With total deal value in 1H 2017 already exceeding that of 2016 by near 23%, the US middle market remains as popular as ever among private equity firms. But where are buyers finding value, given the level of competition?
In our 2Q 2017 US PE Middle Market Report, developed in partnership with ACG and co-sponsored by Madison Capital Funding, our PE analysts delve into trends unique to the US middle market, such as:
- A resurgence in PE sponsors taking companies public
- How PE’s middle-market portfolio is aging
- The growing prevalence of activity in the core & upper-middle-market segments
Also read:
- Middle-Market Vehicles Hit New High In Proportion Of All US PE Fundraising
- US PE Stays Unfazed Amid Evolving Landscape
- Publicly Traded Private Equity Underperforms Peers
Introduction
Key takeaways
- Middle-market PE firms invested $236.9 billion across 1,086 deals in 1H 2017. The volume of deals is nearly on pace with last year, but PE firms are spending greater amounts of capital as activity has moved into the core and upper middle markets.
- Middle-market PE investment in tech companies so far this year exceeds the total amount invested in all of 2016, with $65 billion over 175 deals.
- There have been 23 PE exits through IPO this year, nearly as much as all of 2016. With another 22 PE-backed companies in registration, it looks like decreased M&A activity is resulting in an increase of IPOs for PE firms looking to exit.
- Middle-market fundraising continues to be strong, making up 75% of all PE funds closed this year. Despite a slight slowdown in fundraising numbers, the time it’s taken for a fund to close is down from 15 months two years ago to just 10 months for funds closed this year.
We hope this report is useful in your practice. As always, feel free to send any questions or comments to [email protected].
NICO CORDEIRO
Analyst
Shift To Core & Upper Middle Market
Overview
PE firms invested $236.9 billion over 1,086 deals in the middle market during the first half of the year. While deal volume is on pace with last year, the amount of capital invested is up 23% over the first six months of 2016. This is driven by increased activity in the core and upper middle market as lower-middle-market activity dropped sharply. Upper-middle-market (UMM) activity has trended upward since 1Q of last year and continues to climb, accounting for more deals than the lower middle market for the first time in our dataset. The trend toward the core and upper middle markets is largely driven by massive amounts of dry powder and increases in average fund size over the last few years have necessitated larger minimum investments. Unsurprisingly, median deal size in the middle market is up to $208.5 million, another high point in our dataset. Due to a smaller number of mega-deals through the first half of the year, middle-market deals made up 68% of all PE deals during 1H,well above the 10-year average of 50%.
PE buyers favor SaaS
IT deals accounted for an impressive $65 billion in deal value over 175 deals, surpassing the amount invested in tech companies during all of 2016. This equates to roughly 30% of all deal value in the middle market space and is more than double the 14% 10-year average. The middle market exemplifies the trend toward greater PE involvement in tech as dealmakers, faced with stiff competition and high-priced assets, flock to software companies for two primary reasons. One, many of the software companies targeted by PE employ a softwareas- a-service (SaaS) model. This type of business model is attractive to PE because revenue is generally recurring and established in a service agreement. Such attributes allow PE firms to more accurately forecast expected revenue growth and provide a form of risk management by ensuring the company will not immediately lose revenue and/or clients following the acquisition process. Second, software companies are not capital intensive and growth strategies are not subject to capacity constraints. Expanding top-line figures for a SaaS company is generally confined to expanding a strong business development and sales team.
Outlook
We expect deal flow in the middle market to finish strong through the second half of the year despite a high-priced environment. The need to deploy billions of dollars in commitments and tight credit spreads due to a loose monetary policy continue to make financing readily available. On top of strong incentives for general partners to make deals, the economic outlook continues to be strong in the short term with middle-market businesses rebounding in 2Q after a weak 1Q. Middle-market revenues are up nearly 9% and earnings by 2.3% year-over-year, according to the Golub Capital Altman Index.
LMM Off Pace
Deals by middle-market segment
Inventory Unready To Turn Over
US PE middle-market company inventory
Will M&A help PE firms offload aging investments again?
There are currently 5,758 PE-sponsored middle-market companies in the US, a 40% increase since 2010. While this is not surprising given record capital inflows to PE, what is surprising is the percent of companies that were acquired over five years ago, which now stands at 39.7%. This is the highest percentage of aging inventory in our dataset and could begin to pose liquidity problems if the exit market doesn’t heat up. We last saw a buildup of this kind in 2013, which was then followed by an M&A frenzy, reaching record levels. This depleted aging PE inventory and drove median hold periods down to five years. However, at this point in time, exits via M&A have been trending downward and it is not certain that corporates will step up to help PE unload their investments.
Cyclically Down
US PE-backed middle-market exits
A decrease in M&A activity has driven PE exits downward globally since 2015; the middle market is no exception at $44.5 billion in exit value across 410 deals during 1H. This equates to 87% of all PE exits during the first half. While larger deals are holding exit value steady, the volume of MM PE exits is down 15% year over year and have not grown since 2Q 2015. Strategic acquirers continue to make up a smaller percent of the PE exit environment as M&A accounted for only 48% of MM exits during 2016, the lowest figure in our dataset. This downward trend seems to be continuing as strategics accounted for only 43% of exits during 1H. This is on pace for the lowest number of strategic acquisitions since 2006. With exits via M&A trending downward, secondary buyouts constituted a greater percentage of exits, with 52% of all PE exits at 212 deals this year. We believe sponsor-to-sponsor deals will continue to be a more prominent exit route for PE firms as aging company inventory grows and LPs start requiring liquidity.
One bright spot: IPOs
There have been 23 PE exits through IPO this year, worth $6.2 billion in exit value. This is on pace to nearly double both the volume and value of PE exits through IPOs in 2016. While high-profile unicorns on the VC side have struggled after their debuts, PE firms who list publicly are faring better, as 70% of the stocks are up when compared to the first-day close price. With 22 PE-backed companies already in registration to go public, this is looking to be the strongest year for PE exits through the IPO market since 2014.
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