gonzIn the quarter ended September 30, buyout activity rebounded with approximately $10.8 billion of announced deals, most of which were larger transactions such as QwestDex and Bell Canada Enterprises. But the size of these deals masks the fact that today, as much as ever, middle-market deals continue to represent a most attractive segment of private equity.
In this era of megafunds and consortia bidding on large-scale deals, it’s easy to forget that the origins of the buyout business can be traced back to the early 1970s and the so-called middle-market “bootstrapping” transactions of that period.
Few firms have records that span the past three decades, but those that do all have their origins doing deals in the middle market that is, investing in businesses with enterprise values between $50 million and $500 million. The deals were plentiful. Pricing was attractive. The businesses were generally less efficient, with less access to capital. And prudent, incentive-driven management compensation was not typically in place. Furthermore, a relatively modest improvement in the operating efficiencies of the company could increase earnings markedly.
Many of these attractive characteristics of the middle market endure today. First, there is a greater potential supply of smaller companies. According to Dun & Bradstreet, there are approximately 30,000 businesses in the U.S. with revenues between $50 million and $250 million. By contrast, there are only 7,200 businesses with revenues between $250 million and $1 billion, and only 3,100 with revenues exceeding $1 billion. There are simply more companies in the middle market to be sure a competitive sector, but one providing more possibilities in terms of sheer numbers.
Second, middle-market companies often provide the opportunity for significant operating performance enhancements. A business with revenues from $50 million to $500 million can focus on the fundamentals eliminating waste, improving processes, implementing technology, enhancing productivity and other functions and improve cash flow significantly within a relatively short period of time.
The Harvard Business Review recently reported on a study conducted by Bain & Company of more than 2,000 private equity transactions over the last 10 years. The study points out that success achieved in private equity is not attributed to any fundamental advantages private equity firms hold over public companies. Rather, successful results are related to the rigor of the managerial disciplines private equity sponsors establish within their businesses.
In the context of the middle market, private equity managers have a competitive advantage. With a smaller enterprise, many times it’s easier to actively build value in the business and “move the needle.”
While middle-market deals may not get the attention garnered by larger transactions, the middle market continues to generate many attractive investment opportunities. Data from Venture Economics shows that buyouts ranging up to $250 million in transaction size have outperformed larger buyouts over both the past 10- and 20-year periods. In fact, over both time frames, the largest buyouts, on average, failed to outperform the S&P 500, whereas, the average smaller buyout outperformed the S&P 500 over the 10-year period.
Why are companies in the middle market particularly those in the “lower half” of the middle market (e.g., companies with revenues of $250 million or less) attractive to private equity firms? First and foremost, such companies have a keen need for the expertise and experience that some private equity firms offer. They typically are run by entrepreneurs or families, and therefore may require assistance in enhancing strong managerial disciplines and governance practices. They also often do not have access to superior strategic and operational counsel or other first-rate professional advisors. And finally, leaders of mid-sized companies often are more receptive than their counterparts at larger organizations to new initiatives that can enhance productivity and efficiency and dramatically improve results.
Stravina, a California-based designer, importer and distributor of personalized novelty and souvenir items, promises to be a good case study in building value in lower middle-market buyouts. Stravina is a good company with revenues of roughly $40 million, and while its brand name is not readily recognized by consumers, its personalized pens, key chains and other products are purchased every day at thousands of retail stores. The company is also the market leader in an attractive niche, and represents the kind of opportunities available to private equity firms choosing to invest in the lower middle market.
The North American giftware industry is estimated to generate $20 billion in annual sales, with a projected steady growth rate of about 4.5% over the next several years. There are literally thousands of small giftware suppliers, most of which generate fewer than $5 million in annual sales, compete only on a regional basis, and focus on just a single type of specialty store.
Acquired in May 2002, Stravina is at a very early stage in its next growth phase. Importantly, Stravina has a very talented and receptive management team. Notwithstanding strong historical performance, Stravina now has opportunities from leveraging the rigorous managerial disciplines observed by Bain and employed by the best practitioners. Stravina had not previously accessed superior strategic and operational advisors, had not yet incorporated sophisticated governance and managerial approaches and had not yet built the bench strength of its management team.
Stravina is now laying the foundation and taking the first steps that it believes will make the already strong company even better. For example, the company is focusing on a refined strategy and is developing an organizational plan to ensure that it is staffed appropriately to achieve the agreed-upon performance goals and eventual exit. It is also assembling an independent board of directors comprised of proven executives who will leverage their experience to help Stravina’s CEO create and maximize shareholder value. All of these initiatives – if executed well by a strong, motivated management team – have great potential for a successful result.
Private equity investments take years to mature. But success depends first on identifying the most appropriate candidates for private equity ownership, like Stravina, with winning attributes. These characteristics include a solid competitive position, the nucleus of a strong management team and, perhaps most importantly, the opportunity for the sponsor firm to add distinctive value based on its industry knowledge and expertise.
It’s no secret that there is a substantial amount of uninvested capital in today’s private equity industry $125 billion by some estimates. It’s also a fact that there is an increasingly crowded field of sponsor firms focused on middle-market investments. How then should private equity investors decide with which middle-market firms they should invest their money? And how can sponsor firms build value in this environment?
There are no easy answers to these questions. My view is that the best risk-adjusted returns in the future will be achieved by disciplined private equity managers creating value in middle-market companies where the ability to drive business performance is perhaps greatest. This model has proven successful many times before and should again well into the future.
Peter F. Dolle, is a managing director at Blue Capital Management LLC, a private equity firm that helps middle-market management teams execute growth strategies by providing operating and strategic management expertise. Blue Capital’s investment in Stravina was completed in May 2002.