MidOcean Partners has been a firm on the move in recent months. The mid-market, New York- and London-based buyout shop, which at one time was the in-house PE arm of Deutsche Bank, raised a $1.33 billion fund in the second half of last year. In January, just two days after the New Year, MidOcean brought in former RR Donnelly CEO Mark Angelson as a chairman, a new position at the firm. It has yet to ink a deal since summer's end, but the firm managed to stand tall during the credit crunch, as it closed the acquisition of Bushnell Outdoor Products, representing the only transaction that was fully syndicated in the month of August.

M&A had the chance to sit down with MidOcean CEO Ted Virtue recently. During the interview, Virtue discussed many things, touching on the fundraising market, the split from Deutsche Bank, the secret to finding proprietary deal flow, and the benefits of investing across national borders. He also conceded that the market has indeed become more difficult, from a financing perspective and a reputational view as well. But at the same time, Virtue is embracing the challenge, as he believes an inefficient market historically yields the highest returns for the asset class.

Mergers & Acquisitions: The deal market has been in a state of upheaval, but things seem to be rolling along at Mid-Ocean. You've been doing deals, you've raised a fund, it seems like its all systems go.

Virtue: Outside of the market changing, it's still the same for us. Our strategy is based on finding a unique theme within the four sectors we concentrate on, and we want to make investments through a clean process, at a good price. It's really just old school private equity. But we operate across the U.S. and Europe, which is different than most others in this market.

We've actually seen the opportunities increase pretty dramatically the past couple of months. The market dislocation created more confusion, but as a result, we're seeing better prices.

Mergers & Acquisitions: But the market dislocation must alter some of the things you do. How have you reacted as an investor?

Virtue: Well, we bought a number of consumer businesses in the last year, but we believe we bought companies with protection against the cycle. We believe that the economy is softening, and we are anticipating tougher and more volatile times ahead, so we've been buying companies that can perform in challenging markets — companies where we can control the upside and growth. We're looking for businesses in which we can help transform the product line and pursue consolidation, because those are the opportunities where value can be created in a tougher marketplace.

Mergers & Acquisitions: What might be an example of this?

Virtue: Bushnell [Outdoor Products]. It's a company we bought in August that's really the dominant player within its highly fragmented space. We think the company will continue to grow both through product innovation and acquisitions. It's really the type of company that can control its own destiny in either a good or bad marketplace.

Mergers & Acquisitions: That deal was also a bit remarkable in that you were able to get it financed at a time when no other deals were getting done.

Virtue: It was the only deal that was fully syndicated in the month of August. There was a lot of uncertainty in the marketplace when we went out, but it was ultimately a very successful syndication during what was probably the heat of the credit crunch. GE and Bank of Ireland both stepped up to do the deal. And the fact that we didn't have to re-trade the capital structure spoke well both to the strength of the company we bought and to the structure that we originally put in place.

Mergers & Acquisitions: What about relationships? It seems like the dislocation has really underscored how important they are in an environment like this. Before last summer, anyone could find financing.

Virtue: We used a wide array of our relationships to syndicate and pre-syndicate out the deal. Bushnell, though, is a very strong company that had gone out to the credit markets two or three times in the last decade, so it has a pretty good following in the marketplace. We also stayed away from the big money-center banks, which were addressing the bridge loan issues at that time.

Mergers & Acquisitions: Switching gears a bit, Mid-Ocean spun out from Deutsche Bank back in 2003. If you look at some former captive firms that are out there, quite a few tend to experience trouble generating deal flow following a spinout. But MidOcean has managed to maintain a robust pace. Why do you think that is?

Virtue: We've really stuck to our knitting. Not much has changed in terms of our investment philosophy. We've gone from having a single LP to multiple LPs, but our people, processes and strategy haven't changed.

It created a lot of noise when we first spun out. We were one of the first to do so. When the banking regulations changed in 2002 and capital charges were increased by a factor of three that year, all of the banks that had funded private equity and alternative assets on their balance sheet ran into issues in terms of capital adequacy. The resulting spinoffs created a lot of noise. But in retrospect, Deutsche Bank was able to diversify its capital base, so it worked well for them, and we were able to bring new investors in and establish ourselves as a standalone firm. And the investors that came in were able to achieve a very high rate of return for the risk they took on at the time.

Mergers & Acquisitions: It seems like a lot of the major investment banks can't decide whether or not they really want to invest in the asset class. Most spun off their PE arms only to reestablish new groups a couple years later. The latest was Citigroup, which recently bought Metalmark, a former Morgan Stanley investment arm.

Virtue: It's bank by bank, but a lot of firms have tried to emulate Goldman Sachs, which has really woven a broad based alternative investment strategy into their core business. It has been a real competitive advantage for them. So most banks have tried to make it compatible with their agency business, where they don't have the same kind of conflicts or even the same kind of risk, as most are employing third-party capital.

Mergers & Acquisitions: When you talk to captive firms, they'll often cite as the primary benefit the bank's relationships and the ensuing deal flow that comes from those ties. As an independent firm is that something that you miss?

Virtue: We were relatively independent while we were at Deutsche Bank. Of course we had a lot of close relationships when we were there and we still have those, since we're talking about personal relationships. But now I think we have much better access to the rest of Wall Street since we're viewed as an independent firm.

We look to source all of our deals away from auctions anyway. We never relied on Deutsche Bank or any other big bank to bring us opportunities. We're looking for unique properties, so we're proactively calling on the companies instead of waiting for an investment bank to bring us something to bid on. That's not something we do.

Mergers & Acquisitions: Proprietary deals seem to be the measure of success in this market. Exactly how do you go about finding transactions outside of an auction, especially when the middle market has become so efficient in recent years?

Virtue: It is inspiration and perspiration. We look at where the world is changing, so that usually means we're looking at small, fragmented, and out-of-favor sectors that the rest of the world tends to ignore. And within the middle market, we tend to play at the lower end, so we're looking at companies with enterprise values of between $100 million and $500 million. It's a segment where companies don't tend to intersect the public markets and general Wall Street coverage.

We're looking for areas that maybe haven't experienced any consolidation but are moving in that direction — where we can be a first mover in that space. We're trying to find businesses that may be considered a natural seller. When we bought into the cable TV sector, it was out of favor. When we bought into Jenny Craig, the company itself was struggling. We did a rollup of orphaned brands through Prestige. We want to be out in front of a particular space and we want to back a strong management team. So it comes down to making a lot of phone calls and doing a lot of networking.

Mergers & Acquisitions: Since you're looking at "out-of-favor" industries, how important is having an operational focus to what you do? For example, when you bought Jenny Craig, how did you manage to keep the business from suffering the same fate as Atkins, which struggled mightily following an LBO?

Virtue: It's very important. With Jenny Craig we came in with a very detailed plan as to how we would stabilize and then grow the business. In that case we had a partner, ACI Capital, and we brought in a CEO whom we had worked with in the past. We ultimately had to replace eight of the top ten managers in the business, but the key was to make sure that we kept a disciplined budget and established a plan to really transform both the business and the culture. It was all very hands on, with a number of people from both MidOcean and ACI involved in the day-to-day affairs.

Mergers & Acquisitions: Early on you talked about the sectors you focus on. I imagine that specialization helps too when you're looking at improving the businesses you acquire. What are those areas?

Virtue: Business services, industrial services, media and communications and consumer businesses. Those are big, broad categories, so within those, we're really focusing in on small niches where we can drive value. In the consumer space, for instance, we're spending a lot of time on health and wellness.

So we've bought companies like Jenny Craig, Vitaquest, a contract manufacturer of vitamins, and a health club chain in the U.K.

Mergers & Acquisitions: What are your thoughts on the consumer going forward? In the past, the consumer has proven resilient, but these days it seems like they're more susceptible, particularly with the housing crunch. Where are some areas that might provide more protection?

Virtue: It all depends how you define "consumer." Based on some definitions you could say it's half of the GDP. But we're looking for fragmented businesses with downside production that are ripe for growth.

But we don't typically play in faddish, cycle bets around retailing or single-product companies. We want a good stable platform to build off of, with great brands. Trying to guess what the right luxury item is or the right specialty retailer are bets that we won't make.

Mergers & Acquisitions: Would you say this is true with regards to your European activity as well?

Virtue: There's much more fragmentation in Europe. There has been less consolidation generally, so there's a broad dispersion of brands throughout all of those markets. And what plays well in detergents in Germany might be different than in France.

You also have different regulations. So, because of that, it might be more difficult to do a rollup of electrical contractors across the continent. But all of that is a huge opportunity for us. There are a lot of smaller companies there that need to go through the same efficiency and consolidation that a lot of industries in the U.S. have already experienced.

Mergers & Acquisitions: How does having a European presence help MidOcean?

Virtue: It really helps in a lot of ways. Just leveraging the knowledge and identifying best practices across the U.S. and Europe is a tremendous benefit. Whether it's financing a deal, operating a business or bringing in a high quality management team, having that presence in Europe is important.

The fact that we can use that scale with global vendors is another benefit. The banks, lawyers, accountants and consultants all see us as a value added customer because we can look across all of the markets that they serve.

And the two markets are a lot closer than they used to be. They're operating more on the same cycle. There's a lot more consistency in the markets in terms of financing and M&A practices. In Europe, you still have to look at the eight or nine local markets, which each still have their own nuances, but by and large there's a lot more conformity in terms of the M&A process and even financing across all of those markets than there was even five years ago.

Mergers & Acquisitions: As 2008 ramps up here, what are some of the things you're looking for in the market?

Virtue: I think there's going to be a revaluation of the market place. There's always a bit of paralysis when that happens. It tends to slow down a bit as sellers get reoriented to lower prices.

With the higher cost of debt, I think you'll also see more strategic activity, as there'll be less competition coming from financial buyers. Also, in a lot of cases, sellers will view the strategics as the more credible buyer.

One of the real downsides that has come about from this whole credit crunch is that it's put into question the certainty of a financial buyer around these deals. It's put break-up fees, reverse break-up fees and the definition around MAC clauses front and center in the negotiations. There's a lot more scrutiny now as a result of the number of LBO deals that have been broken up in recent months.

As financial buyers we had been viewed as the quicker, simpler buyer of assets. We were more nimble than the strategics. But that view has started to change as the market sorts all this out.

Mergers & Acquisitions: Let me ask, do you think the Cerberus' of the world (who are backing out of deals), are necessarily wrong in doing so?

Virtue: From an outside perspective, when you have a reverse break-up fee it's a contract. Everyone involved in the deal knows that it's basically an option for the buyer to walk away. Everyone knows that signing up. But it's still a relatively new phenomenon. It used to be that you'd only have a MAC clause as an out, and you'd risk damages if you tried to get out of a deal. But when your damages are defined ahead of time, that's really just part of the agreement.

But this is certainly not good for the reputation of the industry, no question. A lot of time, energy and emotion go into a deal, and for these things to fall apart at the 23rd hour is troubling.

Mergers & Acquisitions: It doesn't seem like it's as large of a problem in the middle market, but, that being said, when it comes to perception, the smaller deal landscape is often painted by the same brush as the large market.

Virtue: The pressure hasn't built up in the same way. The capacity concerns, as they relate to debt, was never an issue. There's still plenty of capacity available from the non-money center banks, so in this market we haven't seen the same kind of fallout.

Mergers & Acquisitions: In the mid-market there is such a diversity of lending sources that deals are still getting done. But is there any chance that we could see the same thing that happened back in 2002, when the universe of lenders essentially dried up due to consolidation? Merrill Lynch Capital, for instance, was recently sold to GE, and other local lenders that cater to the middle market have not necessarily been immune to the credit crunch.

Virtue: There are a whole bunch of alternatives today that weren't around back in 2002. So the market is still vibrant — whether it's a finance company like GE or CIT, the regional banks, or even the BDCs and hedge funds. Back in 2002 there was a general lack of liquidity that impacted the entire marketplace.

Mergers & Acquisitions: Since the landscape today is so much different in the large market, where financing is not nearly as robust, is there any chance those buyers will move downstream.

Virtue: I think it's unlikely. Mega funds will have to move down in size a little bit to transact in today's market, but it's incomprehensible that a firm like Blackstone, with its $20 billion-plus fund would consistently put as little as $100 million of equity into a deal. They'd have to do a couple hundred of these kinds of transactions if they wanted to expend their fund.

There'll be some compression, though, sure. I think you'll see this occur in deals ranging from $1 billion to $5 billion in size. You'll see funds with as much as $20 billion going after these properties competing with other funds that have around $2 billion at their disposal.

Everyone has been a little surprised at how slowly the big banks have responded to the financial crisis. And we keep seeing new writedowns every day, so I don't think we're done just yet. But in a bull market of any kind you're going to find excesses. And a lot of banks got caught up in diversification excesses, personnel excesses, and risk excesses. All of those issues will be cleaned up, and the good news is that unlike 1988 or even 2001, there is not a broad-based fear of a failure in the system.

Mergers & Acquisitions: Tell me about the fundraising market? You were able to close a fund at a time when it looked like the world was ending for the asset class. Does that speak to the strength of the buyout industry as a whole?

Virtue: I think that the fundraising market remains open for quality managers. Investors continue to search for alpha and I believe that private equity can consistently deliver higher returns than the public markets and these chaotic markets are where private equity has historically had its highest returns.

At MidOcean, we have a good core group of blue chip investors that have continued to support us since our spinout from Deutsche Bank. We selectively increased our LP base in our most recent fund, which broadened our information network and increased our flexibility.

Mergers & Acquisitions: If you had to predict what's going to happen in the next ten months of this year for the buyout industry, mid-market specifically, what do you see happening?

Virtue: Values will come down and volumes will slow as sellers readjust to lower valuations. Capital will no longer be a commodity as it has been for the last three to four years. It will be a difficult economic and capital markets environment, which will make for a challenging operating environment for many companies. But those are usually the markets where focused and nimble investors can make their highest rates of return.