The micro-cap market enjoys perhaps the biggest pool of possible targets; a pool, coincidentally, that only gets larger as valuations sink. Sponsors who focus on this segment note that in many cases investors are dealing with the same problems facing buyers in any other market – namely a divide between buyer and seller expectations.
“Owners still haven’t come to grips with where values are,” says David Malizia, managing partner of Florida-based small-market specialist Westshore Capital Partners.
There are, however, a quite a few things that favor investors targeting micro-cap companies. One pro, for instance, points to the debate on Capitol Hill over registration and transparency for private equity groups, noting that the micro-cap funds should be able to slip discreetly beneath Washington’s regulatory radar.
“Regulators only have so much time and resources,” notes Ron Dersch, president of DAI Advisors.
That, however, would qualify as a fringe benefit. As it relates to sourcing and executing investments, other factors provide comfort to sponsors active in this segment, which could loosely be defined as companies with revenue as high as $100 million and Ebitda of no more than $10 million.
Perhaps the biggest driver of interest in the space is its relative inefficiency. Malizia estimates that the micro-cap space counts roughly 250,000 companies domestically that would qualify as a micro-cap business. “The pure quantity ensures that there is going to be dealflow,” he says. Malizia concedes he’s probably seen volume fall of by about 20% in the second quarter, but insists that he continues to see ample opportunities.
While deal flow on its own doesn’t solve the disparity between buyer and seller expectations, the makeup of the ownership and the drivers motivating sales can help mitigate the gap. Malizia notes that right now, “it’s financial and external forces that are driving sales – it could be a divorce, it could be someone’s health or it could be that a business is non-core and the seller simply wants out.”
Given the breadth of the market, this has translated into activity for some firms. Take the case of Ancor Capital Partners. The small-market firm has notched four deals over the past 12 months, including acquisitions of Tom Cat Bakery, home furnishings manufacturer Spencer N. Enterprises, FCA Packaging and Optional Care, an add-on deal for its skilled nursing platform Care Quest Home Health.
Another recent move in the small-cap space was Vista Equity Partners’ $30 million buy of Advent Software division Microedge, a provider of investment management technology. To go back to Malizia’s theme of external drivers, Advent, in a statement, said the sale will allow it to redeploy capital elsewhere. While purchase price was a consideration, if it was the sole motivator Advent would have simply waited for a better market.
Of course, the micro-cap space, like every other segment, is struggling alongside the debt markets. “Micro-cap investing has been a tough way to make a living,” says Jeffrey Manning, managing director and head of the special situations practice with Trenwith Securities.
For one thing, performance can be more volatile, especially if customer concentration is focused on a few important clients. Also, small hits to the bottom line don’t seem so inconsequential when companies are taking in under $5 million of Ebitda.
Moreover, the capital markets have largely exited the small-cap space amid the upheaval, adding that much more friction into an already inefficient marketplace. “The lower end of the middle market has been essentially abandoned by both banks and finance companies during this credit crunch,” says Durant Schwimmer, senior managing director and head of capital markets with Churchill Financial in New York.
Malizia confirms that valuations, suffering from less debt, lower earnings and smaller multiples, might be off from 30% to 40% versus last year.
But more than any other investors on the deal-size spectrum, micro-cap buyers perhaps benefit the most from the “need to sell” sellers. The sunsetting capital gains tax that looms on the horizon provides yet more motivation that could drive sales.
The opportunity is not lost on these investors. Schwimmer observes that practically “anyone with capital can pretty much get whatever returns they want because there are so few alternatives.”
Additional reporting by Ken MacFadyen.