January 21, 2012
Interviewed by: David Snow
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Deal Flow Dynamics

More than ever, small- and medium-sized American businesses need “strategic guidance” as well as capital to adapt to an onslaught of challenges. Private equity firms best positioned to provide this guidance will seal the best deals, according to our panel of experts.

This fascinating panel discussion, the first in a series, includes TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

More than ever, small- and medium-sized American businesses need “strategic guidance” as well as capital to adapt to an onslaught of challenges. Private equity firms best positioned to provide this guidance will seal the best deals, according to our panel of experts.

This fascinating panel discussion, the first in a series, includes TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris.

David Snow, Privcap: Hello, and welcome to Privcap.  I’m David Snow, co-founder of Privcap. Privcap brings you smart conversations about private equity. Today, we are talking about crunch time in the middle market. Our conversation will focus on deal flow dynamics in the US middle market, and we are joined by some experts and veterans of the US middle market.

We have with us today TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners and Jay Coogan of Duane Morris.

Why don’t we get started?

However you define the middle market, clearly it’s changed over the past few years.  Maybe we could start with a discussion about the deal flow in your parts of the middle market, maybe starting with TJ. TJ, your firm spends a lot of energy looking for good opportunities. What has changed in the way that these opportunities have started to come to your firm, whether it’s the dynamics of the seller, or whether it’s the way that you source the opportunities?

TJ Maloney, Licolnshire Management: Well, historically going back really to the ’80s when our firm got started, we were very proactive in terms of covering a network of what today is about 3,800 finders and brokers.  What’s different today is that that network is no longer as productive as it once was, that investment banking firms that 20 years ago we’d say were probably four or five investment banking firms are now 350 to 400 different groups that now actively cover lower middle market and middle market opportunities.  We’ve seen the market get more exact.  It’s more difficult to find opportunities away from the auction environment.

But we still devote a lot of resources to unearthing the opportunities that we can. Over time, we’ve seen the opportunities that we look at increase. It doesn’t necessarily mean that the opportunities that we look at that we close because that’s really going to be subject to certain criteria.

Snow: Is the increase because of your success finding a network, or is it because there are certain sellers that are simply more motivated or motivated in a different way?

Maloney: You have to really look at sort of different time frames. I’d say that we’ve sort of seen a ramp up in our deals in the last three months. I think that is probably driven in part by fear of the future and the fear that we see coming out of Europe, so you probably have a lot of sellers that are saying, “Oh, God, things will get really bad.  Maybe we should sell now.”

We’ve seen some of that recent ramp up, but prior to I’d say the last three months, it was kind of mediocre, not like a huge volume, and a lot of the volume really dropped off in the 2009, 2010 time frame, I think mainly because companies’ numbers are off, and people prefer not to sell when the numbers are off because they’ll usually get a less price, not only because of the fact that their earnings are less, but also because they’ll be some multiple contraction given the fact that the trend isn’t favorable.

Snow: Terry, what is your firm, Arsenal Capital, seeing that is different in the way that opportunities come to you or you source opportunities?

Terrence Mullen, Arsenal Capital Partners: I think it’s been really a continuation of a trend to move from – over time, private equity has moved from more generalist firms. I came out of Thomas Lee Company.  I was there across the ’90s before farming Arsenal in 2000. We looked across all sectors for very high growth businesses. We formed Arsenal to specialize on segments of the market that we thought had this higher confluence of growth, lots of specialty or high value added businesses, and spent the time crafting strategies to really seek these businesses out through a network of industry executives from those fields.

As we built that model 11 years ago, in bringing in house operating people as well who had really judgment – commercial judgment, we all it – on what these businesses are or aren’t. We spent a lot of time seeking out businesses filtering through those for the ones we think have that great combination of growth potential that they’re not tapping yet and also limitations that many of these small businesses have. That approach to us has become more and more important. The market has moved more that way to become more specialized, to add some certain industry focus.

For us, it has really been about staying ahead of the pack by going deeper and more specialized in certain sub-segments, identifying the trends, the problems or issues that aren’t being addressed right now and crafting deals, so really catalyzing deals by reaching out, whether it’s an entrepreneurially owned business who’s doing great, but they could do a lot more, or seeking out corporate orphans that are sitting there. We know the parent is stuck with it or doesn’t know what to do with it, so we solve problems for people by taking assets off their hands.

Snow: And just to follow up on that, would you say that the population or the number of businesses that not only are good and attractive for your strategy, are they increasing in numbers?  Or does the owner of a great business or the owner of a great division feel, as TJ was talking about, less inclined to want to part with that business in this environment?

Mullen: We think that the complexities to this market are significantly catalyzing deals.  Now the type of deals is really kind of what is changing. If you look in the mid – whether it was ’90s or say ’02 to ’07, it was a high growth period. That was kind of the more generic feel. People were looking for capital possibilities to drive growth, and growth was the theme. The complexities in the markets the last four or five years have really brought a lot of pressure on businesses. There’s globalization. There’s this migration of high value added products and services in the US to Asia, and so really the pockets of opportunity have changed quite a bit.

What is driving deals for us is entrepreneur owned businesses who need more strategic guidance and help. They need to have an operating partner who can really help them do harder things, globalizing small businesses, doing more sophisticated manufacturing or providing more sophisticated services, and so the more competitive market environment has brought more deal flow, albeit it has more complexity than it used to have, and that’s where the discrimination happens amongst the buyer and the seller really on what is the value add you specifically bring.

Snow: And Jay, you look across a number of clients in the middle market, however defined, and so I’m wondering as you are aware of their activities and sourcing deals, what is different today as opposed to possibly before the crisis that we all went through?

Jay Coogan, Duane Morris: A lot changed in the ’08, ’09, the arc of what happened. There was a change not just in a lot of the numbers and people’s perceptions of the prospects, but sort of the mentalities, I think. I think prior to that, there was just a much frothier market. There was more leverage available. You could bid things up. People felt more confident about selling.

Humans weigh gain and loss asymmetrically, and sometimes I think the fear that a seller might have that they’re selling at the bottom creates a little bit more rationality on the hold side for some of the sellers who maybe should be selling to private equity firms, and it is the right time for an exit, but they’re afraid because they perceive that they’re near bottom even though for the idiosyncrasies of the arc of their industry or their market or what’s happening in their company, it might be the right time to sell. It can make it a little harder to get sellers to sell for the right price.

Again, to TJ’s point about multiple pressure going down when the numbers are down and sort of downward margin crippling the multiples, even if you try to pull that up a little bit, there’s still that fear that they’re sort of getting taken at the bottom of the market, and they’re made it a little harder to pry things out. As things moved into 2010, I think the sense, at least with some of our clients, was that they were helped by the fear of tax changes. For some reason, we don’t have it this year, maybe because of the election cycle, so that created a little bit more push through in Q3 and Q4 of 2010.

But we’re not quite seeing it though, getting to TJ’s point that maybe now the terminal of Europe might be getting some of the smarter companies to think this might be a good time for an exit. It’s always something a little different when there’s no sort of perfect unified theory of exactly where this stuff heads.

Snow: You mentioned the word frothy. I think when people think about the frothiest kinds of markets, they’re thinking about auctions. And while everybody would prefer to be involved in proprietary deals and deals that they source themselves and where there’s a meeting of the minds of the buyer and the seller, I’m sure that all of you are privy to auctions. I’m wondering, having observed the way that auctions function for so long, what’s different now? What is different in the dynamic of multiple possible buyers, private equity and strategic coming together and bidding for a certain company?

Coogan: One of the fun things you see more of now is not just auction for price, but deal terms to the point of putting out pre-cooked acquisition documents where the seller will say, “Okay, here’s the book.  Here’s the agreement we want.  Send us your best price and an agreement you’ll sign.  Mark it up. You play with things like baskets, caps, indemnities, reps, warranties and so forth, and send us your global proposal.” If there’s too many bidders, that can get a little unwieldy to sort through all of the data. The pricing structure is a little easier when it’s just a number.

But if you have a narrow enough auction, we’ve seen situations where we’ve been asked to sort of work in real time with the deal team at the client in putting bids together, sort of pre-negotiating, negotiating against yourself a little bit. It’s playing a little Texas Hold ’Em, basically with the other bidders who are out there, and you don’t know who it is.  You don’t know what they’re saying, but you know that there are some cards on the table that people have in common, and then you sort of deal with it and move on.

Snow: Is that your experience, Terry?

Mullen: We’re finding it to be an extremely bifurcated market. The top 5 to 10 percent of the businesses in any given segment are continuing to sell for very frothy multiples, as TJ said.  Likewise on the further end of the spectrum, for a medium business on down that’s really struggling in this market, they may go away, and they can’t be sold. What’s really interesting to us is kind of from that top decile to that median where you’re seeing lots of interesting companies. It’s a fat part of the market. You can pick your spots and choose where you want to play, where you really have differentiated views, true expertise.

You’ve got the skills and capabilities to match up to some of those issues or limitations that TJ was mentioning that many of these small businesses have. We’re finding more firms choosing to play in their sweet spot, however they define it. We see lots of auctions processes because we want to see them.

We spend 80 percent of our time on the proactive and network based sourcing, but somewhat closer to half of the deals we’ve done have been through some type of advisor because, as TJ said, everyone’s got an advisor. However, it’s much more discussion about what you can do for the business, the second bite of the apple.  Things like terms and earn outs and very highly structured deals are much more common these days. The perfect, wonderful business often trades for max price, and maybe those more, “Here’s the vanilla term sheet,” everything else is a really nice negotiation.

Snow: TJ, are you seeing a bifurcation that Terry described?

Maloney: A lot of this anecdotal in terms of the investment bankers that we work with, and remember that we’re sellers as well as buyers. We had brought a company to market earlier this year, did not get the prices that the investment banker told us that we should expect, and we pulled the sale basically. We’ve looked at an awful lot of things, and we’ve been told that we had to get to a certain price level in order to continue in the auction, and we were unwilling to do that. I thought, “Well, God, there can’t be that many people that are willing to pay this price. We just can’t see how the math works if they do that.”

Lo and behold, I’ve heard from at least a half dozen sources of investment banks that have a very strong reputation, good coverage in the middle market, that they estimate 40 to 50 percent of the companies that are brought to market in a well conducted auction don’t close.  I think that you’ll see a change. I think that the investment bankers will realize that it probably isn’t good for them to spend a lot of time on companies that can’t get a fee out of.

I think that they’ll start to get back to what a lot of bankers used to talk about years ago, which was that the price was market driven. I think the bankers began to think that the price was driven by what they determined it would be, which is a nice theory, but if the buyers don’t show up, it doesn’t really work well.

Mullen: I think speed and certainty have been huge issues in the market the last four years. I think there was a period of in the second half of ’10, first half of 2011 here where things felt like they were firming up. You started to see more confidence, more enthusiasm to kind of bid more aggressively on things. With quick pull back and a little volatility in the market already, sellers are concerned about, “Who can help me?  How can you help me?” It’s really a reverse interview process. They’re seeking really a buyer of choice, if you will.

Then, the second part of it is they really want speed and certainty. They’re fed up with all the firms baiting and switching, overbidding, back trading 20 percent or not showing, etc. I think that some of the best investment banks have held the mid market firms accountable to this. Harris Williams, for example, has an exceptional database, and they see all the biases – first bid, second bid, don’t close, etc. They’ve told us very specifically that they concentrate on the best buyers for a given asset.

The playing field is not always level. I’m not saying Harris Williams runs an unequal process, but they’re trying to help their clients get to a solution that works for them for many factors other than price, and speed and certainty of closing are really important ones in a complex market like this.

Snow: Would all of you say that you have seen a trend towards a seller being much more interesting in things beyond the price, in, “What can this private equity firm bring to bear that will help this business grow over the next decade or so?”

Maloney: Absolutely. Particularly you’re in situations, and a lot of our clients are at the lower end of the middle market, and you’re more likely to have a less sophisticated or experienced ownership or management team. You are more likely to be taking out some family members and leaving some family members, and people are more focused on – in a good way – they are more focused on, “I need these people to help me really hit a home run for the last 20 percent I’m keeping.” It’s important for the cash. Our ownership group is taking it off the table now, but very often there’s a pretty high correlation between the equity retained and who is actually emotionally and personally involved in running the business.

It’s almost that you’ve got to sell to two different customers. One just wants their cash, and they’re going to go. But more importantly is the person – you’re betting on a horse, and you’re betting on a jockey if you’re the PE firm. The jockey is looking at you going, “You’re gonna help me. We’re gonna do this together because what we sell five years from now, that’s what I care about.” You can over simplify it. Anybody can get some cash and get some leverage and do a wire transfer. Who’s going to be running this business for the next five years so we can have a really big celebration of the real exit? I think there’s a lot of that right now.

Mullen: I think there’s a lot of that, and I think that we are always competing on our knowledge and our expertise in the sector as truly being strategic, identifying multiple ways for these businesses to grow. One kind of investment thesis doesn’t work anymore.  The market is way too dynamic. We’re looking for companies that have multiple ways to win on the upside and often key risks or limitations that these businesses have that we can address. I agree that they get mis-priced or overpriced, these risks, often so that can create a very good buying opportunity.

Also strengthening businesses; lots of businesses understand that they can’t do it alone.  They need greater resources, and private equity firms can do a great job of helping attract exceptional advisory board members. Board members bring talent into the company. We put 8 to 10 senior and executive managers into a typical company, so we’re infusing tremendous skill and resources into those businesses, as well as shepherding them through the process to really sell to a strategic that many of these smaller businesses don’t know how to access the big strategic, so our relationships there help position the business strategically, but also help facilitate that sale.

It’s full life cycle that businesses owners are thinking about, the next 3 to 5 years and the range of things that private equity can do for them.

Snow: It sounds like a lot of work, more work than maybe a firm that would just submit a bid.  I’m interested in asking all of you, maybe starting with TJ, how do you keep costs under control when you are vetting so many different situations and when you are basically doing possibly, as Terry was talking about, more work than perhaps the auction required in helping a business understand how you would help them get from Point A to Point B? I guess the basic question to you, TJ, is just about has something changed in the way that your firm manages the deal process to make yourself more efficient?

Maloney: We obviously have processes and procedures in place. When you look at an opportunity, you not only evaluate the opportunity for its creditworthiness, but you also have to look at the execution risks. You can find some very good properties, but if they have a very high execution risk, it may be an opportunity you don’t want to pursue because you don’t want to be looking at a $1 million, $2 million bill at the end of it just to find out that the seller changed his mind or you were outbid or whatever the case is that results in you not winning the trophy.

I think you have to be careful. There’s no perfect solution to it. We’ve been hung up on some costs from time to time. I think the main thing is just having the judgment up front to realize, “How realistic is this process? What’s the likelihood of us being successful?”  I think the main part is really to just have good judgment about the execution risk.

Mullen: For us, we spend most of our time and money crafting the strategies, understanding from a macro framework where the world is going, where the sector trends are, identifying these micro trends and niche market opportunities, so we spend much more of our time there seeking out businesses that can play these trends or benefit from these trends. When we look at these businesses, it’s a very senior focus early with people who have got a lot of judgment experience in situations to understand what’s possible.

There’s a cross functional team of people with investment backgrounds, industry and operating backgrounds together, initially vetting that business on the first meeting or the first deal review. If we don’t feel we are “the rightful owner,” we don’t have a significant amount of value added strategically and operationally to drive it to that exit, we won’t play. It’s quick kills. On every trade, there’s a sheep and there’s a wolf, and if we’re not sure that we’re the wolf, then we’re going to be a sheep. We like being the wolf there, and we like seeking out the deals that really play to our strengths or we’re going to have to pass on them.

Snow: I like the sheep/wolf metaphor.

Mullen: That’s an old trade expression.

Snow: The final topic, we’ve all been talking a bit about competition in the market and how possibly for certain assets, there’s none, and for other assets, there is competition.  What is the effect of some of these mega firms – and we all know who they are – becoming smaller and, because of their smaller size, seeking to do smaller deals and possibly pushing down into the markets that you two are involved in or some of your clients are involved in.  Is that creating increased competition? What will the effects be of the downsizing of the private equity mega market?

Coogan: In any cycle, and this sort of affects us from the service provider standpoint, you would see in downturns that all of a sudden other law firms that you thought were just priced way out of your client’s bracket suddenly calling on them with dinner invitations and golf and God knows what else because they’re looking to keep themselves busy because the things that are only in their sweet spot are slower.

I think just by analog, in the other markets inevitably, and almost no matter what it is, you start going down the price line a little bit, and if the megas are coming down to the bigger middle market folks, you want to stay busy, and you say, “Well, there’s an opportunity here. I wouldn’t normally look down here, but I’ve got nothing else to do, so I’m coming down here,” and it’s just the food chain. I would expect our lower middle market clients and a lot of  them like playing in that space are going to bump into some of the larger, sort of the more medium firms.  You want to stay busy. “It’s a little small for us, but I’ll take a look at it.” You just get more of that depending on how frothy the market is.

Mullen: There’s definitely some compression, mega, large, mid market, lower mid market. However, I think the lower mid market where we play and see most of the deals is really more protected, quite frankly, because the mega firm or the large firm, they can’t do a $50 million transaction. They just can’t. We look at $50 million to $250 million enterprise value deals. We’re trying to find businesses that have a lot more potential. We’ll be doing buy and builds. We’ll be strengthening management teams, taking them across border to Asia. These are things that the big firms just don’t specialize in.

Our model is built around addressing the issues and complexities of the lower mid market, and it’s not easy stuff. I think that there is some level of protection, if you will.  We love selling, too. We’ve had that over the last cycle that many mid market and larger firms outbid even strategics when we’re selling businesses for $400 million or $500 million. There’s a tremendous level of competition there, but when you get in this lower end of the mid market, we’re not seeing that.

Snow: How about you, TJ? Have you seen a shift in who you would consider your competitors on the deal front?

Maloney: I think it is very similar for us as Terry mentioned. We’re specializing in deals with an enterprise of $50 million to $300 million. Most of the large firms are still above that number. For them, a small deal is a $500 million enterprise value. We’re not seeing that much competition. Frankly, it really isn’t a concern to us. We’ve seen this over 25 years.  They dip down for a while when their market dries up, and then they leave it.

Our market is a very different market. The companies we buy require a really different skill set.  They’re very hands on.  You have to be accustomed to dealing with a different type of risk than what the large firms do. Sometimes it’ll hit the press that they’ve seeded a smaller firm and they’re coming into it, but most of the deals they like are gift wrapped.  We’re sort of used to buying companies with a lot of issues, and they’re not going to go near that.  That’ll never reach the first cut in the firm. Unfortunately, that’s what the middle market and lower middle market is really dominated by is companies that all need to be professionalized.

Coogan: There’s just so many more companies of the size that the middle market is going to be interested in dealing with that you can absorb a little extra competition from on top. It’s not going to cause that big of a ripple. There’s just so many companies to deal with.

Snow: Is there going to be a section of the market that will feel the effects of the big guys dipping down? Is it the $500 million deal size?

Mullen: It’s a crowded space. Whether you cut it by the capital of the fund, whether it’s the $5 billion to $10 billion funds or $2 billion to $5 billion, in that you get to enterprise value range of about $250 million, $300 million, certainly $500 million, that deal gets a tremendous level of focus. Those businesses are still being sold for a big price, so if you look at the spread of multiples, as I’m sure you’ve seen over time, the multiples right now are fairly exaggerated. For the smaller and lower mid markets, if you look at the historical spread between larger deals and small, it’s more exacerbated now.

That tells you there’s both a supply and demand issue. There literally are tens of thousands of smaller businesses in the lower mid market, however you cut it. GE did it one way, and they said there are 40,000 businesses in the US alone that are addressable for this amount of capital.  It’s an extremely deep set. You just have to choose to focus.  What happens is in any kind of supply and demand, there’s a far fewer number. I’ve seen different stats. Where the revenue is between $500 million and $2 billion, there’s only somewhere between 1,500 and 1,800 companies in that range, and there are hundreds of funds each trying to do four or five deals a year.  It just tells you the dynamics don’t work.

Snow: Well, it sounds like all of you are very happy to be in the spaces that you’re in, given the changing dynamics of the private equity market.  We can a lot more about other aspects of the middle market. We can talk about middle market financing. We can talk about the global mandate for the middle market, but as far as deal flow goes, I think we can pause here. Gentlemen, thank you very much for joining Privcap today.

Expert Q&A with Gary Levy, Partner, J.H. Cohn

Privcap: How do your clients understand the private equity opportunity?

Gary Levy, J.H. Cohn: I would say that we have a growth concept companies as clients or what I call ‘emerging concept companies, ‘and those are really ideal for middle market private equity funds because they want growth concepts. Our clients, they are unbelievably curious about the whole private equity arena. Who wouldn’t be? You hear all these stories about people getting piles of cash and what they do with that and the capital gain benefit of doing it. But do they know a lot about it? I don’t think so. I think that’s part of our job is to educate them on that opportunity and introduce them to the right private equity funds that would be a good fit.

When you’re talking about what that right fit would be, those are funds that financial capital, I think, is all equal. All these funds have lots of money. But what you really want is intellectual capital that you don’t have to grow your company. Intellectual comes with guys who have done it before. They get you the right team. They can show you, “This is where we go with the business. These are the right hires. This is how we structure this type of stuff.” I like to say that people have already made those mistakes.

Privcap: What do you mean by ‘growth concepts?’

Levy: One of the areas of expertise we have is in the hospitality in the consumer arena, so growth concepts in the hospitality arena are restaurant companies that are easily replicated, that the math works in terms of the investment to build the units and how quickly they pay back on that investment. You could take a company that has five, ten, fifteen, twenty units, and with the right financial and intellectual capital, very quickly turn that into 50, 80, 200, 300 and get to some point of an exit where obviously private equity funds really like that.

What’s that 5-year time horizon? When I’m introducing my clients to private equity guys, I say, “Yes, you’re going to like them. They’re very smart. But as they’re talking to you, they’re thinking down the road of who they’re going to be selling you to in five years.”

Privcap: Has capital become a commodity, and if so, what can private equity firms do to distinguish themselves in the eyes of business owners?

Levy: That’s a great question, and I don’t want to pigeonhole that all the – is the financial commoditized? There’s going to be differentiators, just staying on that topic, about how a private equity fund is going to present a deal. They’ll more or less be pretty close on valuation of the company, but how they structure that investment could be remarkably different. Some will let you take money off the table, some won’t. Others will want control of the board. Others will be the minority and let you do whatever you want.

To answer your other question about how can a private equity fund differentiate themselves? Again, they have to demonstrate intellectual capital in that industry that they can bring value added to the table. In the end, if they’re all the same from a math point of view, then it’s going to come down to, “Is this the guy I believe is gonna quarterback me and get me into the end zone in the long run?” I tell my clients a lot, when they’re looking doing a deal with a private equity fund – and we have several that talk to lots – don’t look at the valuation of the first offer. Look at the guy and say, “Who is going to be the one that’s going to really maximize the value of this company in the long run?”

That’s the bite of the apple you really want. The first bite is nice, but that second bite, that could be generational wealth changing events, certainly something that could be a legacy for the right type of company.

Privcap: How do investor introductions fit into the J.H. Cohn business model?

Levy: I think that’s a very unique differentiator between us and so many of the other firms out there. We work very hard to provide proprietary deal flow introductions to private equity funds that we know we work well with and we know that are the right match for our clients. That works pretty well because our clients are curious. They want to learn more about it. They want to meet these people. They don’t know much about the arena, and then we’re finding them funds that are really going to help them protect their business.

Getting someone to sell a business or take a new partner on, that’s like a child to these people, so it becomes a very emotional event for them. You’ve got to find them the right partners, people that are really going to have the same values and help you build something that’s great.

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