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The mid-market - differentiate or die

Competition for deals in the European mid-market is becoming increasingly fierce and only those firms able to stay ahead of the crowds will succeed in generating attractive returns. There can be little doubt that the days of the vanilla buy-out are dead and that differentiation is now key, according to Philip Conboy, director of Sovereign Capital.

Deal sizes were small and nearly always completed on a syndicate basis. It was not uncommon for there to be half a dozen equity providers in transactions requiring only modest amounts of capital. The sophisticated network of corporate finance teams and other advisers that pervade the market today were absent. Capital and the availability of deals were the key constraints. Put simply, the market was immature. It was in start-up phase and, as such, largely imperfect.

Following the success of the early European private equity pioneers and with the help of industry associations, greater information and understanding has spread to all parties in the marketplace and the asset class has gained solid roots in Europe. Funds and deal sizes have grown, with most early private equity firms moving up the scale and forsaking the mid-market. And, as with any growing industry, the market has fragmented.

Initial differentiation in the European private equity market was based largely on market focus, specifically with regards the size of deal and geography. But today, these firms are operating in a very different environment, where capital and deal flow are no longer the constraining factors, where advisers are active participants in many investment opportunities, and a host of pundits and researchers follow the market. The mid-market is undoubtedly more perfect than in the early years and the opportunity to make good returns within a controlled risk environment is consequently very much more difficult.

In considering what is key to success in today’s mid-market, where stimulating real growth is more important than financial engineering, a number of essential attributes become immediately apparent. The ability to source deals that match the skills and experience of the team, to understand the elements of risk in each deal, to transact on the right terms, to manage portfolio companies and follow through on the initial and evolving strategy and, finally, to exit investments successfully. Easy as these may be to articulate - and many have done so – applying them is far less so. Carving out a niche in this market and determining strategy and therefore market position, (not the other way round!), is crucial in applying any of these skills.

Why does one private equity house find or win a deal over another? Why are some deals in the same sector, with similar structures and strategies, more successful than others? How do institutional investors know if new funds will match earlier track records or new teams will perform as well outside the institutionalised private equity firms that they have sometimes left?

Defining the mid-market is difficult in itself, both because it is diverse and because definitions vary. The British Venture Capital Association and The Centre for Management Buy-out Research define the mid-market as incorporating those companies with an enterprise value of up to £100m. I believe that it is useful to break the market down still further into lower, middle and upper middle-market segments.

The lower mid-market, in which we invest, encompasses companies with an enterprise value of £10m to £50m. But at the other end of the scale, a recent article in the Financial Times described one firm investing in two companies valued at £274m and £350m, as also being a mid-market private equity house. It is important that this type of differentiation is not ignored, as many institutional investors are now segmenting the mid-market for their own allocation purposes.

Geographical differentiation is also still clearly paramount and can have significant implications for the sourcing of deals. Most firms investing in the European mid-market are either nationally or regionally specific. Even in the UK, there are mid-market firms that are well established in particular regions, be it Scotland, the North of England, East Anglia, or the Midlands. Generally these firms will not be marketing to or sourcing their deals through the City but through networks of contacts in local communities. Others, like us, invest across the country from a single office, usually in a capital city, sourcing deals and marketing through intermediaries in the financial community, or through direct marketing programmes, and by building contacts in specific sectors in which we have built leadership positions.

Another factor in sourcing good deals is sector specialisation. This is a well-trodden and well-sung path for the large buy-out firms that have built up expertise across international teams and invest in their sectors in Europe, the US and Asia. But the mid-market still has a large number of generalist players.

For country-specific funds, a reputation for expertise in specific sectors is often easier to establish because the market is smaller and more concentrated. Every national trade magazine and every sector intermediary, for example, will know the private equity player who owns stakes in three or four businesses and has attracted at least one well-known manager in the sector to a portfolio company.

Those sectors that offer the potential for medium to long-term growth are the most attractive to mid-market firms. Our own focus has been on sectors where changing demographics, market fragmentation or a demand-supply imbalance offer the opportunity in individual investments to cut costs, boost volumes and raise prices and then bolt on similar sized companies to form a group. These include education, health care services, certain areas of financial services, facilities management and death-related services. Mid-market companies in these industries are often family owned and facing succession issues or growth constraints under existing management and want external help to continue to grow. They require particular care in approach and trust is key in negotiations, as emotional attachments to the business can be strong and community identity an important part of the company’s image.

When structuring deals it is essential to take into account the overall plan for the investment in question and not just to maximise any financial opportunities that may exist when the deal completes. This involves a thorough understanding of both the commercial risks involved and the financial risks associated with the level of debt to be raised. Furthermore, the ongoing requirements in terms of working capital, capital expenditure and potential acquisitions in buy and build situations, all need to be assessed and understood. In order to assimilate all of these, you have to be able to work very closely with the management team and there has to be mutual respect and trust. Input from the appropriate advisers in the transaction is helpful when testing the reasonableness of any assumptions.

Another key attribute is the ability to manage portfolio companies and follow through on the initial and evolving strategy. The added value tale, like the sector specialisation tale, is oft told but the most important thing in mid-market investment is backing or bringing in management capable of implementing growth strategies and working with a group of people who may have been with a business for many years. Our job is not to manage companies ourselves but to finance and support others to do so. If we have sourced the right deal, structured it correctly and have ensured that we have the right management, we have put the building blocks for adding value in place. The value itself will only become evident as the company grows and upon exit.

In the mid-market, particularly in sectors with the characteristics we seek, we see growth being achieved through using an individual investment in a sector as a platform from which to build market leading groups – a strategy often called buy and build. Markets with many mid-sized family owned firms reaching succession problems and in fragmented sectors offer myriad opportunities for acquisitions. The key is in identifying those with real synergies, not just cost saving opportunities, and in ensuring management is broad enough and capable of bedding down acquisitions properly and consolidating before moving to the next building block.

How different private equity firms manage their deals is another aspect of differentiation. Some teams expect the team member who has negotiated and made the investment to stay with it to realisation. This means that one or, at most, two people champion, nurture and see the investment through all its ups and downs to exit, in the process building strong relationships with management that often bear fruit for other investments. But other firms are structured with separate investment executives finding and structuring the deal and portfolio management executives thereafter responsible for the performance of the investment. It looks a small difference but says much about the style of the relationships engendered.

The final piece in the differentiation story is the exit. A common myth is that exit is only thought about six to twelve months before it takes place. But seasoned investors know that you should only enter into an investment if you have a clear view of who the potential buyers are – the normal exit in mid market investments. From the time of first investment, everything done with the company must be geared towards the exit and keeping in mind how best to position the investment to attract the highest number of quality buyers. Attracting buyers means being close to them and understanding their requirements, so being plugged in to and regularly talking to the wider community, including advisers, in specific sectors is vital.

The mid-market is an exciting space in which to be investing now. Although not as high profile or as populated as the upper tiers of the private equity field, it is competitive, and vibrant. UK mid-market performance has been the strongest of all market segments in the last two years with £16.2 billion going into smaller buy-outs in 2003 and £5.1 billion in the first quarter of 2004, according to figures by CMBOR. And as the market gathers pace, there can be little doubt that differentiation is now as important to those of us investing, as to the institutions and corporations committing to our funds.

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