Ever since the recession cast a big freeze on big deals, investors have gravitated toward smaller transactions. First, they trolled the middle market, then they moved downstream to the lower middle market. As one indicator of how appealing the lower middle market is these days, consider that the Riverside Co., a consummate middle-market firm and winner of Mergers & Acquisitions' Mid-Market M&A Award for Private Equity Firm of the Year for 2012, just closed its biggest fund ever, dedicated to backing companies valued at $250 million and less.
The overall lull in M&A activity over the past five years has forced the more mainstream names "to fill the factory," says Matthew Carroll, a general partner at Boston-based private equity firm WestView Capital Partners. All the increased interest in the space begs some questions. What counts as lower middle market? How is it different from the middle market? What are some of the challenges? And what does it take to succeed?
From the perspective of transaction values, Mergers & Acquisitions defines the overall middle market as deals worth $1 billion or less, with the sweet spot falling between $250 million and $500 million. We define the lower middle market as topping out at $250 million, with the bottom at about $10 million. Transactions in this ballpark are expected to continue making up the bulk of M&A. According to a recent survey of 1,000 dealmakers conducted by KPMG and Mergers & Acquisitions, 2014 will be a year dominated by smaller deals, with a whopping 77 percent of respondents expecting most activity to fall under the $250 million mark.
One significant difference between the lower middle market and the overall middle market is the focus on tactical planning, which emphasizes improving current operations in selected areas of an organization in the short term, as opposed to strategic planning, which involves setting over-arching long-term goals, explains Joan McCabe, managing partner, Brynwood Partners.
A repackaging of Zest soap for Wal-Mart Stores Inc. (NYSE: WMT) serves as a good example of the strategy. High Ridge Brands Co., a Brynwood-backed company, bought the rights to the Zest brand in the U.S., Canada and the Caribbean from the Procter & Gamble Co. (NYSE: PG) in 2011. Sales in the U.S. had fallen for Zest, which was once a leader in the bar soap category and still a household name. But rather than research, revamp and re-launch the brand as a strategic buyer or high-end private equity firm might have done, Brynwood focused on pleasing just one kind of customer. The result was a repackaging of Zest for Wal-Mart in a convenient multi-pack of 4-ounce Zest soaps.
Another trademark of the lower middle market epitomized by Brynwood's purchase of Zest is flexibility, says McCabe. Procter & Gamble insisted on retaining the rights to the product in Mexico, where it is a market leader. Other buyers would have balked at splitting up the brand, but Brynwood was willing to take what it could get, predicting there was plenty of life ahead for Zest in the U.S.
MORE HAND-HOLDING, MORE CASH
When dealing with family-owned businesses, establishing trust between the suitor and potential target is crucial. "What we're asking owners to do is outside of their comfort zone," says Brendan Anderson, a founder of Evolution Capital Partners. The Cleveland private equity firm invests up to $10 million in entrepreneurial businesses, or companies that aren't yet independent of their founder.
"We point to the success we've had and encourage them to talk to other entrepreneurs that made the leap of faith," he adds. "The ones that do say 'thank God,' but there are others who hold onto that common feeling of control-one where you're always making decisions for the company."
Lower middle market business owners' decisions to sell usually depend on life stage issues, and transition options become more difficult to execute, explains Robert Goldsmith, CEO, BCMS Corporate LLC (North America), a New York investment bank that focuses on the lower middle market.
"The reality is generally the result of weaker balance sheets, more limited outside financing options, higher owner reliance, and management teams on the whole that have less depth and often experience," Goldsmith (pictured) says. And there is "generally less owner wealth outside the business to cushion decision timing."
No audits, coupled with an unsophisticated management team, have caused the quality of the information shared in the due diligence phase of these companies to be less sophisticated. Lower middle market investors zero in on these types of businesses, explains McCabe, where they can perform quicker due diligence.
"They will frequently be able to buy a business at a slightly lower multiple for the certainty of close and the willingness to take on some due diligence risk," she says. Since lenders will lend less to a lower middle market company-usually three to four times leverage whereas their upper middle market peer group could receive six or more times leverage-private equity firms competing in this arena are now relying less on debt and more on cash to close deals.
"We don't finance with debt. We'll buy a business with 100 percent equity and offer certainty to close," McCabe adds. That willingness to pay upfront helps in courting business owners who may not be so cozy with the idea selling to a PE firm.
"That's too much of a risk if you're a big fund, but we're able to do that because we have operating expertise," McCabe adds.
PLENTY OF PLAYERS
"There are more options to smaller companies," says David Felts, managing director of Atlanta investment bank Brookwood Associates.
As the lower middle market has proven its worth, it has also inspired the creation of many new and spinout firms, bringing more and more competitors to the landscape.
"This is just a classic maturation of an industry," says Conner Searcy, managing partner of M&A newcomer Trive Capital Holdings LLC, a Dallas-based lower middle market sponsor that closed its debut fund in July with $300 million of capital commitments.
In addition to Trive Capital, there have been several other new firms making their mark on the lower mid-market scene. They include investment bank Financo LLC and private equity firms Kainos Capital, Mosaic Capital Partners LLC and Yellow Wood Partners.
New York retail-adviser Financo announced fund-raising plans in 2013. The investment bank, which most recently advised Cherokee Inc. (Nasdaq: CHKE) on the $19 million purchase of Tony Hawk and Hawk apparel brands from Quicksilver Inc. in January, hopes to raise $75 million to $150 million for a private equity fund with the intention of buying consumer companies in the lower middle market. Financo will likely seek to invest $2 million to $10 million per deal.
HM Capital, a private equity firm, said in 2012 that it was winding down. Executives from that firm's food and consumer products group went on to create Kainos in 2013. The Dallas-based firm's goal, like other lower mid-market players, sees that it spends anywhere from $50 million to $150 million.
Charlotte, N.C.-based Mosaic Capital closed its first lower middle market deal in January after acquiring The Apothecary Shoppe for an undisclosed price.
Yellow Wood Partners is a relatively new firm that closed its first fund with $225 million in January 2012. The Boston-based firm went on to acquire Parfums de Coeur Ltd. to build a company in the personal care sector, in September 2012. Two months later it formed Bedrock Brands, a consumer brand management company. Yellow Wood aims to invest between $10 million to $80 million of equity.
"There's a constant flood of new blood in the space," 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.
With more private equity firms raising new funds aimed specifically at smaller deals, there are a slew of challenges, according to LP Barry Gonder, a managing partner at Grove Street Advisors LLC, which has invested in various lower middle market private equity funds, including those raised by Brynwood.
"There are a couple of factors," Gonder says. One is that many institutional investors feel they are over-allocated to private equity, which may hinder lower middle market firms from competing with their upper mid-market brethren for the attention of limited partners.
"For the last few years, institutional investors have been, over-weighted to private equity - they've had a higher percentage of their assets in PE than they wanted and that has started to ease. Since public markets have come back, public portfolios are higher and PE percentage is lower," says Gonder.
The second reason has to do with institutional investors wanting to consolidate their portfolios. Big investors want to lessen the number of names in their portfolio that they have to monitor and track.
"It's easier to do the accounting for 100 names than 300," Gonder adds. "Those two trends are making it more difficult for general partners to raise money, especially those with okay, but not great, track records."
"They're saying we want to invest more, but in fewer PE funds," says Jeri Harman of Avante Mezzanine Partners, a Los Angeles and Boston-based lender. "If they're looking to put $50 million in one fund, that's not positive for the lower middle market."
Stephen Berry, co-president of Mayfield Heights, Ohio-based Linsalata Capital Partners, agrees. "The bar has been raised in terms of what you need to do in order to compete," he says. Small funds will look to grossly outperform large funds, as well as offer a greater dispersion of returns.
Lower middle market PE firms with proven track records still prevail in fundraising. Huron Capital Partners LLC, for example, raised its biggest fund in 2013. Like the Detroit firm's previous funds, Huron Fund IV will make control investments in lower middle-market companies
High-end private equity firms may be able to raise generalist funds, in which investments are made in a range of industries and sectors. Lower middle market funds, however, are likely to take up the opposite strategy. They are expected to have an industry focus. Brynwood, for example, conducts deals only in the consumer space - typically with corporations that are selling non-core assets.
When Mondelez Global LLC, the company that was formed in 2012 when Kraft Foods split into two companies, decided to revitalize the SnackWell's cookies and snacks business, it reached out to Brynwood.
"Mondelez probably talked to several parties about exiting," McCabe says. "But they already knew we had a good idea about how it would be run."
Brynwood bought a majority stake in the segment through Back to Nature Foods Co. LLC., the very company it acquired through a joint venture partnership with Kraft in August 2012.
SnackWell's is known for reduced-fat snacks, such as Crème Sandwich Cookies, Devil's Food cakes, fudge pretzels, yogurt pretzels and popcorn products in portion-controlled sizes.
Brynwood plans to combine the SnackWell's business with the Back to Nature business, known for cookies, crackers, granola, juices and trail mix.
Mondelez will retain a significant minority stake in the SnackWell's brand, an arrangement that would give it a chance to profit from the turnaround Brynwood expects to facilitate. Similarly, Prometheus Group, a Raleigh, N.C., software provider, sold a minority stake to private equity firm TA Associates in July. Terms like this underscore another trend-one where dealmakers are becoming more-open minded to doing a minority recapitalization.
Minority stake deals have intrigued both buyers and sellers before, but more as a compromise that allowed investors to put money to work, while business owners can achieve liquidity.
But with deal volume at a significant low, the tactic has become more common. Simply put: "A smaller piece is better than none," says John Farr, managing director of Scottsdale, Ariz.-based investment bank Columbia West Capital.
With that came an emergence of minority recaps, a combination of equity and debt, or sometimes no debt at all, coming together in a transaction to provide liquidity to shareholders, much like a leveraged buyout. But in the case of a minority recap, the new equity investor owns less than 50 percent, different from a typical minority stake deal that may be more like growth capital or a late stage venture investment.
The trend comes from the need for PE firms to find opportunities for all the money they have raised, says Graeme Frazier, founder of Private Capital Research LLC and partner at GF Data Resources LLC. "In 2009, things were so bad, the lending markets were crushed and there was nothing available. Now, we're at a new high in terms of dry powder."
With minority recap deals, the PE firm may also retain some sort of control and have a say in certain decisions reserved for just majority shareholders, which sets it apart from a typical minority stake purchase.
"You need to document into your agreements that if a company is going to sell, it has to seek your approval," Frazier explains.
In an environment where good deals are hard to come by, the strategy is becoming more appealing to buyers because they can get significant personal liquidity without over-leveraging a target, WestView's Carroll (pictured) adds.
"Typically, the minority recaps are for more growth-oriented deals," he says. "You get your return, not by paying back debt, but with growth and earnings."
In addition, minority recaps appeal to the growing number of dealmakers that are reluctant to accept a bargain with an uncertain payoff rather than a deal with a more certain return on investment.
"There's less intrinsic risk than what I might have if I'm a control investor," says Brookwood's Felts, regarding the benefits of a minority recap deal.
Also, a minority recap helps offset any attachment issues a small business owner may have when faced with the decision to sell or not sell-a common factor in many lower middle market transactions.
Since many mid-market firms work closely with entrepreneurs, minority recaps give the seller a chance to capitalize on a deal, but without giving up control of the company.
"They get to participate in a huge way," Carroll notes. "The second bite of an apple-a future sale."