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The UK mid-market: what's the appeal?

The shape of the UK's mid-market has changed beyond recognition over the last ten years or so. So what does it consist of now? And what do investors think of this segment of the private equity industry? Chris Davison reports.

Every wave of private equity enthusiasm is predicated on a story. The venture boom was all about the unprecedented potential of a connected economy. The huge cheques handed over the to secondaries specialists in recent years were attracted by the idea that there were legions of distressed sellers that could be easily exploited. The succession of mega-funds raised by pan-European buy-out firms was supposed to be taking advantage of the gathering momentum behind economic reform and widescale corporate restructuring across the Continent. Sometimes these stories have happy endings. Sometimes they don't.

One of the most popular stories being told by fundraisers over the past 18 months has been about the mid-market, both in the US and Europe. It goes like this: the mid-market is wonderfully inefficient; it isn't all auction-driven like the larger end of the buy-out market; there is a steady and dependable flow of attractive deals; there is a great opportunity to polish these hidden gems into ideal candidates for either trade sale or IPO; and it is much less risky than other sectors within the private equity asset class because it focuses on mature businesses but uses only sensible amounts of leverage.

The story has clearly been compelling because mid-market firms have enjoyed a much stronger relative fundraising performance than other sectors even if it hasn't always been easy. Some of its appeal clearly relates to the way that story sounds in the present financial and economic environment. But a large part of this attractiveness can be attributed to the fact that, unlike some of the other stories presented to investors, this one has been playing out for years. It is familiar. And institutions think they already know how it ends - with a pleasing cheque being passed back in their direction.

If only it were so simple. A new piece of research undertaken by AltAssets to explore the shape of the UK mid-market and the essence of its appeal found a more diverse body of opinion among limited partners and general partners than expected. In particular, it found a deep concern among the interested parties about what precisely constituted the mid-market and how difficult it had become to produce a neat definition. The mid-market, they argued collectively, has become something quite different from the mid-market as it is so often described in marketing materials, they said.

Sometimes this frustration or confusion was best treated as nostalgia and a yearning for the hypothetically less complicated mid-market of old. But sometimes there were more serious allocation issues to consider. Large investors said they had grown concerned in recent years that the act of allocating a proportion of their assets to the mid-market had been made almost meaningless by the dramatic expansion of what it now seemed to accommodate. GPs, meanwhile, complained that some of the characteristics of the mid-market have been inaccurately appropriated by firms keen to benefit from the association. In other words, a lot of people want to be mid-market firms these days.

The report, Understanding the UK Mid-market, argued that a range of factors had combined to create an irresistible force for change at a pace that far outstripped the rate at which it evolved in its earlier history. The massive increase in the size of funds that had been raised, a growing professionalisation among all the parties involved in the market, and broader financial market conditions were all interrelated factors. Also important were a shift from volume investing to a more selective approach among most participants and the withdrawal of some hugely influential and longstanding players, albeit possibly only temporarily. The result has been to segment the UK mid-market. It no longer makes sense to think of it as a single harmonious sector but as being composed of a lower and an upper segment. Both of them are closely related but they also have distinct characteristics and a significant number of participants that restrict themselves to one part or the other.

The research produced a matrix that described these two segments of the market using a series of criteria. Sometimes they looked similar but very often there were important differences. The most important quantitative distinction was in the value of equity invested in individual transactions. The lower end of the market is defined by equity investments of £5m to £15m, while the upper end was £15m to £100m. That meant transaction sizes of anywhere between £10m and £250m, which immediately illustrates the widely divergent character of the two ends of the market. One end features the usual roll call of large mid-market pan-European investors, while the other is populated by much smaller firms and often even sees competition from acquisition finance units of the big commercial banks.

The remaining criteria are largely qualitative, reflecting the challenge of neatly parcelling up the main components of the mid-market. Deal flow, for example, is much more likely to be properly proprietary at the lower end than it is at the upper, where intermediaries have become firmly entrenched. The other criteria look at teams, fund sizes, vendors, exit opportunities, and the nature of the participants to build a complex picture of the different segments of the market. This resulting distinction shows just how much the UK mid-market has matured from its traditional caricature, echoing the concerns and frustrations expressed by its participants.

But this more detailed analysis of the UK mid-market did not have the effect of making it any look any less appealing to investors. In fact, one of the striking outcomes of the research was the strength of institutional interest in a market that for a long period during the 1990s was considered conservative to the point of sleepiness. No more. In the context of a much less certain economic environment, the UK mid-market has suddenly assumed an almost sexy quality among investors. They like its maturity, once considered a dowdiness. They are attracted to the dependability of its deal flow. They think the teams are generally of a high quality. And they are unmoved by the sophistication of vendors.

So despite a mismatch between the conventional mid-market story and the reality of the UK, the report found something just as compelling. That endorses the fundraising experience of the last 12 months and should provide some encouragement for all those firms girding themselves for a foray into hostile waters. And it goes some way to disputing the commonplace prejudice that mature and relatively efficient markets are anathema to attractive private equity returns.

Understanding the UK Mid-Market was conducted in conjunction with the BVCA. For further details and purchasing options, please click here.

Chris Davison is head of research at AltAssets

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