Private Equity in the Lower Middle Market

Glance at the front page of the Wall Street Journal on any given day, and there is a good chance the term "private equity" will be mentioned at least once. Whether in a discussion on federal tax policy or in an announcement of the latest multi-billion dollar buyout, it seems everyone is talking about private equity. Despite the term’s newfound ubiquity, it is important to avoid painting the entire industry with the same brush. In this article, we note some key differences between various types of private equity and discuss our views on the opportunities and challenges present in an often overlooked sector, the lower middle market.

Generally speaking, private equity can refer to any sort of partnership which invests in the securities of a company, but it is most often used in the context of high-profile leveraged buyouts of large, mature companies. After these larger transactions are completed, the investors tend to focus on identifying operating efficiencies and optimizing the balance sheet, and to a lesser extent, shaping future corporate direction. For private equity deals on the smaller side, successful investors usually work closely with the company’s management team and devote significant resources to helping define and execute a growth strategy. This focus is especially important for investors focused on the lower middle market (LMM), which we define as the set of all companies with revenue between $10 and $50 million. LMM investing presents a unique set of challenges for the private equity investor, but also offers opportunities for solid returns.

One factor contributing to our optimism in the LMM is the sheer number of companies in the sector. According to the Small Business Administration, the lower middle market is comprised of nearly 125,000 U.S. companies, compared to only 30,000 companies with revenues exceeding $50 million. As a result, LMM-focused investors generally face less deal competition relative to their counterparts who target larger companies. Further, LMM companies are comparatively less likely to retain sell-side advisors, so fewer deals go through a formal auction process. Given these two factors, it is not surprising that larger transactions tend to be valued at higher earnings multiples compared to LMM transactions. This "multiple expansion" is clearly evident in a recent Standard & Poor’s study: the average leveraged acquisition in the first half of 2006 was valued at 10 times the target’s EBITDA, compared to a 7.5 multiple for transactions valued at less than $250 million¹. We believe that this valuation arbitrage could be a key reason why smaller funds average a 20-year rate of return of 25%, more than 10% higher than the average across all fund sizes (Exhibit)².

Another interesting aspect of the LMM is that the owners and managers of LMM companies who would not consider an outright sale to a strategic buyer are in many cases willing to partner with private equity firms. These investors can offer existing stakeholders upfront liquidity while allowing them to retain a portion of their equity stake and can also provide the resources and expertise necessary to facilitate the expansion of the company.

While there are a number of advantages to the lower middle market, private equity firms must be aware of the challenges as well. Firstly, companies in the lower middle market tend to be riskier than larger companies as they usually have less robust internal infrastructure and processes in place and are more likely to have issues with customer and product line concentration. Secondly, while the departure of key management is a serious risk to the success of any company, this is especially true in the lower middle market, mostly due to the aforementioned lack of formal infrastructure and process. Finally, deals in the LMM, though smaller in size, often require the same commitment and resources from private equity investors. Therefore, private equity firms need to ensure that the potential returns are sufficient both in terms of achievable IRR and absolute dollar returns.

In order to overcome these challenges and unlock the potential of the lower middle market, we believe it is necessary for private equity firms to focus on three key principles:

In conclusion, we believe that there are significant opportunities for the foreseeable future for vertically-focused private equity firms who are committed to the lower middle market. As more private equity firms enter the lower middle market and as more company owners become open to the idea of partnering with financial investors, those firms who have built a successful track record and a solid reputation in the lower middle market will be well-positioned to lead this important segment of the private equity landscape.

Enterprise Profiling Services

It should come as no surprise that in our ever-modernizing and increasingly connected world, spending in the information technology (IT) industry is on the rise. The worldwide IT market will exceed $1.2 trillion in 2007 with an associated five year CAGR of over 6%¹. Sales quotas for companies which serve this market are on the rise as well, increasing 10-15% over last year, while sales budgets are only projected to rise 9%². As a result, technology sales personnel need to work smarter to hit their quotas, which in turn means maximizing their leads from both a quantity and quality perspective. Virgo Capital believes that Enterprise Profiling Services (EPS) provide a clear solution to these issues and that the sector as a whole represents a promising area for investment.

While sales cycles vary considerably from company to company and industry to industry, they all have several key points in common. For example, all new sales cycles begin with lead generation to identify potential targets. Sales personnel are increasingly turning to online information sources such as EPS for help with this step, as evidenced by the 71% growth in the online lead generation industry from the first half of 2005 to the first half of 2006³. After leads are generated, it is important to rank and prioritize them, and then augment the most promising leads with auxiliary value-added information. According to industry research, finding high-quality, detailed information to augment leads is the most difficult part of the sales cycle, but also one of the biggest factors in the outcome of the sales process⁴. Examples of high-impact auxiliary information include organizational charts to provide context on how a particular contact fits into a company’s overall structure and information on upcoming IT initiatives to allow a salesperson to cater a pitch to a client’s specific needs.

Although Enterprise Profiling Services are gaining acceptance as an important part of the sales process, they can vary significantly in the type, quality, and sources of the information they provide. For example, services like Jigsaw and LinkedIn primarily provide access to contact information generated and qualified by their users, but typically offer little information on the companies where the contacts work. On the other end of the EPS spectrum are providers such as Hoover’s and OneSource, which aggregate information from a variety of sources to produce detailed reports on a large number of companies, but tend to lack contact information for decision-makers below the executive level.

Between these two extremes lie niche providers such as iProfile, a Virgo Capital portfolio company, who provide the best of both worlds by virtue of their strong vertical-market focus. iProfile employs proprietary methodologies to create extensive, thoroughly verified databases of contact information, organizational charts, and other information covering the IT departments of large US and European corporations. We believe services such as iProfile are particularly valuable because the leads and the augmentation information they provide tend to be both higher quality and accessible to fewer people, giving sales personnel who use these particular services a distinct advantage over their competition.

Aside from filling a need within a sales organization, our optimism on the Enterprise Profiling Services space is fueled by the overall dynamics of the sector. The companies in the EPS sector have a significant opportunity to grow: the sector has low current addressable market penetration of 1-5%⁵, and our internal analysis indicates that the market opportunity in the technology industry alone is in excess of $1 billion. Additionally, we believe there are significant expansion opportunities for EPS beyond the technology industry. Further, due to the initial investment of time and resources required to create and verify large databases of information, EPS providers enjoy defensible market positions. Recent investment activity, including infoUSA’s $100mm acquisition of OneSource in June of 2004 and the sale of AberdeenGroup, a company backed by Commonwealth Capital, First Light Capital and TL Ventures, to Harte-Hanks in late 2006, lends additional support to Virgo Capital’s belief that the EPS space offers a promising opportunity for the motivated investor.