Article: Middle-Market Private Equity Activity Outlook 2011

By Andrew D. Gardner

Middle-market merger and acquisition activity has not yet returned to its recent highs between 2005 and 2007. As banks tightened credit standards, the availability of financing for acquisitions and management buyouts became scarce. With the largest generation of middle-market business owners in America’s history reaching retirement age, many delayed their exits due to a lack of attractive pricing or issues with the underlying fundamentals of their business that made a sale unattractive or improbable. However, as the economy recovers, merger and acquisition activity is increasing.

Activity Beginning to Upswing¹

Throughout 2008 and 2009, middle-market private equity groups (“PEGs”) and large corporations were unable to leverage acquisitions at historical levels due to a lack of available credit. Between 2006 and 2009, the average percentage of debt used in buyouts decreased from the high-50s to the mid-40s. This was a major obstacle for buyers of private companies, since the lack of debt financing reduced returns (with less available leverage, the potential return on equity decreases) and increased the exposure of private equity firms to investment specific risk (investing more equity into each acquisition results in fewer discrete investments and therefore reduced diversification in a given fund).

According to Pitchbook, the number of private equity deals closed during 2010 increased 21%, and the amount of capital invested in private companies was nearly 250% more than in 2009. The middle-market’s share of total acquisition capital invested also increased, with companies valued at $50 million or less constituting slightly above 40% of the total capital invested in private companies during 2010. Acquisitions during the first quarter of 2011 continued the trend, increasing further in the first quarter of 2011. The percentage of total acquisitions involving companies valued between $50 million and $250 million was slightly above 30% in 2010, which increased to its highest percentage in 7 years of nearly 40% in the first quarter of 2011.

As the credit markets continue to unfreeze, PEGs and large corporations are enjoying more access to debt capital, which we expect will cause continued increases in demand for middle-market companies.

Demand for Middle-Market Company Investment¹

As a result of the period of decreased activity between 2008 and today, PEGs have amassed unprecedented amounts of undeployed capital. In 2010, PEGs had $490 billion of undeployed capital, $350 billion of which was raised in 2008 or earlier (and has been committed to a PEG for more than 2 years) and $194 billion of which was raised in 2007 or earlier (and has been committed to a PEG for more than 3 years). Meanwhile, PEG fundraising activity is increasing, and middle-market funds are raising a majority of the capital.
We expect PEGs to rapidly deploy these hundreds of billions of dollars of capital.  Undeployed capital has already decreased from $521 billion in 2009 to $490 billion in 2010, indicating that PEGs are investing faster than they are raising capital for the first time in over 6 years.

Qualitatively, the number of calls and visits we have received from PEGs, all seeking potential acquisitions, has increased rapidly over the past year, and it continues to increase.  In addition, non-PEG acquisitions by larger corporations appear to be increasing, as corporations have also amassed unused cash that they may use to fund acquisitions.²

Implications for Middle-Market Business Owners

We believe that the increased demand for middle-market acquisitions by PEGs and corporations will result in a short-term opportunity for middle-market business owners. For example, we have seen a number of PEGs lower their minimum EBITDA requirements in order to gain exposure to more potential targets. In a supply and demand framework (Figure 1), we saw pricing and activity in middle-market acquisitions decrease during 2008 and 2009 due to decreased demand. We also saw supply decrease, causing significantly lower activity.

We believe that demand is recovering quickly as PEGs and large corporations explore options to deploy accumulated capital. This increased demand results in a short-term increase in both pricing and activity (Figure 2, shift #1). However, this shift should eventually be offset by an increase in the supply of middle-market companies for sale, as many baby boomer owners prepare for retirement. The result will be an increase in the number of middle-market companies available for sale (shift #2), which will further increase the number of acquisitions, causing a decrease in pricing. While we  cannot predict the exact magnitude of these changes in pricing, we believe both will be substantial considering the hundreds of billions of capital amassed by PEGs and large corporations (shift #1) and the trillions of dollars expected to change hands during the next several years as baby boomers retire (shift #2).

In addition to these changes in pricing (multiples), we expect the fundamentals of middle-market companies to continue to improve. We often say that the intrinsic value of an owner’s business is determined by three things: expected cash flow, perceived risk, and expected growth. As the economy recovers from the recession, economists expect increased expected cash flows, reductions in perceived risk, and more bullish expectations of future growth. Already, corporate profits increased 29.2% during 2010, and the first quarter of 2011 showed an increase of 8.5% over the first quarter of 2011. According to Moody’s, business confidence is improving,³ and real GDP growth (a measure of overall economic growth) expectations are generally strong (3% to 5%).⁴  These improving fundamentals should also help to increase the prices paid by PEGs and corporations for middle-market businesses during the next few years.

Private Equity Groups

There are thousands of private equity groups located throughout the U.S., ranging from small groups with less than $100 million in committed capital to very large groups with many billions of dollars under management spread throughout many funds. Most of these groups focus on acquiring middle-market, privately-owned businesses. Since all of these groups have a mandate to put this committed capital to work, PEGs often have to compete for quality acquisitions.

Due to the amount of committed capital discussed above, PEGs devote significant resources to looking for investment opportunities. One way they look for opportunities is to call or send letters to business owners and their advisors (accountants, lawyers, etc.), who the PEGs believe might be or know a quality acquisition target. The goal of these calls and letters is to begin negotiations with a target without the presence of competition or an experienced advisor. Increasingly, we have seen PEGs outsource this function to buy-side deal sourcing specialists, who may represent several private equity groups with different industry focuses.

In addition, there are many business brokers and other “finders,” who call and send letters to the same general group. Brokers may appear to have money backing their interest in your company and even portray themselves as a private equity group. However, once they are able to determine your interest in a transaction, they will begin finding a buyer for your company, or worse: they will refer it to a single PEG for whom they find potential targets and collect their finder’s fee.

This is where Decosimo Corporate Finance comes in. We help you determine whether an offer is genuine and worth pursuing, and, if so, we help you position your business for sale and help you understand what it is worth. Should it be warranted, we will run a three-phase process that will create competition among willing buyers in order to help you maximize the value of your company.

Even if you end up doing a deal with the first group that made contact, it is our experience that the mere appearance of competition can considerably increase the price and create more favorable terms for the business owner. Of course, having a knowledgeable advisor also helps you to navigate and negotiate the deal to closing. In our experience, this process typically results in pricing 30% or more above that of an initial offer and on much more favorable terms.

1. Pitchbook Data, Inc. Pitchbook PE Trends 2Q 2011. http://www.pitchbook.com/, accessed 5/16/11.
2. According to the U.S. Department of Commerce Bureau of Economic Analysis, corporate internal funds available for investment decreased in the first quarter of 2011 by $11 billion (seasonally adjusted at annual rates, SAAR) after increasing $110.3 billion in 2010 and $188.5 billion in 2009.
3. Moody’s Analytics. World: Moody’s Analytics Survey of Business Confidence, 6/6/11. http://www.moodys.com/, accessed 6/10/11.
4. See Decosimo Advisory Services’ National Economic Conditions report for the first quarter of 2011 at http://www.decosimo.com/ and available upon request.

By Andrew D. Gardner