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Small Deal Sweet Spot

Evolution Capital Partners' Jeffrey Kadlic likes the lower middle market

Ever since the recession took the wind out of M&A's sails, dealmakers have been looking downstream to the lower middle market for opportunities. In this pool, where deals top out at $250 million, the pace of acquisitions has been accelerating over the last few years. The upshot is that small deals are here to stay - whether or not mega mergers return with the recovery - and private equity firms are taking advantage of the trend by raising new funds aimed specifically at smaller deals. For proof that the lower middle market is thriving, consider data from the first quarter of 2013. Thomson Reuters marked 432 transactions with values of $1 billion and under. A full 367 of those middle-market deals, or nearly 85 percent, were valued at $250 million or less. (For more, check out the May issue of Mergers & Acquisitions.)

Now more scrupulous than ever in the post-recession era, limited partners (LPs) have begun to appreciate the appeal of the lower middle market. Debt levels and initial rates of return in this sweet spot tend to be more consistent-a sharp contrast to many of the deals that are facilitated by bulge-bracket private equity firms.

"Over the last five years, there's been a view that private equity funds are not generating the kinds of returns everyone expected," says Jeffrey Kadlic, co-founder of Evolution Capital Partners. The Cleveland firm's success over the past year is emblematic of the opportunities down at this end of the dealmaking realm, Kadlic adds.

Part of Kadlic's job is to convince the buyout community that "there's a whole new world for them to put capital to work."

Evolution invests as little as $2 million to $10 million in entrepreneurial businesses, or companies that aren't yet independent of their founder. The firm's most recent deal, announced in April, was the acquisition of Axiom Sales Force Development, the third investment from Evolution's second fund. Axiom, based in Dallas, offers sales training and software resources through live events, customized coaching and an online learning center.

While it takes the same amount of time to exit these smaller investments as it does for larger ones, the hit rate of finding potential buyers is much higher, Kadlic adds.

Such was the case for one of Evolution's portfolio companies, Accurate Group Holdings LLC. The Charlotte, N.C.-based company, acquired by Evolution in 2009, provides real estate transaction services to mortgage lending and loan-servicing clients. During that three-year hold period, Accurate's revenue growth was nearly sevenfold, with annual year-over-year growth of 70 percent. Operating earnings increased roughly 50 times, and the company experienced compounded annual growth of about 165 percent. Under Evolution's ownership, Accurate went on to hire more than 100 new employees.

When it came time for the firm to sell Accurate, pitch books were sent to 175 financial and strategic acquirers. Of that number, 35 groups indicated interest.

Baltimore-based ABS Capital Partners eventually won the auction with a $55 million equity investment in December.

"I think it speaks to the dearth of opportunity in the middle market," Kadlic says, regarding the competitive sale process. "Today, not that many companies have impressive growth dynamics, so when you add one to the pool, it gains a lot of attention."

"LPs have shown a fairly explosive amount of interest" in the lower middle market, says Brett Palmer, president of the Small Business Investor Alliance, a networking and advocacy group that counts 87 percent of its membership as lower middle-market funds. The sheer volume of transactions, steady results and higher rates of return make the space a more favorable arena to source deals, he explained at a recent event hosted by the Alliance of Mergers & Acquisitions Advisors, a coalition of sellers and buyers specializing in deals of up to $500 million in transaction value.

While deal flow is down across the general M&A market, there is plenty of opportunity for financial sponsors to put capital to work in smaller companies that have been overlooked and underserved generally.

Indeed, much of the private equity community would rather invest heavily in well-known markets such as media and technology in Silicon Valley, whereas a successful janitorial business in Arizona would normally get dismissed by investors because "it's not sexy enough," Palmer says.