Connections - Duane Morris · PDF fileubs Alternative investments us ... past editions of connections have prompted considerable commentary and response from interests across the

INNOVATIONS @ HAND

Volume 2 | Issue 1

IN THe mIDDle mArkeT Connections

THe New pArADIgm IN prIcINg, prepArATION &

perfOrmANce

Today’s Liquidity Landscape:

Private Equity | Winter 2012

®A global growth sponsor of

p r I V A T e e q u I T yc O N N e c T I O N S

exit prospects improve, but

mArKets Are still chAllenging

CONTRIBUTORS:

DARA F. CASTLe, managing partner,mcgladrey

strAtegics plAy A lArger role: buying groWth

duAl-trAcK strAtegy: ipo

versus Auction

secondAry sAles: flush

finAnciAl buyers undAunted by

mArKet volAtility

Adjusting to the neW reAlity: lessons leArned When you cAn’t

get out

4 12 16 20 24

eDWARD gOLDSTeiN, vice president, morgan stanley Alternative investment partners

JeFFReY A. HOWARD, executive managing director, compucredit holdings company corporation

MiCHAeL R. HOWeLL, partner, c.W. downer & co.

SAMeeR JAiN,head of investment content & strategy, ubs Alternative investments us

CHRiSTOPHeR W. keRSeY,managing member, camden partners

iN THiS iSSUe:

the remarks and quotes of dara castle, edward goldstein, sameer jain and chris Kersey were delivered at duane morris’ private equity connections program on november 3, 2011, in Washington, d.c. jeff howard and mike howell provided their remarks and quotes during interviews conducted between december 2011 and january 2012.

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perhaps no issue confronting private equity over the last three years is more vexing than the challenge of liquefying the massive equity represented in the thousands of portfolio companies populating sponsor balance sheets. disrupted by the 2007–2008 financial meltdown and ensuing credit crunch, the classic private equity formula that had performed energetically for the previous two decades no longer offered the assurance of dependable exits; the initial public offering (ipo) market fell off the liquidity radar screen; sponsors were left without the toolkit required to maintain distribution flow; and vulnerabilities crept into established relationships with limited partners.

At the duane morris private equity connections conference held in Washington, d.c., in november 2011, the dynamics underlying sponsor and seller strategies in this environment were examined by a blue-ribbon panel of general partners (gps), limited partners (lps) and leading-edge transactional support professionals in investment banking, accounting and law.

iNTRODUCTiON


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in this edition of our regular publication, connections in the middle market, we capture the insights from our panel, augmented with commentary from authorities on the corporate strategic and investment banking sides.

past editions of connections have prompted considerable commentary and response from interests across the middle-market private equity spectrum. As always, we invite your views on the issues presented here or on other issues facing the industry.

for more information on duane morris’ private equity capabilities, or to discuss the issues presented in this edition of connections with one of our featured attorneys, please visit www.duanemorris.com/practices/private_equity.html.

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in a low-growth, high-unemployment economy, with the slow-motion potential european economic implosion rattling debt and equity markets worldwide, many private equity investors find themselves holding onto their portfolio companies longer than they expected. fortunately for those general partners, private equity investors typically have shown an understanding of the need to stay in for the long term. that said, however, general partners are facing pressure from their distribution-starved limited partners, many of whom have not seen significant returns in four years.1 Amid the prevailing uncertainty, even the simple task of valuing an asset for sale is a challenge—let alone finding multiple buyers to enable general partners to generate those critical high returns.

the numbers are daunting. While private equity firms hold approximately 5,900 companies in their portfolios, roughly half of those assets were acquired between 2005 and 2008 when valuations were much loftier—which means that the median holding period for these assets is about to cross five years.2 do the math: Attempting an exit in this environment requires mastering the art of being a seller in a buyer’s market.

the good news is that exit prospects seem to be improving. After plunging to an almost-catatonic state in 2009, 449 portfolio companies were sold by private equity firms in 2010, followed by 420 exits in 2011.3 the typical

exiT PROSPeCTS iMPROVe, BUT MARkeTS ARe STiLL CHALLeNgiNg


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cHArT 1

Source: PitchBook Data (Prepared exclusively for this publication and furnished upon request)

number of pe-owned portfolio companies by year

Num

ber of

Pe-

Back

ed C

ompa

nies

2,187

2,849

3,621

4,483

5,064 5,341

5,665 5,952

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2004 2005 2006 2007 2008 2009 2010 2011

Num

ber o

f PE

Back

ed C

ompa

nies

As of Year

2009-2011*

2005 - 2008

2000 - 2004

Year of Investment

Year of investment

2009–2011

2005–2008

2000–2004

As of Year

6

exit was a middle-market company, based in the midwest or southeast, sold to a larger corporation for around $200 million.4 exit valuations for portfolio companies of all sizes have been holding steady at a median of 8x to 9x earnings before interest, taxes, depreciation and amortization (ebitdA) since 2009.5

however, there is a great difference at the micro level. At the higher end of the middle market, manufacturers with an enterprise value of $100 million to $250 million achieved valuations of 8.7x ebitdA last year.6 At the lower end of the middle market, the average sales multiple was only 5.5x ebitdA for firms with an enterprise value of $10 million to $25 million.7 this valuation gap has widened significantly since 2010,8 when there was a gap of only 1x ebitdA between sales of smaller middle-market companies versus larger ones. “size premium—the reward in valuation for larger businesses over smaller similar ones—is now the defining dynamic in middle-market m&A,” writes Andy greenberg, ceo of gf data.9

cHArT 2median holding period by year


4.37

3.82

4.38 4.16

3.67 3.57 3.84 3.93

4.68 4.81

0

1

2

3

4

5

6

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

# of

Yea

rs H

eld

Year of Exit

Median Holding PeriodMedian Holding Period

Year of exit

# of

Yea

rs H

eld


7

cHArT 3


number of exits by Quarter

116

92

113

128 120 124

143

123

99

79

114

58

33

51 44

79 83

104

84

163

96

111 101

112

-

20

40

60

80

100

120

140

160

180

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

2006 2007 2008 2009 2010 2011Corporate Acquisition IPO Secondary Buyout

“Size premium—the reward in valuation

for larger businesses over smaller, similar

ones—is now the defining dynamic in

middle-market M&A.” Andy Greenberg,

GF Data

Corporate Acquisition iPO Secondary Buyout

8

in an ideal world, private equity investors generally would have three types of exit opportunities available: sales to strategic acquirers, secondary sales to other private equity firms and initial public offerings. however, uncertainty in the public markets creates a difficult environment in which to engineer an ipo. there were

30 private equity-sponsored ipos last year10—a remarkable number given market volatility—but public markets are unlikely to provide an exit for more than a handful of private equity portfolio companies, at least until the economy enables the markets to stabilize.

for middle-market companies, strategic acquisitions remain one of the most promising exit avenues; in fact, strategic buyers accounted for more than half of all private equity exits in recent years and paid an average of 9.6x ebitdA in 2011.11 Why? strategic buyers bring to the table significant cash and access to senior debt, and after almost three years of doing more with less, many corporations are seeking to grow through acquisition. middle-market companies in consumer and business products and services, healthcare and information

cHArT 4capital raised through exits


$41

$19

$45

$16

$28

$33 $34

$25

$23

$9

$42

$6 $7

$4

$8

$21

$17

$29

$22

$38

$25

$39

$22 $21

$-

$5

$10

$15

$20

$25

$30

$35

$40

$45

$50

1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

2006 2007 2008 2009 2010 2011

Capital Exited ($B)Capital exited ($B)


9

technology in particular are finding an audience with corporate acquirers.12 certain subsectors—cyber security, healthcare it and cloud technology, for example—are bringing the highest valuations from strategic buyers, says dara f. castle, managing partner of mcgladrey and partner-in-charge of private equity in the mid-Atlantic. the reason: companies are paying top dollar for products or services that would cost more to develop in-house than buy ready-made—the classic “buy versus build” strategy.

meanwhile, private equity investors are finding willing buyers among their own ranks; in fact, secondary sales accounted for one-third of exits last year. look for further secondary activity in the year ahead as private equity firms put more of their substantial uncalled funds to work and expand portfolio companies with bolt-on acquisitions.

When finding a buyer is not an immediate option, some gps are able to return money to lps by “recapitalizing” a portfolio company. this is a common strategy, particularly for over-equitized portfolio companies with strong cash flow that can handle a heavier debt service. in some cases, large leveraged buyout (lbo) shops have used this strategy to recoup their entire equity investment while retaining ownership. An additional benefit: recapping may also give gps additional latitude to time an exit. however, big recaps have earned something of a checkered reputation, since some heavily recapitalized companies, unable to service the new debt, have ended up in bankruptcy.

For middle-market companies, strategic

acquisitions remain one of the most promising exit avenues and the

most profitable.

10

cHArT 5


exit ebitdA multiples

6.0

7.0

8.0

9.0

10.0

11.0

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

All PE Exit EBITDA MultipleMiddle-Market exit eBiTDA Multiple

All Pe exit eBiTDA Multiple


11

cHArT 6


proportion of exits by exit size

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006 2007 2008 2009 2010 2011

Under $50M $50M-$250M $250M-$500M $500M-$1B $1B-$2.5B $2.5B+

even with improved deal flow, it is unlikely that private equity firms will find an easy exit for all of their long-held portfolio companies over the next few years. for many gps, the best approach in this environment

may be to hold onto assets and invest in them for the much-longer term—and to communicate this strategy to their lps so they understand that it is worth the wait.

THe DUANe MORRiS VieW

R. Timothy Bryan

12

After three years of accumulating cash while waiting out the great recession, u.s. corporations have amassed a capital arsenal of $2 trillion—but to date have deployed very little of it.13 many are still as focused on divesting businesses as they are on acquiring them,14 but they are acquiring: As we’ve pointed out, u.s. corporations are the most active buyers of middle-market private-equity assets.15

even with strong balance sheets and available credit for the biggest borrowers, great caution remains among corporate boards; huge transformational acquisitions are still rare, even if they generate the most press. for every headline deal with the drama and dimension of At&t’s failed bid for t-mobile, hundreds of smaller, bolt-on acquisitions are completed with little fanfare. middle-market companies in particular should benefit from this deliberate, focused approach to growth through acquisition by strategic buyers.

on the strategic side, large corporations look for mergers to fill a niche, usually acquiring a product or service that would take too much time or cost too much money to create from scratch. coca-cola, sara lee and general electric are some of the most active acquirers, even as they continue to divest some of their existing less-profitable lines of business to focus on core lines.16 two recent examples: in november, ge transportation bought rmi, a small software company ($45 million annual revenue), from carlyle group17; and sara lee

STRATegiCS PLAY A LARgeR ROLe: BUYING GROWTH

“Strategics are more comfortable with [regulatory] risk than Pe funds, typically because they live with it day-to-day.” Jeffrey A. Howard, CompuCredit


13

announced plans to buy coffeecompany, a café store operator, from Krc capital in december—with plans to acquire tea forte following soon thereafter, in january 2012.18 While neither of these acquisitions is material to the revenue or balance sheets of ge or sara lee, they represent prototypical middle-market platform buildouts for fortune 500 buyers.

companies are also buying market share. dara castle of mcgladrey anticipates a similar trend developing in the government services industry. “given federal budget pressures in the coming two to three years, public companies in this sector will have a great deal of trouble generating organic growth; they will continue to look to the smaller end of the middle market to buy some of that growth with strategic customers.”

christopher W. Kersey of camden partners in baltimore sees a different dynamic in the healthcare and life sciences areas in which camden invests. Kersey believes that “oftentimes, the number-two and number-three players in their markets are under a lot of competitive pressure to evolve.” medical technology companies, for example, need to tack on additional product or service lines to their core business. private equity firms in this space, he says, “should focus on new product development to make their portfolio companies attractive to strategic buyers.”

Private equity firms “should focus on new product development

to make their portfolio companies attractive to

strategic buyers.” Christopher W. Kersey,

Camden Partners

14

strategic investors in regulated industries have an additional advantage because they tend to be more comfortable with regulatory risk, says jeffrey A. howard, executive managing director in charge of corporate development at compucredit, a consumer finance firm. “the regulatory landscape we’ve been facing over the

past two or three years has added some uncertainty and, in some respects, affects the valuation of these businesses. i think strategics are more comfortable with this risk than pe funds, typically because they live with it day-to-day—they understand it and they know how to manage it.” Adds howard, “As an add-on acquisition, it’s not quite as dramatic a consequence as it might be to a private equity fund that is building a platform.”

howard has seen the effects of regulation from both the buy side and the sell side: compucredit recently sold two smaller units and has acquired middle-market firms as well, often in competition with financial investors. “there are a lot of financial buyers in this sector but, historically, the strategics tend to be able to pay a little bit more,” he says, because once the regulatory concerns are behind you, you view “opportunities with an eye towards add-on value.”

cHArT 7breakdown of deals by geography of non-u.s. buyers


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2004 2005 2006 2007 2008 2009 2010 2011

Canada Europe China and East Asia Western and Northern Asia OtherCanada europe China and east Asia Western and Northern Asia Other


15

While most strategic buyers are incorporated in the united states, sales to non-u.s. firms still accounted for one out of eight pe-backed exits last year.19 With the canadian dollar near parity with its u.s. counterpart, more companies north of the border are seeking to buy u.s. assets; in fact, canadian strategics bought one out of three pe-sponsored companies sold to non-u.s. buyers in 2011.20 chinese and east Asian firms, eager to acquire expertise and an entry into global markets, have also stepped up their acquisition of sponsor-backed companies with the purchase of seven pe-backed companies in the last year, compared with two in 2010 and none in 2009.21

michael howell, a partner at investment bank c.W. downer & co., is seeing much more interest from chinese strategic buyers to purchase companies in the united states and europe, particularly if unique technology and consumer products exist that can be used in the chinese market. “they have a lot of support to do deals in the u.s. and, in some cases, can finance a deal entirely with debt from chinese banks with government support.” culturally speaking, working through the bidding process with a potential chinese acquirer can be a challenge. says howell, “you can’t just put a cim in the mail and expect them to submit a bid in a competitive auction process. We’ve got to really tailor a process for them.”

We see an opportunity for private equity firms’ portfolio companies to “grow their own” pool of potentia l acquirers among distributors and competitors—the people who understand their business

most intimately. these firms operating in the same marketplace are in the best position to value a target company fairly and to integrate it smoothly. in this regard, some pe funds, particularly those implementing sophisticated bolt-on programs in specialized industry verticals, are looking more like strategic acquirers.


P. Blake Allen

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While there are more than 100 private equity-backed portfolio companies that have filed registration statements and have thus queued up for an ipo,22 most of them will be waiting a long time; in fact, only six23 went public in the fourth quarter last year. sameer jain, head of investment content and strategy at ubs Alternative investments, notes that pe-backed firms “are filing for ipos with the expectation that when the window opens, they will go to market, but at this point in time it looks pretty bleak.” the question is: how long will they hold out?

for companies that make it to market, the process to get there is trying, but the result can still be rewarding. in a typical deal last year, onex corp., a canadian private equity firm, took its portfolio company tms international corp. public in an April offering, but sold fewer shares and at a lower price than the originally estimated range. despite the curtailed offering, tms shares subsequently sank below their offering price. nonetheless, onex’s remaining 61-percent stake was valued at 30 percent above its original cash investment in 2007, and the ipo allowed it to take some of its equity off the table.24

While not every case will replicate the tms experience, there are nonetheless drawbacks to pursuing an ipo—among the most salient is that a public listing does not usually permit a complete exit for a pe fund. even when an ipo is possible, most private equity firms are selling a relatively small part of their stake, if any, in the initial offering. in taking the ipo route, generally a primary offering made on behalf of a portfolio company, sponsors

DUAL-TRACk STRATegY: IPO VeRsUs AUCTION


17

most often use the proceeds to pay down debt or invest in the business. those sponsors can then seek to arrange a secondary offering six to 12 months later, depending on market conditions. in summary, however, with markets so volatile, an ipo can make for a protracted, expensive and problematic exit strategy.

Another downside to an ipo strategy is that it consumes an enormous amount of management’s time—often with little real expectation of going the distance. says mcgladrey’s castle: “even for a well-run, fairly sophisticated company, it can take a minimum of a year to prepare. there are a lot of things that need to be scrubbed, and typically, there are procedures and behaviors that need to be modified for the company to be in compliance with the requirements to file with the sec.”

What’s more, the public market is really a viable option only for the largest middle-market companies. for 2010 and the first half of 2011, pe-backed ipos had a median market cap of $835 million when they began trading.25 if sponsors are trying to raise less than $100 million in capital, an ipo is rarely a viable exit strategy. very few middle-market companies ever go public. in his extensive 2009 study of the middle market, richard trottier points out that of the 300,000 companies with annual revenues between $5 million and $500 million, only a fraction are in public hands. As trottier comments: “the odds of a lower mid-market company going public are worse than those of a college athlete making it in the big leagues.”26

“even for a well-run, fairly sophisticated company, [an

iPO] can take a minimum of a year to prepare. There are a lot of things that need to be scrubbed, and typically, there are procedures and behaviors that need to be

modified for the company to be in compliance with the

requirements to file with the SeC.”

Dara F. Castle, McGladrey

18

for most middle-market companies, a sales process in the form of an auction remains the more-promising alternative to a public offering. shopping a company to multiple buyers in an auction customarily entails a less-challenging level of preparation and, in most cases, offers the promise of a complete exit.

While three of camden partners’ portfolio companies filed for ipos in the last 18 months, Kersey believes it is important to pursue all reasonable options. “We love auctions on the exit. it’s really exciting. you’ve got the financial buyers lining up. And then you’ve got the strategic buyers lining up,” he says. “you never know what is going to happen with a filed entity in these markets, but it does give you leverage as you contemplate potential exits,“ he explains. “so, in many cases, this dual-tracking process is a prudent strategy. it has worked in the past. you cannot time the ipo markets.”

importantly, the dual-track approach tends to boost multiples, at least for highly valued properties with a significant amount of interest. “it used to be that you’d run an auction, you’d get to your favorite horse and you’d have weeks of diligence,” says castle. “nowadays, we’re seeing that the time from picking your suitor

“in the industries that are going through tectonic change, sometimes companies that you don’t think would be acquirable may end up on a buyer’s radar screen much sooner than you think. So you better have your companies organized internally.” Christopher W. Kersey,Camden Partners


19

to close is hyper-shortened. you’re running the full diligence process with multiple entities, and basically, it’s just a grudge match as to who’s going to be the top bidder.” sellers can often shorten the timeline—and avoid surprises—by actually paying for their own third-party diligence rather than waiting for each set of buyers to bring in their own accountants and lawyers. interestingly, given the expense of serial outside diligence, this strategy can actually reduce the seller’s transactional costs.

Kersey provides another argument for preparing for the dual track early—even when a quick exit seems unlikely. “in the industries that are going through tectonic change, sometimes companies that you don’t think would be acquirable may end up on a buyer’s radar screen much sooner than you think. so you better have your companies organized internally,” he said.

both ipos and auctions involve more diligence in this environment, and deals fall apart much faster than they previously did. in the past, dealmakers were far more willing to work through some of the bumps in the road, but

in the new paradigm, they are much less willing. the sooner you clean up the company before you get to the table, the better. consequently, sellers pursuing a dual-track strategy for a portfolio company should consider preparation for listing requirements by establishing, for example, audit and compensation committees, independent boards and whistleblower programs—a significant expense and management burden, but one which preserves all options.


keli isaacson Whitlock

20

even in light of the preceding, there remains a very vibrant secondary market, where companies are sold by one private equity firm to another. since the beginning of 2010, one out of every three exits was a secondary sale, and this level of activity looks set to continue. As of october 2011, buyout funds held $436 billion in dry powder,27 with just more than half of that overhang scheduled to reach the end of the investment period between the fourth quarter of last year and the end of 2013.28 even private equity firms that claim never to participate in auctions are going toe-to-toe with strategic investors to acquire assets from other private equity firms.

for private equity sellers, secondary sales permit more-creative exit structures than public offerings and strategic sales. for private equity buyers, secondary sales offer the chance to bolster platform companies by making add-on acquisitions that may subsequently attract strategic buyers or even burnish the prospects for an ipo. growing through acquisition also allows private equity investors to arbitrage the valuation gap between small and large companies. robert landis, a partner at the riverside company, estimates that around half of the companies riverside has acquired are add-on acquisitions—a strategy he believes has improved exit multiples for portfolio companies by as much as 1x ebitdA.29 And riverside is not alone: Add-on deals now comprise one-half of all buyouts.30 yet even in this active sector of the marketplace, secondary sales are subject to the same roadblock as any other private equity deal—financing.

SeCONDARY SALeS: FlUsH FINANCIAl BUYeRs UNDAUNTeD BY MARKeT VOlATIlITY

21

it may come as no shock that raising debt to finance a leveraged buyout is harder these days, especially in the lower middle market, but liquidity per se is not the issue. rather, the hesitation in the debt markets is more a lack of confidence in the potential borrower than a lack of capital. the markets are putting a higher price on risk, and banks are still cautious. london interbank offer rates (libor) are close to zero, yet financing is particularly difficult at the lower end of the middle market, where deals for companies with an enterprise value of less than $100 million encounter more resistance in securing senior debt. Alternatives are expensive: subordinated debt carries rates of 11 percent to 13 percent on average31 plus an equity component, while rates on senior debt run at 4.4 percent to 6.1 percent.32

less leverage means financial buyers have to put up more cash. While this “over-equitization” may not be ideal for middle-market private equity firms because it covers their returns, it is increasingly the best option to put more cash up-front with the hope of refinancing when markets improve. While the equity component for middle-market deals currently hovers in the vicinity of 50 percent,33 at the lower end, it is now averaging as much as 60 percent.34 As a consequence, some pe firms are considering all-equity deals rather than paying what lenders are asking.35


Robert Landis, a partner at The Riverside Company, estimates that around half of the companies Riverside

has acquired are add-on acquisitions—a strategy

he believes has improved exit multiples for portfolio

companies by as much as 1x eBiTDA.

22

however, on secondary sales, a range of debt options still exists—mezzanine financing being one prime example. unitranche debt is another option that lets middle-market firms “sidestep costly bank and subordinated debt” in favor of a combination of senior and mezzanine debt supplied by one lender, according to ted Koenig of monroe capital.36 in many cases, hedge funds are now becoming the lender of first resort, stepping in where banks fear to tread, particularly for more-customized financing packages.

An earn-out is a strategy that allows for some deferred consideration to the seller by structuring a portion of the price to be based on future performance. including an earn-out component can help bridge the valuation gap between what a buyer would like to pay and what a seller would like to receive. for the buyer, earn-outs remove some risk; if an asset does not perform, the total price paid is held down to a pre-agreed level. Alternatively, seller financing can permit time-based debt service or having amortization and interest paid based on the performance of the asset. says howell: “We’re seeing lots of earn-outs—either a seller note or a performance-based earn-out—despite the fact that sellers hate to give them.”


23

some pe firms also are selling significant portions of their holdings in portfolio companies to harvest returns for lps, while maintaining a stake and partnering with new pe owners. this strategy enables the firm to participate in the potential upside and may look like a good plan if the seller believes valuations are not at ideal levels; selling a majority stake means being a passive investor.

some strategics explore a pe firm partnership when an acquisition makes sense, but where the price is too high. compucredit is considering this approach, building on its experience partnering with financial investors to buy liquidating assets such as credit-card receivables. “We partner with private equity funds to look at deals, because we are a good operating and capital partner for transactions that are larger than maybe we would look at on our own,” says compucredit’s howard. “hypothetically, we also think that having us already in the business makes for an easier exit if private equity partners want to sell. We sometimes have buy-sell provisions that everyone can agree on at the front end, with standard tag-along rights, so that we are aligned when an exit opportunity presents itself.”

While the world is not ending, unmistakable signs indicate that the irresistible need for liquidity is bumping up against immovable forces in the credit markets. the clash of these opposing forces can produce one of two outcomes—

fatal stress fractures to the gp/lp relationship, or thoughtful solutions that call upon the deep ingenuity and statesmanship of the best private equity managers.

While today’s exit climate is enigmatic at best, the middle market is finding a way through the liquidity labyrinth with a range of unconventional structures and combinations. We think the high performers in the industry are likely to clear this maze successfully—not only with relief but also with new skill sets and flexibility.


Michael D. Schwamm

24

frustrating though they may be, longer holding periods provide an opportunity for gps to demonstrate their mettle and show how patience in the face of instability can still pay off. Anyone can flip a company when the market is soaring. however, only the best-communicating gps can grow their portfolio companies amid economic uncertainly and market volatility, ultimately demonstrating that patience is not only a virtue, but also may yield the highest return.

According to jain, who invests client money across a range of private equity funds and who understands this well, “At least with some of the good gps, we’ve seen five percent to seven percent revenue growth on a portfolio basis over the last year, five percent to seven percent ebitdA growth, and around 10 percent to 12 percent debt paydown. When we go to some of our lp meetings, you would never believe that we were in the middle of a slowdown or one of the largest recessions.” fortunately, most lps recognize that their gps are operating in a very tepid economic recovery characterized by an extended period of instability in the debt and equity markets. lps understand that it might make sense

ADJUSTiNg TO THe NeW ReALiTY:lessONs leARNeD WHeN YOU CAN’T GeT OUT

25

to wait it out, as long as gps can communicate that they are actually using this time to continue to drive value creation through growth and operational improvements. explains jain: “so if a gp can communicate that his focus is on exits and distributions—but at the right price and at the right time—and in the intervening period, he is working to make portfolio companies better or finding opportunities in market dislocation, i think there should not be overwhelming pressure for realizations.”

edward goldstein, a member of morgan stanley Alternative investment partners’ private-equity fund-of-funds group, points out that waiting for better valuations is especially important when markets are so volatile. on the one hand, goldstein has seen a couple of quarters of year-on-year ebitdA growth and an expansion in expected valuations as gps mark their portfolios to market anytime there is a successful sale of a relevant competitor. “but i think the consensus view is that there’s now a massive headwind given the volatility in the market,” he says. that could weigh on exit valuations going forward, even for good companies.

“if a gP can communicate that his focus is on exits

and distributions—but at the right price and at the right

time—and in the intervening period, he is working to make portfolio companies better or

finding opportunities in market dislocation, i think there

should not be overwhelming pressure for realizations.”

sameer Jain, UBs

26

not all lps will be so understanding, however, especially where gps appear to be giving up on underwater investments while collecting fees on uncalled, committed capital.37 some bubble-vintage investments are far below the hurdle rate that would trigger carried interest for gps; lps are understandably frustrated. this could hold down exit volumes and distributions to lps going forward38; thus, articulating a sound plan is essential for any gp who plans to raise money in the future.

As discussed, earlier recaps can be used to make distributions to lps, and middle-market pe firms are less likely to encounter negative perception issues than the big buyout funds. for one thing, it is more challenging for companies on the small side to secure credit facilities even when credit is more accessible. taking some equity off the table—especially when the investment is equity-heavy—is not the same as recouping one’s entire cash outlay within weeks, as is what happened in some of the more-egregious recaps a few years ago. those

“The consensus view is that there’s now a massive headwind given the volatility in the market.” edward Goldstein, Morgan stanley Alternative Investment Partners


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already holding debt of a portfolio company will scrutinize the terms of any new lending, as they should, and complain loudly if they feel their position appears jeopardized. for solid, well-seasoned companies that can find debt financing, recapitalization remains a way for gps to reduce their equity stake, return some money to lps and wait for an optimal time to exit.

Waiting for better valuations is also essential for gps who plan to raise new funds. Kersey says that gps “really need to be showing a 2x net cash-on-cash return to current investors to make sure they are ready to discuss perhaps investing in your next fund.” to appeal to new investors, returns need to be even higher, at least 2.5x net cash-on-cash, he says. “the bar is high.”

far from monolithic, middle-market private equity comprises a highly interdependent network of interests—sponsors, lps, private sellers, lenders, strategic buyers, transactional support entities and more—a complex

ecosystem to be sure, but all focused singularly on the goal of generating optimal returns from more-discerning capital resources.

As in any ecosystem, when a critical component falls out of balance—in this case, the credit markets—the rest of the system must adjust to the new reality for survival. fortunately, in our view, there is sufficient convergence of interest in the middle-market sector to make those adjustments and reacclimate to the new normal with new levels of communication as well as new and unconventional operating and financing solutions—in short, the new paradigm in pricing, preparation and performance.


Brian gannon

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CONCLUSiON to tackle the new reality, pe investors and their advisors have had to devise strategies to strengthen their portfolios and give lps a return on their investments. Among them are the following:

• longer holding periods for portfolio companies. this means more opportunity to build better businesses, improve margins and time exits.

• rethink the ipo process. While a public offering may be the gold standard, it is unattainable for most middle-market companies. preparing for an auction process is a more-reliable option, although a dual track may be optimal for the upper slice of the mid-market.


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• consider add-on acquisitions. even when markets are volatile, strategic buyers and private equity investors are always in the market to acquire niche companies. some companies look even better in a downturn.

• Widen the pool of potential acquirers. gps who attract overseas buyers to their portfolio companies may find a creative way to overcome the challenges of a cross-border deal.

As a result of recent market realities, private equity may be developing a more tolerant view of the longer risk horizon now facing the industry and the impact this will have on returns. that tolerance is paying off for those who have waited for the right moment to engineer a successful exit at a more-attractive multiple. A track record of building and selling thriving businesses is not only essential for future fundraising prospects, but it also demonstrates the value of middle-market private equity, no matter the state of the economy.

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Dara F. Castle is the managing partner of mcgladrey’s Washington metropolitan offices, where she leads the assurance services practice for private equity portfolio companies, as well as the commercial assurance practice for the Washington metropolitan area. these practices involve working with closely-held and private equity-backed entities in government contracting, technology, software sales and development, manufacturing, engineering and a variety of other service-based industries. in addition to leading these assurance practices, ms. castle participates on the firm’s government contracting merger-and-acquisition engagements, lending her expertise in revenue recognition and related receivables, working capital, purchase accounting, opening balance sheet and other accounting concerns unique to the industry. she has nearly 20 years of experience, specializing in serving government contractors in a variety of industries and customer bases.

ms. castle earned her undergraduate degree in accounting at north carolina state university. she is also on the board of directors of the Association for corporate growth, national capital chapter, and is a member of the northern virginia technology council.DARA F. CASTLe, CPA,

managing partner, [email protected]

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edward goldstein is a member of the morgan stanley Alternative investment partners private equity fund of funds group. he joined morgan stanley in 2007 and has led or participated in lp, direct and secondary investments totaling more than $500 million of committed capital. prior to his current role, mr. goldstein worked for sterling partners focusing on early-stage private equity investments in healthcare and technology. previously, he was an associate in the investment banking department at toronto-dominion (f/k/a commerce capital markets) where he advised public and private firms on mergers and acquisitions, going-private transactions, and capital placements. before that, mr. goldstein was a consultant for Andersen consulting/Accenture in the firm’s healthcare and life science practice. mr. goldstein received a b.A., magna cum laude, from the university of pittsburgh and an m.b.A. from the Wharton school of the university of pennsylvania.

eDWARD gOLDSTeiN, vice president,morgan stanley Alternative investment [email protected]

3232

Jeffrey A. Howard is the executive managing director at compucredit holdings corporation, where he is responsible for the company’s mergers and acquisitions activities, partnership opportunities, strategy development and oversight of the company’s credit-card and auto finance operations. during his tenure, compucredit has acquired more than $6 billion in assets and numerous businesses, resulting in platform expansion both domestically and internationally. prior to joining compucredit in 2001, mr. howard was a director at suntrust equitable securities, a division of suntrust bank, where he spent time in mergers and acquisitions advisory as well as the corporate and investment banking unit. mr. howard has an m.b.A. from the goizueta school of business at emory university and a b.s. from the georgia institute of technology.

JeFFReY A. HOWARD, executive managing director,compucredit holdings [email protected]

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Michael R. Howell has worked in the field of mergers and acquisitions for more than 15 years. mr. howell joined c.W. downer & co. in 2001, and during his tenure, he has advised both domestic and international clients on acquisitions, divestitures and joint venture transactions. prior to joining c.W. downer & co., mr. howell worked in the corporate finance department of a big four accounting firm.

mr. howell has extensive experience in the areas of manufacturing, business-to-business services, consumer products and defense-related services. Additionally, he is responsible for leading c.W. downer & co.’s material handling & logistics transaction group, which has established itself as a market leader. mr. howell has completed numerous transactions involving businesses located in the united states, canada, Western europe, scandinavia, south America and Australia.

mr. howell is a graduate, cum laude, from boston college’s carroll school of management, and also holds an m.b.A. from the smeal college of business at pennsylvania state university, which he attended as a graduate teaching assistant. mr. howell is a non-practicing certified public Accountant. mr. howell has lived in switzerland and france and currently resides in boston.

MiCHAeL R. HOWeLL, partner, c.W. downer & [email protected]

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Sameer Jain has 18 years of experience across a broad array of alternative investment activities, including product development; research; asset allocation; and private investments oversight. At ubs, mr. jain evaluates, allocates capital to and represents lp interests, and he also monitors performance in private equity and real estate funds. prior to joining ubs, he was a director of product development and research at citi Alternative investments and a partner at cambridge Alternative investments. mr. jain is a graduate of mit and harvard university.

SAMeeR JAiN, head of investment content & strategy,ubs Alternative investments [email protected]

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in his work at camden partners, Dr. Christopher W. kersey focuses on private equity investments in the healthcare and life science industries. founded in 1995, camden partners is one of the largest growth equity and investment management funds in the united states with more than $700 million under management.

dr. Kersey serves on the boards of directors of essence group health corporation, liposcience inc., medivance inc., minsec corrections corporation, patientsafe solutions inc., santa rosa consulting inc. and Webmedx inc. dr. Kersey’s previous portfolio companies include medserve inc. (acquired by stericycle corporation, nAsdAQ: srcl), Algorx pharmaceuticals inc. (acquired by Anesiva corporation, nAsdAQ: Ansv), comview medical systems (acquired by electromed corporation), macrogenics inc., pet drx corporation (acquired by vcA Antech inc., nAsdAQ: Woof), rejuvenon corporation (acquired by helsinn healthcare s.A.), targacept corporation (nAsdAQ: trgt) and xeotron corporation (acquired by life technologies corporation, nAsdAQ: life).

dr. Kersey serves on the boards of trustees of johns hopkins medicine and the johns hopkins hospital (#1 ranked for 21 consecutive years in u.s. news & World report). dr. Kersey serves on the board of directors of the johns hopkins hospital endowment fund, and he is the chairman of the board of johns hopkins medicine international (jhi)—the global development arm of johns hopkins medicine—with hospital management and clinical education services in the middle east, north America, south America, europe and Asia.

dr. Kersey received his b.A. degree from stanford university, his m.b.A. degree from the harvard business school and his m.d. degree from the emory university school of medicine.

CHRiSTOPHeR S. keRSeY, managing member, camden partners410.878.6815 [email protected]

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notes

1 the triago Quarterly, june 2011, at 2.2 pitchbook, 4Q 2011 presentation, slide 20 and charts 1 and 2.3 pitchbook, 4Q 2011 presentation, slide 17 and chart 3.4 pitchbook, 4Q 2011 presentation, slides 6 and 19. 5 pitchbook data, prepared exclusively for this publication, and chart 5 herein.6 gf data, february 2012 report; at 5, chart 14.7 gf data, february 2012 report; at 4, chart 11; at 5, chart 14.8 gf data, february 2012 report; at 2, chart 3.9 Andy greenberg, “valuation gap surging in middle market,” private equity professional digest, August 29, 2011.10 pitchbook data, prepared exclusively for this publication, and chart 3 herein. 11 pitchbook data, prepared exclusively for this publication, and chart 5 herein.12 pitchbook & grant thornton, private equity exits report 2012 Annual edition, at 9.13 for fortune 1000 companies as of november 15, 2011, press release: “ernst & young says fundamentals Will finally prevail over uncertainty to get deals rolling in 2012,” december 7, 2011.14 press release, “ernst & young says fundamentals Will finally prevail over uncertainty to get deals rolling in 2012,” december 7, 2011.15 pitchbook, 4Q 2011 presentation, slides 18 and 19.16 pitchbook & grant thornton, private equity exits report 2011 mid-year edition, at 14. 17 press release, “the carlyle group sells rail software provider rmi to ge transportation,” november 16, 2011.18 press releases, “sara lee to Acquire tea forte” and “sara lee to buy dutch café store leader coffeecompany,” january 3, 2012, and december 12, 2011.19 pitchbook data, prepared exclusively for this publication, and charts 3 and 7 herein.

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this publication is for general information and does not include full legal analysis of the matters presented. it should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. the description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. each legal matter should be considered to be unique and subject to varying results. the invitation to contact attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

“innovations@hand” is a service mark of duane morris llp. © duane morris llp 2012.

20 pitchbook data, prepared exclusively for this publication, and chart 7 herein. 21 pitchbook data, prepared exclusively for this publication, and chart 7 herein.22 id.23 id.24 lisa Ward, “ipo frenzy?” the deal, may 20, 2011.25 pitchbook & grant thornton, private equity exit report 2011 mid-year edition, at 16.26 richard trottier, middle market strategies: how private companies use the markets to create value, at 1 and 137 (john Wiley & sons, inc. 2009).27 pitchbook, 4Q 2011 presentation, slide 29.28 the triago Quarterly, november 2011, at 2.29 robert landis, yale school of management private equity conference, november 11, 2011.30 pitchbook, 4Q 2011 presentation, slide 12. 31 this is based on average rates since the beginning of 2010. gf data, february 2012 report; at 8, chart 28.32 this is based on average rates for the last six months of 2011. gf data, february 2012 report; at 7, chart 26.33 this is based on average percentages for 2009, 2010 and 2011. gf data, february 2012 report; at 6, chart 21.34 pitchbook, 4Q 2011 presentation, slide 14.35 max frumes, “the 100% solution,” the deal, september 19, 2011.36 ted l. Koenig, “blended beauty,” the deal, october 31, 2011.37 the triago Quarterly, june 2011, at 2.38 id.

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