Key Insights from Leading PE Partners, 2019
April 16, 2019
We spoke with industry veterans from the 2019 Top 50 Middle Market PE Firms to get their insights on opportunities and challenges for PE firms, the predicted fundraising boom, using equity versus debt for acquisitions, branding, and marketing for PE firms, preparing for the forecasted growth downturn, and prognostications on the viability of the venture-backed AAF (Alliance of American Football).
Included in the interview:
Mark McManigal
Managing Director, Capital Alignment Partners
Andrea Nelson
Managing Director and COO, Spell Capital
Bill Spell, Founder & President,
Spell Capital Partners
Brian O’Conner
Managing Partner, Next Generation Partners
Nick Russell
Partner, Tuckerman Capital
Here’s what they had to say:
Where do you see opportunities for PE today?
Mark: If you look at the economy, we’ve had an unprecedented run of a strong economy, which has created a significant number of investment opportunities. And if you look at the economy today, I think, by all indications, the fundamentals seem to be in place. There’s a lot of discussions that there’s going to be some sort of slight correction here in the next, call it, 12 to 24 months, but I think when you have a strong economy that equates to growth and with growth comes an opportunity and need for capital from the entrepreneur’s standpoint. In this marketplace, there’s a significant amount of capital out there that comes in a lot of different forms. I think it’s incumbent upon the private equity funds to make sure that they’re finding the right opportunities from a risk and return standpoint to invest the capital. I know it sounds simple, but when you make good investments with good management teams and you have a good economy, in most, if not all instances, you tend to get good results.
Andrea: At Spell Capital, we continue to see opportunities for acquiring the lower middle market manufacturing companies for our private equity business. And then we also see opportunities in the lower middle market across a variety of industries, for our FDIC mezzanine lending business.
Our equity business focuses on buying a majority interest in primarily industrial manufacturing businesses where we’ve been more competitive due to our successful track record and the experience and expertise of our team. We are expanding our reach somewhat; we’re looking at slightly distressed companies or industrial service companies for our private equity business.
From a geographic standpoint, we see opportunities across the United States, Canada, and Europe. And our mezzanine business focuses on investments of loans and minority equity positions and the same opportunities in healthcare, manufacturing, consulting and media companies.
Brian: We play in a smaller part of the market than some of our middle-market or lower-middle market private equity peers. The businesses we seek to acquire typically generate between $2 and $5 million in EBITDA at the time of acquisition and are sourced by forming relationships directly with owners of these companies. Despite the competitive dynamics in other parts of the market, we still find a lot of opportunities to buy great businesses at fair prices where we operate. We believe that this opportunity will endure.
Nick: It is an increasingly difficult private equity market. We believe the smaller middle market (i.e. sub $10M EBITDA, where Tuckerman has always focused) will continue to offer pockets of inefficiency due to its fragmentation, but every space in the market is extremely competitive where there are intermediaries running sales processes, right down to $2M EBITDA companies.
Tuckerman has been a pioneer in partnering with and supporting independent sponsors since our founding in 2001. The independent sponsor community has grown and taken market share tremendously over the last 5 or so years. I believe this will continue and it offers a great opportunity for our firm.
Finally, I agree with the market data that “platform” or “buy and build” type investments can offer great opportunities in the middle market, but we also have a cautious view as to the difficulty of the thorough investment thesis development and post-investment integration work required to truly combine a number of companies and have the value of the sum be greater than the parts. Platforms are easy to execute on paper but difficult to execute effectively in practice.
What are the greatest challenges? (differentiation, price, deal flow, etc.)
Mark: From our vantage point, the biggest challenge comes from the abundance of capital available in the market. Companies have a lot of different choices out there regarding who they can partner with to fund whatever the initiative might be, whether it’s acquisitions, growth, a minority recap or majority recap. With that significant amount of capital, you tend to see some price compression, you tend to see valuations at near all-time highs, it becomes difficult to differentiate yourselves from others, and if someone’s looking for capital purely based on the cost of capital, that’s commoditized, in our opinion, and not a place where we really want to try to differentiate ourselves.
Brian: Our model is a bit unique in that every investment we make is led by an entrepreneur-in-residence. These “EIRs” develop a thesis, work with our firm to source a great business, then transition into a leadership (typically CEO) position with that company post-investment. Finding and partnering with the right people, especially in today’s competitive employment landscape, where the opportunity cost for highly-talented entrepreneur-operators has never been higher, can be a challenge. However, we only look to partner with a select few EIRs per year and believe that our culture, mission, and investment model is extremely compelling for those that are most interested and qualified to follow this path.
“I think it’s incumbent upon the private equity funds to make sure that they’re finding the right opportunities from a risk and return standpoint to invest the capital.“
Mark McManigal
Nick: For us, the biggest challenge currently is overall valuation levels in the market. We are value investors and have a fundamental philosophy around the importance of mitigating risk in PE investing via maintaining a low absolute valuation multiple of cash flow (or said inversely a relatively high cash flow yield).
The level of competition combined with an environment where the quantity of opportunities we are seeing has been consistently increasing has made it difficult to find opportunities that clear our underwriting hurdles. This is not a unique challenge to our firm. However, our deal flow from our deal partners empirically has typically at a turn of EBITDA or greater discount on average to the average market valuation data advertised by market data aggregators. The stage of the economic cycle compounds that challenge as many businesses currently going through sale processes will suffer some degree of cyclicality in demand through a cycle, when the cycle comes. These are challenges for all investors but heightened for groups with a value orientation to their strategy.
In terms of our specific business, another big challenge (as well as an opportunity) is the significant inflow and growth of participants in the independent sponsor community. This is a channel through which Tuckerman has invested exclusively for almost 20 years, and while on the one hand its extraordinarily exciting to see the model gain traction, on the other hand, there is a bi-directional need to know your partners well when investing in these sorts of partnerships, which is difficult with a lot of new entrants both among independent sponsors and other funds and capital providers like Tuckerman. We are conscientious of the fervor to “get deals done” and how that can incent short-termism from market participants that can ultimately be costly to this particular corner of the PE market that has been our home for many years.
Andrea: There’s just a lot of capital in the private equity marketplace driving up purchase price multiples. The mezzanine business is also very competitive due to the additional financing sources such as uni-tranche providers and the joint ventures between providers and banks offering alternative structures.
How does your firm overcome those challenges?
Nick: On valuation, we overcome this the way we always have – by design. Our fund is structured to remove the pressure of running after marginal deals. We must be prepared to act extremely decisively around situations where our conviction is high.
With regard to the traffic in the independent sponsor market, because we’ve been in this market for so long, we have long term relationships with many great potential partners in place, and we are very active in forming relationships with newer entrants in the ranks of independent sponsor where we think there are value-added partners and where we find our experience can be constructive.
“Many of our best deals come from broken deals, where the buyer was unable to secure the purchase.”
Andrea Nelson
Andrea: We’ve been in business for over 30 years and therefore we have great deal flow from a variety of sources. We see a lot of deals from investment banks, accounting firms, and independent brokers. We also have great relationships with many banks and financing sources, of which there are many more lending in our space.
Our principals and our management teams are very active with local and national private equity and other business community groups. In addition to the networking and outreach, we are also known to stick to the terms established at LOI and not re-trade our deals with constructed issues, providing more of a certainty to close to sellers. Many of our best deals come from broken deals, where the buyer was unable to secure the purchase.
Our focus on manufacturing companies and our specialized professional approach to the lower middle market gives us specific advantages. However, with the higher multiples, we do expect to concentrate more currently on organic growth and less on add-on acquisitions. And the higher valuations have translated into us having a slightly longer time horizon withholding periods. So, we may be extending from a three to five year holding period to more in the seven to eight range.
Our mezzanine investments have a shorter time horizon; however, our mezzanine team can provide creative structures that allow companies the repayment flexibility. We are well into investing our second mezzanine funds with 14 investments consummated this year. So, we can be patient, as well, as we’re only a few months into our five-year investment period on our latest mezzanine funds.
Mark: We have adhered to the same objectives now across three funds. We work very hard to ensure we are aligning our capital with the needs of the company. Additionally, we are very consultative in our approach to companies and it has been our experience this differentiates us to some extent.
So, if you have an alignment of interest, it’s been our experience you tend to have good outcomes because you and the management team are all pulling the same direction and are going to react, in almost every scenario, in the same way.
I think the other thing that you’ll hear us talk about is the fact we’re remaining disciplined investors in what we deem as a somewhat undisciplined marketplace. We’re not going to change our underwriting criteria just to get an opportunity; we’re going to continue to make sure that we get adequately compensated for the risk we take on any given investment.
Brian: We form long-term relationships with our EIR partners before making any commitments. It’s critical that we have alignment or interest, see eye-to-eye and are sure that all parties are doing this for the right reasons. This typically leads to partnerships with the best talent.
Similarly, we’re forming long-term relationships with business owners when sourcing investment opportunities directly. We’re finding owners that are motivated by price, sure, but perhaps more so by the fact that they’re partnering with the right firm and the right entrepreneur to take their business to the next level -- to carry on the strategy and the culture that they’ve worked so hard to create.
Fundraising is predicted to boom in 2019 similar to 2017. What are your thoughts?
Brian: I tend to agree. I don’t see any slowing in new fund formations, or capital coming together for continued investment activity from existing strategies. I think the groups that will be most successful in raising capital are the ones that have a unique and defensible strategy – “niche-y” and very focused mandates. This puts us in a good position here at NGP given our laser focus on high quality, small, asset-light, recurring revenue, business services models, led by our EIR partners. A team with a track record that’s focused on a defensible niche will continue to attract capital in 2019 and beyond.
Andrea: We’re neutral to the current fundraising environment. We raised our latest equity fund, Fund Five and last year our $275 million mezzanine fund both in less than three months each. This is, we believe, due to our established track record as well as our loyal group of investors that reinvest with us in each fund. And we add to that list with each new fund. Again, it’s a testament to our track record and to our experienced investment team.
Nick: I’d watch the economic cycle. There is typically a boom in fund raising toward the end of the cycle isn’t there?
Mark: We just completed the successful raise of our third fund in June of 2018. Investors have been investing less in the public markets and more in the private equity asset class over the past few years and this has a direct impact on why PE funds continue to be successfully raising capital.
In February, Reuters reported that more PE firms are using equity versus debt for acquisitions. Has that been the case in your firm?
Andrea: Spell Capital has always avoided the excessive use of leverage. We’ve always used a judicious amount of leverage when financing our buyouts, which reduces the risk and allows us to be opportunistic when evaluating add-on acquisitions and considering a growth-oriented capital investment. The amount of equity in each deal has gradually increased over the past few years; however, we use leverage as a return enhancer. It’s not an integral part of our structure.
The last deal we acquired in late 2018, we closed with 100% equity and then subsequently set up financing at a very low debt-to-equity ratio.
Our mezzanine business also takes a cautious approach and invests with sponsors of a similar mindset.
Mark: We invest a combination of equity and debt, and, once again, it depends upon the scenario that we’re trying to address or the objective we’re trying to identify. And so, while we do invest equity, I think to some extent, for the pure equity funds, one of the reasons that you’re seeing a larger amount of equity as compared to debt in the acquisitions has to do with the fact the acquisition multiples have gotten to be significantly higher than they would have been three, four, and five years ago. In order to fund them, it requires more equity.
“ I think the groups that will be most successful in raising capital are the ones that have a unique and defensible strategy – “niche-y” and very focused mandates.
Brian O’Conner
As you’re paying a greater multiple for the business, there’s a certain limitation, if you will, on the amount of debt that you’re able to put on that acquisition, which is going to require you to use more equity if you’re going to pay a higher multiple or value on the business.
Nick: Since our founding, we have pursued most of our deals on an “unlevered” basis, employing both equity and debt capital directly from our single fund and thus minimizing the use of third-party debt. We find this has been a constructive structure across market environments, but particularly in more volatile environments, so I’m not surprised if other traditional equity-focused investors are also looking for ways to widen the goalposts on successful investment outcomes with their current investments by utilizing less leverage. This is another sign of “turbulence ahead”.
Brian: Just a quick point of clarification on our model - all the capital we invest on behalf of our LPs is invested as equity. We typically would not consider a debt-like investment as a use of our capital out of the fund, as we are control-investors. However, all our transactions do have a conservative amount of third-party debt in the capital structure. This comes from both bank and non-bank lending partners.
Do branding and marketing have a role in your firm? Does your firm’s brand add value to your portfolio companies?
Brian: No question. We believe it does. For the companies we partner with, typically we’re their first institutional partner. It is important to highlight the resources and capabilities that come along with being the value-add partner they’re looking for. Further, we believe that a clear articulation of these capabilities, and how they benefit our portfolio companies post-investment, creates a competitive advantage in the markets in which the businesses operate. We’ve found that the best way to do this is through clear and consistent branding and marketing across our website, collateral, and communication.
Andrea: Going into our 32nd year, we have solid recognition in the investment community and PE community, which is evident through our strong investor base deal flow and financing relationships. Our successful tenure allows bringing value to our portfolio companies through strong lending relationships and the ability to provide deal flow for add-on acquisition. We do send out regular updates to our mailing list and have website update initiatives in process for our portfolio companies.
Mark: We’ve had our heads down since we started this fund in 2010 and we have continued to operate with very little emphasis on branding and marketing. I think we have incredible relationships with not only our limited partners but also with our executives. And it’s one of those things where we’re now looking at different ways that we can take and create more of a brand around what we’re doing in hopes of getting the benefit of becoming a more well-known fund within a very specific area in which we’re trying to invest.
We think our brand can add value to our portfolio companies. We think it’s an area that we can improve upon and we think that as we improve upon that business owners will look to us for their capital needs, and we’ll continue to see more deals that fit within the very specific criteria we have. We think it will be something that will also help us get some recognition from potential investors that might be interested in learning more about our funds.
Nick: Having been in business for almost a couple of decades, our brand is established with many in our partner community of independent sponsors, but it is something we think about and work hard to live every day. For our portfolio companies, the most enduring element of our brand is our “do what you say you are going to do” approach to business and partnerships, but I’m not sure that creates specific value for our companies, so much as engendering credibility between us, our deal partners and our management teams, and supporting our efforts to be the partner of choice for independent sponsors.
Economists say the record-setting growth the US economy has enjoyed over the last 2 years is coming to an end – it’s a good time to step back and prepare for the next rise. What is your firm planning to do to prepare?
Nick: Growth over two years? How about growth over 20-30 years (with a couple of blips), or at least over the last ten years. We believe in the North American small company economy, but we are also realists when it comes to both the expectation of a cycle, and recognition of the difficulty in precisely identifying the cycle’s timing.
Brian: It’s about staying disciplined and true to what we believe makes an attractive investment opportunity and the price that we’re willing to pay to access that opportunity. We are in the business of partnering with great companies and doing so at fair prices. That’s not going to change. If you’re disciplined in your investment process, we don’t think you need to try to time the market.
Andrea: We believe the economy is still strong and we expect it to continue. At some point in the future, however, there will likely be some slow down. We have gone through three recessions, however, in the history of Spell Capital and therefore have taken precautions. Again, all of our portfolio investments are conservatively leveraged, and we are prepared with ample dry powder to support our investments if necessary or to take advantage of opportunities in the marketplace.
“For our portfolio companies, the most enduring element of our brand is our “do what you say you are going to do” approach to business and partnerships.”
Nick Russell
Mark: We have been in an almost unprecedented economic situation where the economy has continued to grow, and nothing lasts forever. We do anticipate that there’ll be some type of correction in the marketplace. We think we’re prepared for that from the standpoint of having adequate capital to utilize in the event of a correction, but I think there are really two key things that we’re doing right now in preparation for that.
One is active portfolio maintenance. To some extent, it’s a lost art, but it’s something that we focus on all the time about actively managing our portfolio to ensure that from a risk-reward standpoint we’re being adequately compensated for the risk we’re taking and to make sure that the business that we underwrote is the same business today. Because businesses all change and evolve, and active portfolio maintenance helps us stay on top of that. In the end, it helps us generate a very consistent superior return for our investors.
The second thing we’ve done is to remain very disciplined investors in what we view as an undisciplined marketplace avoiding what we call “style drift”. We’re not going to pay an excessive multiple for a business that we can’t justify just to “win” the deal. On the debt side of things, we’re not going to put excessive leverage on a company in hopes that it executes perfectly without any opportunity to have some buffer in case there are any changes in the business, and every business has challenges. Apple has challenges in its business, so to think that lower middle-market companies aren’t, I think is a bit naïve.
It’s time to put a stake in the ground: Is the AAF (the venture-backed Alliance of American Football) going to succeed?
[EDITOR’S NOTE: This question was asked in March when the AAF was still viable. By mid-April, the organization folded.]
Nick: I love sports, and watching athletes compete. I wish the AAF and their investors luck. This year I will be following another exciting new league -- Major League Rugby, and our local squad – the New England Free Jacks.
Mark: Bottom line, I don’t believe so, but who knows!
Brian: Being a Chicago native, I’m naturally a Bears fan. Just like I think about all industries and all new and emerging business models, competitive forces are a good thing. If this keeps the NFL innovating and thinking about how they maintain relevance and market dominance as it relates to viewers of professional football, I think that’s a great thing. Best of luck to them and it’s fun to see innovation in professional sports.
Andrea: I’m not in a place to comment on the AAF since I’m not very familiar with it, but there is a lot of excitement here in Minnesota about our soccer team and a new stadium, Allianz Field and the Loons.
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