is important. Experience matters when it comes to understanding the alternatives these structures offer for the allocation of profits, losses and distributions to target owners and investors alike, and for creating critical incentives for management to drive growth.

Special skill also is required to address and balance the economic and tax concerns of the target owner's rollover equity -- such as maintaining a single-level of tax and maximizing capital gains -- and the investor's goals -- such as qualifying for consolidated return filing, or a step-up in tax basis and amortization of the investment.

Capitalization issues. Growth through add-on transactions often drives returns in midmarket investments, while high leverage drives the megadeals. In fact, many midmarket deals are initially funded entirely with equity, sometimes later refinanced.

The result is that the post-money capitalization of a midmarket target follows its own pattern, and creates its own dynamic -- all with a profound effect on valuations and returns -- and all requiring a different approach to financial modeling.

Most important, because add-on transactions are so crucial in the middle market, the ability to complete them quickly and in a cost-efficient manner with positive effects on the target's balance sheet and P&L statement takes deft handling.

Supporting players. The accounting firms, lenders, investment bankers, lawyers and others that source midmarket opportunities for investors are all cast from a special group focused on the middle market. Dealing with any one of these advisers will put all the necessary experience and resources of the other advisers within the reach of investors, enabling them to close the deal quickly. This special group also is best-suited to stay ahead of market trends and solutions that can create commercial efficiencies.

It is worth noting that this "fit" is as important to cost control as it is to overall success. Successful midmarket deals demand advisers who staff their deals with lean-and-mean teams, and provide the same partner and team from deal to deal.

So getting the right fit and the right experience can make the difference between closing the deal and losing it.

Mitchell S. Ames is a member of Pepper Hamilton LLP's corporate and securities practice group in New York City.

Post a comment

Name:

Email Address:

URL:

Remember personal info?

Comments: (you may use HTML tags for style)

Please only click "Post" once. It may take a few moments to process.