Is the Middle Market Lighting the Way?

The answer to that question is yes. Indeed it can be argued that despite bank failures and other precarious situations middle-market deals may be one of the few safe havens out there. While the financial markets are in turmoil U.S. private equity firms continue to accumulate capital and have noticeably picked up their fundraising pace according to a recent Dow Jones Private Equity Analyst report.

According to the report a total of 264 U.S. private equity firms raised $222.6 billion during the first three quarters of 2008. This represents an 11% gain over the $200.4 billion raised by 298 PE funds in the prior year. The jump however is in contrast to the halfway point of this year as fundraising lagged slightly behind last year’s pace. Meanwhile there has been a slowdown in buyout fundraising.

Distressed firms which are calculated in the buyout/corporate finance category are seeing strong gains with eighteen funds having raised $37.9 billion thus far this year up 28% from $29.5 billion raised by 16 funds in the prior year. Distressed firms alone raised a record $48.2 billion in 2007.

As might be expected from our readers mezzanine funds are having a terrific year gathering $36.9 billion across thirteen funds compared to just $3 billion across nine funds through the third quarter last year.

We now have some corporate numbers. Collectively 78 funds have raised $103.3 billion but this total is down 12% from the 98 funds that raised $118 billion during the first three quarters last year.

This fundraising activity may possibly be attributed to two things: 1) Institutional investors aren’t seeing their money work in the public markets especially with an over 35% decline in the Dow Jones Industrial Average this year to date. Therefore institutional investors are seeking alternative investment strategies from private equity a group that has seen its returns average over 18% per year. In addition 2) the PE funds may not be as busy closing transactions and therefore while the timing is right may be focusing time and resources on raising the next fund.

Kara Sharp Director of Advisory Services with the accounting firm of Kaufman Rossin. however cautions that while it may be a buyers’ market a buyer “must be prepared to have their funding sources in advance as sellers in today’s market will want to know that the buyer can actually follow through with the sale. Understanding the motivation of the target as to why they want to sell can be a critical piece of information. Sellers today may see that the price they can get now is deflated and they may therefore hold off selling.”

Sharp also warns that in today’s turbulent times “Sellers should always make sure that the target passes the “”sniff test.”” Is what they are telling you and what you are seeing in the financial information consistent? Talk to people throughout the company – not just the finance guys. Sellers should make sure to have all internal agreements in place before going to market.” Whether a buyer or a seller it is clear that—even with solid Q3 numbers—capital is tighter and the number of active participants in the senior lending market has gotten smaller. In fact the number of active senior lenders has shrunk from 12-15 to 5-6 today. Sponsors however that have aligned themselves with lenders are not experiencing difficulty in financing transactions. And some lenders are increasing hold sizes to bring liquidity to the market.

While it may seem counter intuitive contrary to the headlines large commercial banks have not pulled back from the leveraged lending market. And while some U.S. banks may be capital constrained foreign banks are making a push in the middle market.

Meanwhile sponsors are now finding themselves under serious pressure to put cash on hand to good work. Sponsors are now pushing the envelope with the intent to refinance at a later point in time. Some companies are creating all-equity capital structures just to standout taking the financing contingency out of the process altogether.

As the credit crisis continues senior debt financing is in shorter supply. This reality means that there more covenant and amortization issues than ever to grapple with. To speed the process sponsors are turning more to mezzanine weighted capital structures where the senior component of the capital structure is actually smaller than the mezzanine.

All-in-all premium valuations can and are being achieved. Good companies can and are attracting buyer interest while bringing in top market prices.