Mid-Market Firms Go Mega In Huge Q1

The fat times continued for LBO funds in the first quarter—provided they had the right stuff.

U.S. buyout and mezzanine firms raised $68.0 billion in the first three months of the year, among the most active quarters ever. Last year, the fundraising total, as tracked by Buyouts, was $34.8 billion at the end of the first quarter.

Behind the numbers, a few trends emerged. First, while mega-buyout firms raised huge sums last year, it is the upper-middle-market firms that have stepped up to raise the largest funds so far in 2007. Hellman & Friedman, Leonard Green & Partners, Providence Equity Partners and Sun Capital Partners all raised funds much larger than their predecessors.

Second, limited partners, after showering mega-funds with money last year, have begun paying more attention to smaller, niche strategy funds this year. A number of niche players succeeded in the market, including Aquiline Capital Partners, MissionPoint Capital Partners, and Monomoy Capital Partners.

“Investors were clearly looking for something different in the first quarter,” said Mac Hofeditz, a partner at placement agency Probitas Partners. “There seems to be movement away from the big buyout funds, towards the more interesting funds with unique strategies. JAMMBOGs [Just-another-middle-market-buyout-group] are not appealing.”

And finally, though they have no shortage of capital for brand names and promising up-and-comers, LPs have become unforgiving of firms with personnel problems, few realizations or poor returns.

Multiplying Fund Sizes

The consensus entering this year was that 2006 was the year of the mega-fund, and that more capital this year would wash back into the middle market. Whether that actually happened depends on how the middle market is defined. Many say that the floor for the middle market has moved up to at least a $500 million fund, and probably closer to $700 million. The ceiling could be $5 billion or higher.

Make no mistake, there still are whales prowling the seas of liquidity. Goldman Sachs’s private equity arm, GS Capital Partners, has about half of a targeted $19 billion global buyout fund. Boston-based Bain Capital, which raised $10 billion a year ago, is expected to come back to market this year for another generalist mega-fund. Washington D.C.-based The Carlyle Group, meanwhile, is targeting a first close in June for its $15 billion fund, which LPs anticipate will reach $20 billion. The firm has raised a diverse slew of funds over the last few years. This one will be earmarked for U.S. buyouts.

But the biggest fund closes of the first quarter came from firms in the middle or upper middle markets, accelerating far beyond the sizes of their previous funds. These firms had stunning success. Leonard Green & Partners, Los Angeles, printed its PPM for its fifth fund in October and had its fund raised by January, though it put off closing till March to complete its paperwork. The fund, earmarked for consumer products, media and retail acquisitions, closed on $5.3 billion, ahead of a $4 billion target. Leonard Green’s last fund closed on $1.85 billion in 2003.

A source familiar with the fundraising said it was the “easiest” the firm has ever undertaken. It also was the first time the firm had been actually courted by LPs, well in advance of its fundraising. “The LPs were marketing to us. That was a new phenomenon,” said the person.

Sun Capital Partners, a buyout shop with roots in the turnaround industry, plans to close early this month on $6 billion in commitments. Its target was $4 billion and its fundraising lasted only a month. Its last fund, raised in 2005, closed on $1.5 billion. The Boca Raton, Fla.-based firm also upped its carry to 25 percent for the fund, after providing a 10 percent preferred return.

Media and communications buyout specialist Providence Equity Partners began raising its new $10 billion fund late last summer, and closed on $12 billion in the first quarter. Its previous fundraising reaped $4.25 billion in 2004. Apparently because of the big jump in fund size, Providence agreed to lower its carry to 20 percent, down from 25 percent.

Hellman & Friedman, meanwhile, is soon expected to close its sixth fund at $8.4 billion, more than double the size of its $3.5 billion predecessor. The San Francisco-based firm invests in media, telecommunications, financial services, technology and marketing.

LPs also had their eyes out for first-time funds in the first quarter, especially those with niche strategies and experienced teams.

New York-based Aquiline Capital Partners closed Aquiline Financial Services Fund with $1.1 billion. The firm is headed by former Marsh & McLennan Cos. head Jeffrey Greenberg. Meantime, Denver-based Excellere Partners’ debut fund closed on $230 million. The firm is headed by former KRG Capital Partners team members David Kessenich and Robert Martin. New York-based Monomoy Capital Partners, a spinout group from KPS Capital Partners, closed its first turnaround fund of $280 million.

Elsewhere, GB Merchant Partners garnered $320 million in commitments for its 1903 Equity Fund. GB Merchant Partners is the private equity affiliate of Gordon Brothers Group, the Boston-based advisory shop. Having named its fund for the year Gordon Brothers was founded, the firm will use the capital to make acquisitions in consumer and retail companies. MissionPoint Capital Partners, a Norwalk, Conn.-based firm, raised $335.5 million for clean energy deals. And Quintana Capital Group, headquartered in Houston, raised $650 million for a debut fund focused on energy.

Struggling Funds

Despite all the success stories, many mid-market buyout firms struggled on their road shows—sometimes because it’s simply tough getting respect as a mid-market firm in our mega-fund era, other times because of very real obstacles. Unfortunately, the mid-market is often cynically viewed as either a stepping stone towards larger funds, or a place for underperforming managers to rot.

“It’s in a GP’s DNA to want to raise a larger fund,” said George Gaines, a partner at placement agency BerchWood Partners. “Firms that stay in the middle market for an extended period of time are either truly disciplined or have been forced to stay there because their performance doesn’t warrant getting bigger.”

Defections appear to have kept a few firms from raising funds. After losing Co-Managing Principal John Janitz, Questor Management Co., a Southfield, Mich.-based turnaround firm, said it wouldn’t raise another partnership. Co-founder Jay Alix brought in long time friend Larry Ramaekers to oversee the selling off of its remaining portfolio companies. Technology investor Garnett & Helfrich Capital, a San Mateo, Calif.-based technology specialist, has put on hold raising a $750 million second fund. That came after the departures of Vice President Betty Hung, Director Mark Barrenechea and Director Mike Guthrie.

Also in the first quarter, Managing Partner Andrew Heyer and Managing Director Bill Phoenix left New York-based buyout shop Trimaran Capital to form a new firm, Mistral Equity Partners, raising questions about the $700 million fund Trimaran would like to raise. The firm initially tried to raise a $1.25 billion third fund in 2004, but limited partners pushed back because the firm hadn’t spent enough of its vintage 2001 fund and hadn’t seen enough realizations.

Elsewhere, Heritage Partners has delayed raising its next fund, apparently for performance reasons. Peter Hermann, co-founder of Heritage, told Buyouts that his firm would be returning to market with its next fund early next year. “Parts of Fund III have performed well, parts haven’t,” he said. According to the Washington State Investment Board, the 1999 fund had produced an investment multiple of 0.48 and an IRR of -31.4 through the third quarter of 2006. For now, Heritage is raising money on a deal-by-deal basis.

In the last analysis, the middle market appears more competitive than ever, awash with funds, overcrowded auction processes and record EBITDA multiples made possible by cheap debt. And for their part, LPs are busy, often too busy, to find good stories.

Steve Costabile, head of the private equity funds group at AIG, said cynicism among middle market fundraisers can be pervasive, but it is also warranted.

“There’s no patience in the market right now,” Costabile said. “Limited partners are not digging through to find hidden gems. It seems to me the most capital is going to the path of least resistance.” In other words, to mega-funds.