John LeClaire, co-founder and co-chair of Goodwin Procter’s Private Equity Group, helped shed some light on the PE industry as part of our recent 2Q M&A Report. To download your copy or check out our other free reports, head over to our Reports Library.
Can you share some thoughts on PE activity in 2014, relative to what you’ve seen in prior years?
I’ve been a private equity lawyer since the mid-80s and was around when it seemed everyone was leaving banking to get into the buyout business—it was something of a green field then and a lot of people had success as early movers.
I remember private equity as I think the public now knows it, or thinks it knows it, circa 2005-07. I think that view—PE as a dominant force in the economy—reached its apogee around then. I recall that sense being captured in an article in The Economist called “The New Kings of Capitalism”, which had a cartoon of what I guess it thought of as a PE investor type on the cover sitting on a big stuffed chair made of money.
Private equity has been through a number of cycles, but it’s really very sector-oriented now, both in market size and industry sector. It’s matured. If you look at the data, aggregate PE transactions were pretty much flat from 2013-2014. On a volume of transactions basis, most of the action occurred in the middle market and lower middle market segments. PitchBook has been one of the main sources of coverage for this: you’ve been banging the drum about add-ons going from around 40 percent of buyouts ten or so years ago to around 60 percent today. Many investors are looking to the middle market for growth opportunities. It’s getting crowded!
While activity was flat overall in 2014, middle market activity was up to around 78 percent of all U.S. activity. Growth equity has been consistent, too. This category can be somewhat amorphous, but it includes complicated minority deals that feel like buyouts, but don’t involve control and PE firms that are agnostic about buying a majority stake in a company or a significant minority interest.
So, to bring it together in answer to your question, I’d say that the U.S.’s PE market was flat in 2014 relative to 2013 and down from historic peaks, but up overall in the middle market.
Is it fair to say that aggregate PE data doesn’t say as much today as it did several years ago? In other words,you have to dig in more today to see where the real trends are?
Yes. The interesting thing, though, is if you’re comparing firm-to-firm, it may not tell you which firms are doing well because most of the big firms span several sectors and segments. A Carlyle, a TPG, a Goldman or a KKR all have flagship funds that tend to do their larger deals—and mid-market and growth equity oriented funds, as well—the full suite.
The middle market dynamic in PE reflects the law of averages in many other contexts. Where are most of the people in the U.S.? In the middle class, as the politicians on either side of the aisle will surely tell you. Where are most of the growth companies? In the middle market. And there are certain dynamics about that market, both on a macro level and on deal-by-deal level, that are very important and differentiated, at least compared to transactions at the level above, say, $1 billion.
I wanted to ask you about first quarter data. Usually first quarters are artificially low because of deals getting completed before the calendar turns, but 4Q 2014 deal flow was unusually flat and 1Q 2015 data showed another big decline, but not an artificial decline this year. What’s your sense of the market right now? Could we be looking at a significant decline this year?
Well, my group’s first calendar was strong, but the data you cite is striking and we’re watching it. There are people still willing to sell their companies, or a piece of them, at 7 times—and of course there are more people who are willing to sell their companies, or a piece of them, at 15 times. And the smart, aggressive PE principals who pay those multiples to buy in are running around looking to add other companies to what they’ve bought and sell as strategics, often with a lot of cash, are looking to acquire growth in a low-growth environment. So transactions do happen. For PE investors, a number of them involve deals below the $100 million level as they add $4 million of EBIDTA here and $8 million there, looking to build $50 million-$100 million EBITDA companies.
What may be happening to a degree is that the overall willingness to consistently pay a high multiple is abating, or maybe taking a pause. What some investors have been successful at doing is to find those unwanted gems in a market niche where the company is good, but for whatever reason it’s more important for the owner to divest it. In that context, really good returns are achievable but it requires a good network to find those gems. And some investors are diversifying geographically in search of return opportunities and growth, offering the core idea of a growth transaction to entrepreneurs in these markets—i.e., take some chips off the table and participate in the next phase of growth with a strong financial partner.
So there are a lot of little things happening, but that doesn’t mean the sky is falling.
Interest rates are still really low. Good companies are growing, even though the economy is not growing at a dynamic pace. The sky is not falling.
Goodwin has a very specific strategy—to be a dominant player and market leader in the middle market and growth equity sectors. I think the data support our focus in the middle market. If all of the best PE law firms are focused with their best people on the upper market, it’s easier to do well in the middle market. It requires a certain touch with entrepreneurs that we believe a lot of law firms don’t have. It’s not surprising that if the middle market is doing well, we’re seeing growth despite what the top-line numbers say for the market as a whole.
Why are the lower and middle markets an attractive place to invest right now?
We think they have always been attractive. Just as most Americans are middle class people, most companies in America are in the middle market. It’s the law of numbers. Factors that are attractive in the middle market can include multiples that are more reasonable than at the higher end of the market, direct one-to-one contact with entrepreneur owners rather than agents and fiduciaries of owners as with public companies, the prospect of growth in an economy where organic growth has not been robust for a number of years now (in this regard, it’s easier to post 10%-15% growth off a base of $10m EBITDA than off a base of $500m EBITDA), and the ability to make impactful and positive changes in a company once you become an owner. And for those who like working on a relatively smaller, more human scale, and in the center of the growth economy, the middle market and growth segments offer that.
This isn’t to say that the lower MM and MM are not efficient markets. There are intermediaries at just about every level, and reasonable transparency. But approach and “touch” really matter in these sectors, and I think more than they do in the upper end of the market.
You’ve been with Goodwin Procter since 1982 and you’ve seen quite a few twists and turns in the PE industry. What are the big differences between the industry today and from when you started?
One: private equity wasn’t really an industry. It was just a bunch of folks who had done buyouts who took advantage of a set of circumstances that were historically unique, almost like a continent waiting to be developed. And at the same time, there was a lot of pension money that was freed up by legislative change several years earlier, and many companies run by agents and in need or improvement, and all that smart money from the post-World War II boom looking for returns. Ten or fifteen years after the 80s boom, private equity started maturing from that amazing early circumstance, where almost anyone could do it and do it well. It’s a much more mature industry now. And PE in a way has replaced the IPO as the capital provider/liquidity source for companies at a certain stage of growth. It’s more institutionalized. It’s more regulated, but still not that regulated. And, as we’ve discussed, it gets the most headlines at the upper end of the market, even though most of the transactions by volume happen in the middle market.
What really gets the job done today is the ability to partner and to add value, because PE is not the green field it was in the 80s and 90s.
Looking out at the next five years, what are going to be some of the skills or qualities that are going to be necessary to thrive in the PE industry—as an investor or, in your case, as a trusted advisor?
-Real value-added experience and insights for the company.
-Ability to bring contacts and networks to companies and their principals.
-Candor, honesty, genuineness, lack of arrogance.
-Ability to execute functions or assist in functions that are not core competencies of most emerging growth companies—AND if you don’t charge special fees for these contributions.
-Great facility with LLCs and tax advantaged structures.
-Ability to adapt the best parts of your brand to local markets on an international basis and gain international synergies.
-Knowing how to structure win-win equity arrangements with management.
-Generally knowing how to win over management, and in that regard knowing how to be a partner as opposed to being an owner.
John LeClaire is co-founder and co-chair of the firm’s nationally ranked Private Equity Group, which was named the 2009 U.S. Buyout Firm of the Year by Buyouts magazine. The Goodwin Procter Private Equity Group serves leading private equity firms and growth companies operating in the U.S., Europe and Asia. Mr. LeClaire’s practice focuses on private equity transactions and relationships with growth companies. He joined Goodwin Procter in 1982 and has been a partner since 1989.
Featured image courtesy of Wikimedia user Andres Nieto Porras.