Industries

With speculation that volatile capital and lending markets could slow private equity transactions, there is significant buzz on dealmakers’ strategies to continue the high M&A activity levels. According to research conducted recently be Citigroup, middle-market deals are on the rise and could be a viable strategy for sustaining the robust private equity activity.

Middle-market deals outpacing large buy-outs
Tighter credit has slowed loan volumes. As a result, private equity groups (PEGs) are looking for an alternative to large buy-outs. That’s where middle-market deals come in. According to a recent article in Financial Times, the European Head of Citigroup’s private equity placements group, Stephan Murphy, explains, “In the current credit climate, we believe middle-market buy-out groups will attract much greater investor interest as they are still very active and also less dependent on leverage to boost equity returns.”

For the first time in more than three years, the total value of deals worth less than €500 million ($703 million) surpassed those valued at €1 billion ($1.4 billion) or more in August — and in September, there were 243 deals worth €500 million or less while there were only eight deals worth €1 billion or more (source: Citigroup).

Good deals in the middle market
Even in the current credit crisis, banks and lending sources still need to finance quality deals —many of which are taking place in the middle market. According to Michael J. Grossman, a director with RSM McGladrey’s transaction support services practice, the benefits to being active in the middle market include:

• More potential deals in the middle market. There are many privately held companies in the middle market and several are looking for an exit strategy.
• Better value for middle-market deals. Middle-market companies are often under-managed — with leadership focused on day-to-day details and not enough on the overall state of the business.
• Easier financing. Smaller deals rely more on traditional capital structures involving senior debt, traditional mezzanine debt and sponsor equity. These types of debt are less impacted by the tight lending market. 
• More flexibility. Because middle-market deals typically involve private companies, there is more flexibility when it comes to structuring the transactions.

Factors to consider when buying a middle-market company
PEGs that invest in middle-market companies are looking for the most effective strategy — one that affords them the opportunity to make high-quality purchases with large returns on funds. “While there is no universal approach to investing in the middle market, there are best practices that can be applied to help assure a successful strategy,” explains Grossman.

• Make sure to perform the “right” due diligence. Consider factors such as the company’s management, accounting systems and industry, as well as whether the company is audited or reviewed.
• Seek third-party due diligence. In the current credit market, banks are more interested in the results of due diligence and often require third-party due diligence.
• Pay attention to key deal issues. While private equity deals are primarily EBITDA driven, it’s increasingly important to pay attention to issues such as customer concentration, sustainability of margins, growth potential, quality of earnings, quality of assets and working capital analysis.
• Consider integration issues. To grow the company, it’s critical to successfully integrate crucial areas such as IT systems and culture.

In this evolving private equity market, PEGs continue to raise a lot of capital, but deal sizes are changing. “This means that even with the predicted slowdown of mega deals, private equity activity in the middle market will remain steady and active,” says Grossman.