Small Deal Sweet Spot

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.

"The private equity community thinks we're crazy," Kadlic quips. But a growing number of LPs are beginning to change their outlook, and financial sponsors may be on the cusp of major change.

Because the lower middle market is so broad, Kadlic says, various firms operate at different ends. Evolution, for example, grows micro-sized companies to more than $5 million in Ebitda and shops them to other lower middle-market firms.

Audax Group is especially active in buying small companies. The Boston firm typically writes checks of at least $10 million for equity in companies valued between $50 million and $250 million. Audax has also found success in raising funds geared specifically to deals this size.

In December, Audax Private Equity Fund IV was 25 percent oversubscribed, raising a total of $1.25 billion.

"We look at any situation where we can start with a platform, or buy-and-build opportunity," says Audax managing director Jay Jester, citing business services, health care, building products, medical devices and technology as some of the sectors on which Audax focuses.

Facilitating deals this far down the M&A chain, however, is often laced with various challenges, such as a lack of financial data to support industry trends. "What we do is entirely different from what's going on in the rest of the middle market," Kadlic says.

Advisers and private equity firms often end up working with family-owned businesses-a process that requires a different set of skills and negotiating tactics than they would need while facilitating larger deals.

"You're on the ground more in places like Louisiana and Arkansas, shaking hands," Palmer says.

Here, companies generally don't have the resources, capital, infrastructure or professional management depth that you need to scale a business. The goal of the target is often to become independent of the founder, Kadlic says.

Lower middle-market firms are also known to roll up their sleeves more with the companies they acquire.

Brynwood Partners, for example, tends to get deeply involved in the operational aspects of the businesses it buys, according to managing partner Ian MacTaggart. "We do fewer deals, but get actively involved in the operations of those funds."

That strategy has helped gain the confidence of new LPs during each fundraising round.

Brynwood is currently investing out of its sixth fund and getting ready to go out to market to fund raise again. The Greenwich, Conn. firm expects to raise more than $300 million for its seventh fund during the upcoming cycle.

"From what I hear, funds that are performing well in the lower middle market are getting well received by the LP community," MacTaggart adds. Brynwood, which has been investing primarily in the food and beverage space since 1984, taps primarily domestic LPs, with a few, select international investors.

Several other major players with a small-company focus are making strides with their fundraising efforts. They include Glencoe Capital and Prospect Partners, both of which are based in Chicago, as well as Sentinel Capital Partners in New York, Trivest Partners in Coral Gables, Fla. and Plexus Capital LLC in Charlotte, N.C.

Glencoe Capital is still investing in small companies out of its third fund, Glencoe Capital Partners III, which raised $380 million in 2004.

In 2010, Prospect closed its third fund, Prospect Partners III, above its original goal of $185 million-picking up roughly $200 million in commitments, 18 percent more than what it pulled in for its second fund.

Sentinel, which is currently raising its fifth fund, previously raised $765 million for its fourth fund in 2008, nearly 28 percent more than its $600 million target.

Trivest surpassed expectations with its most recent fund. The firm announced the final closing of a fifth fund, Trivest Fund V, in October, and generated capital commitments of $415 million due to an uptick in demand from LPs. Trivest Fund V surpassed the original target of $325 million and accepted commitments of up to $400 million. Trivest partners put in $15 million of capital while the rest of the fund tapped a variety of LPs, including endowments, corporate and public pensions, insurance companies, funds of funds, family offices and individuals.

On May 3, small business investment company (SBIC) Plexus Capital announced that it raised $150 million in capital from LPs. The firm plans to combine that amount with leverage from the Small Business Association (SBA), to create a $300 million fund that will invest in U.S. lower middle market businesses.

Plexus currently has $550 million under management, and invests in middle market companies throughout the U.S. The firm launched its first and second funds in 2005 and 2009, respectively, and has closed a total of 45 investments between the two.

New players are also showing up on the scene. In January, John Mueller left his post as chief executive of Cleveland private equity firm CapitalWorks LLC, also a lower middle-market firm, and opened up Partners Private Equity LLC across town. Mueller's new shop set a goal to raise $50 million for the debut fund, which it will use to invest in lower middle-market manufacturing companies. Mueller started the firm with Michael David, a former managing partner of hedge fund Endurance Capital Advisors, and Andrew Kuhar, most recently president of his own firm, Kuhar Consulting.

Armed with a different investment philosophy, lower middle-market players continue to build credibility among investors. Once that happens and more LPs make commitments, Kadlic says, "the upside is pretty darn exciting."