Interchange July09: Middle market deals - Ernst & Young - United States

Middle market deals

While private equity (PE) activity has generally stalled in the past 12 months, PE firms have continued to forge deals with so called “middle market” companies, those businesses with historic earnings between $10 million and $300 million. The pace of activity, while slow, is occurring despite scarce credit and economic uncertainty. Increasingly, PE firms are cultivating new forms of financing, structuring and deal sourcing to get transactions done.

In stark contrast to the highly leveraged deals that characterized PE activity in the past, many middle market transactions these days are being completed with 100% equity. Cash is king. And so sellers want to avoid any financing risk that can slow the progress of a deal. They want the certainty of dealing with a PE firm they already know — one that is able to quickly deliver the cash needed to complete the transaction. Certainly, there is cash available for investing, with PE funds in command of an unprecedented $400 billion fundraising overhang, according to the Alliance of Merger & Acquisition Advisors and PitchBook Data, Inc.

Alternatively, some PE buyers are choosing to take a less-than-100% interest in an investee business. This allows the buyer to avoid taking on debt, while the original owner can monetize a portion of the business yet retain some upside potential.

Mutual interest. PE firms no longer view a controlling interest as a must in every transaction. That new attitude is sparking more joint venture deals or other forms of alliances with corporations, which are eager to jettison noncore and underperforming business units but are faced with low valuations and cautious buyers.

For example, a company may sell part of an operating business into a joint venture with PE. PE funds may provide fresh capital to the business while creating synergies with other companies in the PE portfolio. Both parties may benefit from the combined management talent.

In some operating alliances of this nature, PE may take a minority stake while the corporate partner still holds the majority ownership. In some instances, joint ventures get an unwanted business off the corporate balance sheet, and allow the majority owner to get a step closer to executing an outright sale at a later date.

Relationships. Today’s market conditions are changing the traditional deal sourcing paradigm for the larger PE funds. During the last deal boom, the giant PE firms, those valued at $5 billion or more, relied on investment bankers to present them with prospective targets. Similarly, corporations looking to sell would work with their bankers to orchestrate an auction process.

Given today’s realities, PE investors in middle market companies have a greater appreciation and need for direct relationships with corporations and business owners. It’s also important for PE to strengthen ties with law firms and restructuring firms that handle workouts and bankruptcies. It seems that all PE investors are becoming distressed investors, adding competition to those historically focused on this sector.

For PE, an upside of the current downturn is the availability of seasoned executives, including talented CEOs. PE firms bring them on as operating partners to fix problems in the portfolio or to await the right portfolio buy. In addition, it can be a distinct advantage for a PE firm to bring on board an executive who is well recognized in his or her industry and can help build relationships between the PE firm and other CEOs.

Neil I. Harris
Ernst & Young LLP (US) n New York
Transaction Advisory Services