Lower Middle Market Private Equity

Transcription

1 Your Private Equity Partner in the Lower Middle Market Lower Middle Market Private Equity White Paper by RCP Advisors 2014 Charles Huebner, Managing Principal Jon Madorsky, Managing Principal Cris Conner, Senior Associate RCP Advisors 100 N. Riverside Plaza Suite 2400 Chicago, IL Tel: Copyright 2014 RCP Advisors, All Rights Reserved.

2 Over the past several decades, private equity has become as much of a mainstream investment for certain investors as the term alternative investments will allow it to be. Over time, investors have reclassified the larger private equity universe into sets of sub-classes, such as venture capital, mega buyouts, small buyouts, special situations, and a variety of others. In addition to sharing the general private equity characteristics, each of these categories has risk/return /market characteristics that are believed to be unique to it. Since its inception in 2001, RCP Advisors has been a specialist investor in North American middle market buyouts (through fund investments, secondary investments, and direct co-investments). In the ensuing years, this segment has drawn lots of attention and investors now tend to make even further market distinctions between the upper and lower segments of the middle market. Why the growing interest in lower middle market buyouts? We believe that there are differences in sourcing, valuation, leverage, value creation, and exit opportunities which can provide risk/return advantages to strong lower middle market sponsors. These characteristics are summarized in Figure 1. These are general characteristics that have changed remarkably little since we first put this together in Figure 1 Advantages of the Lower Middle Market Sourcing Leverage Value Creation Exit Less competition and less capital seeking deals Fragmentation and dispersion in scale of intermediaries Non-economic factors influence sellers Deep and diverse universe of lenders Fund managers able to deploy capital in disrupted markets Natural leverage ceilings constrain purchase prices New management implements best practices in companies Add-ons can be purchased for attractive valuations Easier to ignite exceptional growth on a small scale Competitive sale process on exit Exits not reliant on IPO windows Opportunity for multiple expansion Lower purchase price multiples Ability to grow faster than the broader economy There is benchmark performance data supporting persistent outperformance in the lower middle market, specifically for funds raised from with over 300 funds in the sample set. According to Preqin, as of December 31, 2013, the top quartile net IRR for LMMBO during that period has been 20.0% vs. 18.2% and 16.2% respectively for upper middle market and mega funds respectively. It is intuitively appealing to believe that these are the advantages that result in that attractive performance. However, we have struggled to validate these beliefs through a more analytical approach. Part of the problem is that private market data is scarce and often unreliable. This is not for lack of trying and is not necessarily a bad thing. Private equity information, by definition, is private and this aids in the inefficiency that makes returns overall attractive and which allows certain particularly skilled managers to significantly outperform the average ones. If reliable data is scarce for private equity in general, one can imagine that it is even more difficult to obtain for the market sub-class. Lacking comprehensive third party data, we created our own database over a decade ago, which focused on the LMM and we have been diligently collecting data on hundreds of sponsors and thousands of portfolio companies. The primary purpose for this endeavor is to make us smarter, fact driven investors which, we believe, will result in improved Lower Middle Market Private Equity White Paper Page 2

3 performance for our LPs. We also found that, when aggregated, all of this information sheds some light on the lower middle market characteristics described above. This also provides some interesting comparisons and counterpoints to the mainstream PE data providers, where mega fund data tends to dominate the conclusions. We are pleased to provide this white paper, which attempts to discuss the dynamics of the lower middle market in more detail. The statistical information used herein comes primarily from aggregated data from RCP s database as well as from third party providers. Of course, we know that success in PE investing is as much qualitative as quantitative. To that end, we recently commissioned an anonymous opinion survey, which asked GPs a broad range of questions on their views of the market and how they approach it. We had a remarkable response rate of 200 GPs and those responses are worked into this white paper. We acknowledge that all surveys are subjective and thus may reflect respondents perceptions rather than reality. Even when taking the responses with some grain of salt, however, we find interesting patterns in LMM GPs views of the market. This paper is organized to examine each of the components that we identified: Sourcing, Leverage (along with its close companion, Valuation), Value Creation, and Exit. While third party analysts have long shown that there is a persistent return premium between lower middle market buyouts and deals in adjacent private equity markets, this paper does not attempt to assign specific cause and effect weights to each of the characteristics that can lead to this better performance. Rather, it identifies the various characteristics that can affect performance. Private equity returns remain highly manager-specific. To start out, it helps to define the addressed market, our data set, and discuss some general characteristics. Definitions and General Characteristics Nearly every investor has a different definition of what they consider to be middle market. No one definition is right or wrong. RCP s investment focus is on the lower end of the market and we define the general parameters of this focus as companies with between $25 million and $250 million in enterprise value and/or funds sized between $200 million and $1 billion. The scope of this study is for firms based in the United States and Canada which primarily focus investments in companies based in North America. This paper does not attempt to include the sizable middle market PE activities in Europe and other geographies. We wanted to view the characteristics of investments at both the fund level and at the underlying portfolio company level. For funds, we primarily analyzed buyout funds with capital of $1 billion and less. This group, we believe, generally represents managers focused on companies with less than $25 million in EBITDA and enterprise values of less than $150 million. In setting this fund size parameter, we acknowledge that we exclude a number of billion dollar-plus funds that frequently purchase smaller companies. These situations may be an interesting subject for a future analysis, but we wanted to create a buffer zone of sorts to distinguish small from large. For companies, we thought it would be interesting to bifurcate the data into two different size categories based on EBITDA. With respect to the GP survey in particular, we cut the responses into Lower Middle Market ( LMM ), which we defined as EBITDA of $25 million or less and Upper Middle Market ( UMM ), defined as EBITDA between $26 million and $50 million. In general, these LMM companies are associated with funds of less than $1 billion and the MM companies with funds over $1 billion. Lower Middle Market Private Equity White Paper Page 3

4 According to the RCP database, our current LMM GP data set is made up of approximately 550 unique, active GPs who manage private equity funds with less than $1 billion in capital. The universe that we analyzed is large and extends well beyond firms in which RCP has invested. This is intended to represent the entire LMM universe and eliminate any RCP selection bias. In Figure 2, we examine GP diversity with respect to a number of general characteristics, including location, strategy, and staffing. Private equity is commonly stereotyped as a New York City-centric industry; however, as Figure 2 indicates, this is not the case (although New York is the home base to many more GPs than any other location in both the above-and-below $1 billion segments). Figure 2 60% 50% Percentage of Firms by City 53% 40% 30% 25% 29% 32% 20% 10% 0% 11% 7% 8% 8% 5% 4% 5% 3% 3% 3% 3% 2% New York Chicago San Francisco Boston Los Angeles Dallas Greenwich Other <$1B (LMM) >$1B (MM) Source: RCP Database as of 3/31/14 This geographic spread is seen throughout the industry, but is even more pronounced in the lower middle market. Our data on the billion dollar-plus market is more limited, but we believe that the relative spread is fairly accurate. Significantly, over 50% of LMM managers are located outside of the top seven largest concentrated geographies that we examined. In our experience, the location of the GP is occasionally, but not typically, correlated to their geographic preference in investments. To be sure, some of the finest LMM GPs concentrate on their home territories based on personal relationships, local reputations, and less competition from other groups. However, the magnitude of this advantage has waned as other groups have moved into previously dominated territories. The market has become incrementally more efficient as sellers are more aware of PE sale opportunities, especially in the better-travelled geographies. The wide spread of locales seen in the lower middle market is probably influenced more by the fact that proximity to money center investment banks and financing sources is not as important in the small deal market as it is in the large deal market. If regional identities are becoming somewhat less important, investment specialization has become increasingly relevant. As shown in Figure 3, we examined specialization based on industry focus. We did not measure other forms of Lower Middle Market Private Equity White Paper Page 4

5 investment specialization, such as distressed and other style specializations, although we note that specialization can take many forms other than by industry. Just over 50% of LMM managers in the RCP database are focused on one or two specific sectors as seen in Figure 3. By remaining focused, these managers are able to develop expertise in their industry with the goal of enhancing their sourcing and returns while limiting risks related to investing in unknown industries. We classify industry generalists as GPs with 3 or more areas of focus. This explains why the data shows industry generalists as comprising of nearly 50% of the LMM. In actuality, few GPs describe themselves as generalists due to competitive positioning and their attempts to show a differentiated strategy. We attribute this to the increasingly competitive environment for deal sourcing and fundraising where presenting a distinctive advantage is seen as important. Although not specifically addressed in this paper, we previously analyzed investment performance within our portfolio against industry specialization and found specialization was only weakly correlated to performance. This does not negate the notion that specialization is important. Rather, it just reinforces the notion that performance is highly manager-specific. Figure 3 Sector Focus by Firm: Lower Middle Market Media- Communications 5% Manufacturing 8% Healthcare/Life Sciences 6% Other 8% Technology 4% Business Services 7% Consumer 9% Defense 1% Education 1% Energy 4% General 47% Source: RCP Database as of 3/31/14 We queried our database on staffing issues. One of the commonly voiced concerns on the LMM sector is the issue of more limited resources and bandwidth. Smaller deals are attached to correspondingly smaller funds. The assertion is that these funds produce less fee income and cannot support adequate staffing. There are many ways to examine staffing issues and we chose to look at the relationship of number of portfolio companies per partner. These results (arrayed by most recent fund size) are presented in Figure 4. Lower Middle Market Private Equity White Paper Page 5

6 Most Recent Fund Size Figure 4 Firms with Funds Raised Between 2001 and 2009 Funds Size $100M - $1B Number of Portfolio Companies Per Partner Source: RCP Database as of 3/31/14 According to our database, an average LMM firm has 4 partners and currently holds 11 portfolio companies for a ratio of approximately 3 portfolio companies per investment partner. This ratio is fairly tightly clustered, with 66% of funds having between 1 and 4 portfolio companies per partner, as shown in Figure 4. Furthermore, this ratio is stable across fund sizes between $100 million and $1 billion. We acknowledge that this single measurement does not incorporate all of the issues inherent in the bandwidth argument, but it is one indication that the benefits of investing in small deals through smaller funds can be accomplished without sacrificing adequate investment attention to each deal. Very large funds are clearly staffed and resourced more heavily. This may give rise to concern that these funds would use these resources in a more competitive market to reach down into the LMM and put traditional LMM managers at a disadvantage. We have seen little evidence of these occurrences other than large add-ons. Paradoxically, we believe that the much larger size of these funds and the amount of capital they need to deploy per deal makes an encroachment into the LMM out of step with their business models. These larger funds must invest in larger deals in order to move the needle on their own deployment and performance. Lower Middle Market Private Equity White Paper Page 6

7 Deal Sourcing The market opportunity for investing in the LMM can be summed up in the supply/demand illustration shown in Figure 5, variants of which we have used in our marketing materials for over a decade. Figure 5 Capital Commitments to Buyouts Universe of Investments >$1B Buyout Funds 125 Funds $938B committed to Funds over $1B in size 80% 23,836 companies w/ revenues >$500M 14% RCP s Focus <$1B Buyout Funds 550 Funds $236B committed to Funds <$1B in size 20% 145,412 companies w/ revenues between $10M and $500M 86% Source: RCP Database as of 3/31/14 and Thomson Reuters OneSource. The concept and allure is that the LMM comprises a minority of the private equity dollars as compared to the capital controlled by large funds, and this smaller amount of money is directed toward a vast universe of smaller companies that may be available for purchase. This is not to imply, however, that sourcing these opportunities is easy. While our basic illustration has stayed the same over the years, many of the numbers associated with it have gone up, including the number of players competing in each market. Competition for lower middle market deals has increased with the maturation of the industry, the larger number of players, and greater intermediation. Proprietary sourcing was once a real avenue for advantaged deal flow among the best LMM managers. Today, GPs fear the loss of any credibility if they even suggest that deal flow is truly proprietary. Many of the questions in our GP survey centered on the broad topic of deal sourcing. Of the LMM GPs we surveyed, reviewed deal flow has been dispersed amongst proprietary sources, brokers, limited auctions, and broad auctions. However, closed deals were sourced almost exclusively from brokers and other professional sources (with a limited amount of sourcing that was viewed as truly proprietary). While the market has clearly become more efficient over time, the good news is that it is not completely efficient. There is a spectrum of sourcing efficiency and sophistication in the Lower Middle Market Private Equity White Paper Page 7

8 private equity world that is graduated primarily based on the size of the company and the nature of the seller. At the very upper end of the market, companies are sold by the large, global investment banks (Goldman Sachs, etc.) through broad, tightly controlled processes. Highest price is always the main, if not only, goal. This is not only the goal of the selling bank, but often of the sellers, who are often public companies with a duty to maximize value. Similar processes are becoming the norm at the UMM where highly sophisticated middle market investment banks (Harris Williams, etc.) and national brokers conduct auctions, which range from broad to targeted. These intermediaries consist of approximately 30 bulge bracket firms and 20 generalist investment banks focused on companies with $80 - $250 million in enterprise value. At the lower end of the market, there are approximately 800 intermediaries focused on enterprise values less than $80 million. Of these, only about half are of sufficient size to register with FINRA. These are often regional or local advisors and brokers who close very few deals per year. Often, the intermediaries are non-broker trusted advisors like accountants or lawyers. These deals certainly go through a sales process. However, this process is often far narrower and less thorough than with larger companies. There are a number of reasons for this. First, the companies themselves may lack the requisite financial, accounting, management or other characteristics that would make them appeal to a broad range of buyers. Many LMM managers try to capitalize on this by their ability and willingness to pursue companies that have certain imperfections or are difficult to analyze. Secondly, small brokers limited resources create some inefficiency. Often, they have a more limited knowledge of or access to the full buyer universe, or they lack the skills and resources to create selling materials and processes that present the company in the best light. These issues sometimes result in failed auctions, which offer interested LMM GPs the opportunity to continue pursuing the company with less competition and greater bargaining power. Finally, the sellers themselves sometimes create the opportunity for advantaged sourcing. Over 95% of our surveyed managers claimed that price is not always the most important factor for sellers. Many buyout sponsors attempt to make personal connections with small business owners and their families in hopes of pre-empting a broader process or to position themselves to be the preferred buyers by offering various financial and non-financial incentives that often resonate with small business owners and CEOs. Sometimes, these sellers are not really looking to sell the company. Rather, they are looking for a financial partner that can demonstrate an ability to grow the company beyond the capabilities of the current owner or management team. These incentives not directly related to sale price are possible in the LMM due to private ownership and lack of Go Shop provisions seen in public markets. In situations where these owners are looking to rollover a substantial portion of their equity to participate in the future upside and stay involved in a business they helped build, fund managers can gain an edge by providing founders with a second opportunity for liquidity upon subsequent exit, presumably at a higher valuation. This factor is evidenced by our survey results in which managers focused on companies with less than $25 million in EBITDA were far more likely to differentiate themselves by offering equity roll over incentives. A stylized example is detailed in Figure 6, showing the results of retaining a 20% ownership versus full sale by the business owner. While in the Full Sale scenario the seller receives more cash up front, he loses out on the upside as the business is grown and sold into a more efficient market. Specifically, the business owner would receive 37% more cash, assuming 3x EBITDA leverage and full debt pay down. Figure 6 Stylized example EBITDA ($M) Purchase Price EBITDA Multiple Initial Transaction Enterprise Value ($M) Seller Liquidity ($M) (Assuming 3x EBITDA leverage) EBITDA ($M) Exit EBITDA Multiple Second Transaction Enterprise Value ($M) Seller Liquidity ($M) (Assuming full debt paydown) Total Seller Liquidity ($M) Full Sale $10 6 $60 $60 $60 Retain 20% $ $55 $50 $20 8 $160 $32 $82 Lower Middle Market Private Equity White Paper Page 8

9 An additional important, non-economic factor is certainty of close. Within LMM, sellers are generally owner entrepreneurs, larger corporations or other private equity firms. While these groups have different reasons for selling, a failed sale is disruptive as they are forced to restart a tarnished sale process or abandon the process altogether. While some GPs will use this misfortune as leverage to renegotiate a sales price, many others will highlight their history as a trusted buyer, as evidenced by their reliable close-rate, in an attempt to win a deal. This is highlighted by 31% of our survey respondents who reported using certainty of close as a differentiating factor. The following chart summarizes the various differentiating sourcing tactics considered important by GP respondents. There are some differences between LMM and MM managers, but they follow the same basic patterns. Figure 7 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 72% 81% Strategic Angles or Industry Expertise to Add Value Post-Close 56% 52% Relationship with Management (Preferred Buyer) Differentiating Factors 43% 14% Provide Management/Owners Incentives for Incremental Upside (Roll-Over Equity, Equity Incentives, Etc.) 31% 52% Certainty of Close 6% 0% Preferred Non-Price Terms (Lack of Escrows, Earn Outs, etc.) EBITDA Focus $0-$25M EBITDA Focus $25M-$50M Source: RCP Manager Survey, As of 3/31/14 The best GPs devote considerable time, thought, and energy around techniques to give them a competitive advantage in sourcing, even if the advantage is on the margin. Given that sourcing can create an advantage in the LMM, firms in this space are more frequently employing dedicated sourcing professionals. Anecdotally, it is common for firms to employ dedicated professionals to focus on specific territories or industries, attending trade-shows, meeting with local bankers and lawyers, cold calling business owners and building relationships with small business brokers. In our survey, 45% of LMM managers reported employing a sourcing professional, resulting in actionable deal flow. The goal and payoff from such techniques is a reduction in competition and a moderation of purchase valuation. As we discussed earlier, the very nature of smaller companies often results in lower purchase multiples as compared to very large companies. Also, as discussed in this section, the nature of sourcing small companies and the techniques that some GPs employ to gain a sourcing advantage are geared toward moderating purchase valuations. In the next section, we will evaluate if and how these factors result in lower purchase prices and correspondingly lower levels of financial leverage. Lower Middle Market Private Equity White Paper Page 9

10 Valuation and Leverage in the LMM The data on lower purchase multiples in the LMM is fairly convincing from a variety of sources, including: the RCP database, third party providers, and the feedback from our survey. This is not to suggest that prices do not fluctuate with the market or go through periods where prices are considered unfavorably high. However, the valuation gap between the LMM and the rest of the market is nearly always present, as shown in Figure 8. Additionally the volatility of purchase price multiples tends to be lower in the LMM. The historical average EBITDA purchase price multiple from according to the data collected by S&P (generally skewed towards larger deals) has been 9.6x EBITDA, compared to 6.8x EBITDA for small deals (less than $25 million in EBITDA), according to the RCP database. Buying companies at reasonable valuations relative to EBITDA has proven to be one of the most consistent drivers of fund performance in private equity. This is further evidenced by our survey results with 95% of respondents who indicated that low purchase price is important to value creation for investors. Figure x EBITDA Purchase Price Multiple x 8.0x 6.0x 4.0x 2.0x 0.0x RCP Median EBITDA PPM (Under $25M EBITDA) (581 Deals Reporting) S&P Median EBITDA PPM (ALL) Source: RCP Database as of 6/30/14 and S&P LCD as of 6/30/14 LMM leverage has, on average, been 1.1x in EBITDA multiples lower (25% lower) versus its larger market brethren. RCP s survey respondents claimed that 84% use moderate leverage of 60% (or less) debt while 33% of larger fund managers use greater than 60%. While the L in LBO still very much exists in lower middle market leveraged buyouts, leverage is constrained by the providers of debt and the scale of target companies. The dynamics of the leverage market must be evaluated because it affects returns and risk. Figure 9 shows leverage levels over time for LMM companies in the RCP database versus S&P s broader universe. The clear takeaway is that leverage levels in the LMM are lower and that the changes in leverage levels are reflected in purchase price multiples, as shown in Figure 8. Lower Middle Market Private Equity White Paper Page 10

11 Figure 9 7.0x Debt to EBITDA Levels x 5.0x 4.0x 3.0x 2.0x 1.0x 0.0x RCP Median Debt/EBITDA Multiple (Under $25M EBITDA) (491 Deals Reporting) S&P Median Debt/EBITDA Multiple (ALL) Source: RCP Database as of 6/30/14 and S&P LCD as of 6/30/14 LMM companies are smaller, which limits the total dollar amount that they can or need to borrow. There are a number of specialized finance companies and banks which specialize in lending into this market, whether through cash flow loan, asset based loans, or other variations. The smaller size of the typical LMM debt facility and related lower liquidity characteristics of the loans keeps many of the global agent banks and larger institutional loan investors (like CLOs) somewhat less active in this market. Bank loans (sometimes accompanied by private mezzanine debt) are overwhelmingly the debt package of choice for LMM portfolio companies. Public high yield debt has never been a real factor in this market because of constraints on minimum issuance size. Capital market techniques have certainly entered into the finance plan for upper middle market portfolio companies, particularly at the larger end of the spectrum. Larger facilities are either syndicated (using methods similar to larger deals) or are put together on a club basis by a small number of like minded lenders. However, it is still generally the case that LMM lenders are more risk absorbers than risk distributors. In our survey, 52% of LMM managers are using mostly private debt from a single provider or seller financing, whereas only 4% reported regularly using broadly syndicated debt or hedge funds. These specialty lenders have developed strong relationships with private equity managers and offer more non-financial advantages. The most important consideration for GPs in the RCP survey is favorable lending terms while maximum leverage is considered important by less than half. Relationships between the fund manager and lender serve to push both parties to work together to weather difficulties when they arise. Conversely, in larger deals, with broadly syndicated or publicly traded debt, negotiations in times of adversity become much more difficult given the diverse interests of the parties, high friction costs of renegotiating, and lack of long-term relationships. In periods of credit market disruption, where lenders are generally unable to take the risks associated with syndicating debt for large deals, they are often willing to hold the debt of small deals directly where a strong relationship exists. This is evidenced by survey results in which over 90% of LMM GPs indicated that lending relationships are important. Lower Middle Market Private Equity White Paper Page 11

12 The characteristics of the debt providers and markets in the LMM tend to make financing availability more stable across cycles than in the upper end of the market. The evidence of this is more subjective, but a look back at debt conditions during the 2008/2009 financial crisis (and other cycles) seems to bear this out, which makes sense. For large deals, the public debt markets (which are a major source of financing) and certain types of debt buyers (like CLOs and hedge funds) tend to react quickly to major market corrections and expansions. Relative to LMM debt providers, you are more likely to see periods of credit crunch and credit excess in these larger markets. Using the financial crisis as a case in point, financing conditions at the upper end of the market started to deteriorate as early as the summer of 2007 when the subprime issues started to become apparent. LMM debt markets remained functional for the next year and only closed down upon the Lehman collapse and related crises. Even then, asset based financing remained available and the rest of the LMM debt markets started to recover fairly quickly toward the middle of This resiliency comes from a number of factors. The law of small numbers at work in the LMM means that facilities are smaller, relatively easier to raise and don t require significant syndication risk. LMM lenders tend to be relationship-oriented and the fact that they retain the risk on their books makes them more committed to the market. Finally, a significant number of LMM lenders are nonbank finance companies where they are generally not constrained by regulatory burdens. Creating Value Buyout returns are increasingly influenced by operational improvements rather than the traditional combination of low purchase price and high leverage. Only 9% of survey respondents listed debt pay-down or multiple-expansion as the most important value creation factor where 60% listed active operational improvement or organic or acquired growth as the most important factors. For the best LMM GPs, this has become a repeatable strategy because target companies often lack industry best practices seen in larger companies, such as independent board members, formalized strategic planning, and techniques such as Six Sigma and lean operations. Additionally, small companies can grow at rates much faster than GDP, with increasing returns to scale as they move up the efficiency curve, while very large companies are more likely to be constrained by the size of their markets and organization. Given the need for operational improvement in many small companies, it is natural for many LMM managers to employ a strategy of utilizing outside talent to professionalize and reinvigorate management teams. This strategy can take many forms, from loosely connected groups of industry experts brought in as consultants, to in-house, full-time, operating executives and CEOs ready to lead companies through transitions. These types of operation improvements are seen as important by over 95% of our survey respondents, as shown in Figure 10. Over 80% of LMM managers in our survey considered existing company management to be highly important. Keenly focused on talent, GPs will either continue to support existing management teams, replace management or bolster management with key position hires. For example, many of these companies have a controller acting as CFO and limited financial reporting. By professionalizing the financing and accounting function, management is able to effectively measure, manage, and understand the true drivers of the business. Management is then able to efficiently benchmark key metrics such as working capital and sales margins against industry norms. Private equity owned companies are able to retain and/or attract higher quality executive level talent by offering equity incentives not generally found in other small companies. Years ago, smaller PE firms often had trouble attracting first rate talent to a small portfolio company. However, as the rewards associated with private equity ownership have become better known, this is generally not a large issue. Other typical management upgrades include new CEO and key sales functions. While ownership levels in terms of management options vary, value and alignment for management can be significant. This, and other drivers deemed important by managers in our survey are shown in Figure 10. Lower Middle Market Private Equity White Paper Page 12

13 Figure % 100% 80% Portfolio Company Value Drivers Percentage of Respondents Indicating Always or Usually Important 99% 95% 81% 90% 60% 40% 51% 50% 20% 0% Company Management Operating Partner Oversight by PE Firm (Other than Operating Partner) 12% 0% Outside Consultants EBITDA Focus $0-$25M EBITDA Focus $25M-$50M Source: RCP Manager Survey, As of 3/31/14 In the LMM, managers frequently employ a strategy of purchasing a platform company and seek add-on acquisitions to create scale or to decrease the average purchase price multiple paid. In fact, 99% of our survey respondents claimed to pursue add-on transaction strategies. Add-on acquisitions can provide geographic expansion, customer penetration, manufacturing capacity, product-line extension and simple growth. These add-on companies can vary in size and cost. Many general partners attempt to execute a downward cost averaging strategy through add-on acquisitions. General partners are able to average down acquisition multiples by purchasing one well-run company (platform) at market price and then merging in smaller or less well-run companies (add-ons) that can be purchased cheaply. A simple example is shown in Figure 11. Figure 11 Stylized example Add-on Example EBITDA ($M) EBITDA Multiple Enterprise Value ($M) Platform $10 6 $60 Add-on 1 $3 3 $9 Add-on 2 $5 4 $20 Add-on 3 $1 2 $2 Add-on 4 $3 3 $9 Effective Roll-Up Multiple 4.5 Lower Middle Market Private Equity White Paper Page 13

14 Many smaller, founder or family-owned companies are managed primarily for current, after tax, free cash flow with less attention focused on strategic investment for future growth. GPs are able to professionalize these companies by installing an institutional quality board of directors and formalizing strategic planning. By changing the culture and aligning incentives, fund managers focus executives on firm value at a 5 to 7 year time horizon. Many small companies suffer from significant supplier and/or customer concentration. By reinvesting for growth, broadening supplier relationships, and reducing customer concentration, fund managers are able to grow out of these problems and make these companies more attractive to prospective buyers. GPs also focus on improving the sales and marketing function in these small companies. By adopting a CRM system, bringing in new talent, and instituting incentives, these companies are able to grow faster than their peers. According to RCP s company tracking database, 71% of the LMM companies have outpaced GDP growth since 2002, with median holding period revenue and EBITDA CAGRs of 8.4% and 5.7% respectively, compared with a median US GDP CAGR of 1.5% for each corresponding holding period. We attribute this to managers making specific changes to improve the business, reduce costs or buying scale. Exit Options The ultimate goal of every private equity manager is to exit their portfolio at significantly higher values than their purchase price. Simplistically, investment value is created by fundamental operational improvement, multiple expansion, and/or debt reduction. In an increasingly efficient market, multiple expansion cannot be counted on, as it once was, thus (as we discussed previously) the main focus for LMM managers has become operational improvement. This is achieved through growth and professionalization of the portfolio company. Larger fund managers and strategic buyers are interested in purchasing companies with clean financials, stable earnings, professional management, and sufficient scale. The goal in the LMM is to buy an imperfect or small company and grow, improve, and sell it through an efficient process to a buyer who values the improvements that have been made. LMM managers have demonstrated a relative advantage in their ability to exit investments through multiple means and not entirely tied to the capital markets or the M&A cycles. In contrast, large funds rely more often on IPOs or on sales to large strategic buyers, whose appetites for acquisitions can vary cyclically. IPO conditions can vary greatly, limiting the time periods where companies can be taken public, as evidenced by Figure 12. Exits in our database have been steady with a consistent year end effect. While IPO valuation can be favorable, lock-ups frequently delay monetization of public stock, eroding eventual time weighted returns. Lower Middle Market Private Equity White Paper Page 14

15 Figure RCP Portfolio - Number of Exits vs. IPO Pricings Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Number of Exits IPO Pricings Source: RCP Database and Renaissance Capital, As of 12/31/13 Almost universally, LMM managers exit their portfolios through an efficient process to maximize value. While only 5% of our LMM surveyed managers purchased half or more of their companies through broadly competitive auctions, 74% of managers sold more than half of their companies through broad auctions. With over a quarter trillion dollars in dry powder held in large funds at the end of 2013, quality companies of sufficient size and quality generate significant interest from larger PE funds as well as from strategic buyers. Figure % 80% Portfolio Company Sourcing Channels vs. Sale Channels Percentage of Respondents Indicating Half, Most, or All 74% 86% 60% 40% 20% 0% 5% EBITDA Focus $0-$25M Purchased in Broad Auction 10% EBITDA Focus $25M-$50M Sold in Broad Auction Source: RCP Manager Survey, As of 3/31/14 Lower Middle Market Private Equity White Paper Page 15

16 While multiple expansion as an exit strategy is often dismissed as simply lucky timing, by buying in a depressed market and selling in a high market, the best LMM GPs are often successful in employing multiple expansion as a thoughtful and repeatable strategy. The combination of a larger, more diverse, and higher quality company and a more competitive exit process often results in multiple expansion. RCP has observed a median multiple expansion of 1.8x within its portfolio. Approximately 31% of LMM survey respondents expected at least one turn of EBITDA valuation multiple expansion while 37% expected over two turns of expansion. One turn of expansion will yield over 15% of value increase and two turns of multiple expansion will yield 31% value increase assuming an entry multiple of 6.5x EBTIDA and flat corporate growth. The magnitude of this multiple expansion increases as the exiting company s underlying financials grow. For multiple expansions to occur, tangible operational improvements and growth must occur. Figure 14 60% 50% 52% Anticipated EBITDA Multiple Expansion 40% 30% 32% 31% 32% 29% 20% 19% 10% 0% 0.0x 1.0x 2.0x 3.0x+ 5% 0% EBITDA Focus $0-$25M EBITDA Focus $25M-$50M Source: RCP Manager Survey, As of 3/31/14 Conclusion Lower middle market buyout funds have become a focal point of interest for private equity investors in the past several years. Since RCP Advisors entire business is focused on this market, we devote substantial attention to identifying the characteristics of a GP or an investment which may lead to outperformance. We examined the main categories in the deal process Deal Sourcing, Valuation and Leverage, Value Creation, and Exits which each have characteristics that are unique to investing in smaller deals. We also examined the refinement of these techniques and whether the traditional outperformance can persist in a more efficient and populated LMM world. While these market characteristics make sense, we attempted to go a bit deeper and utilize data that we have been collecting on LMM deals and GPs for over a decade to make the observations more fact-based. We also completed a survey of 200 LMM GPs to garner patterns of opinions on the market and what it takes to succeed in today s LMM. Despite the application of data to this exercise, we are still struck by the fact that private equity performance is still highly manager-specific. Therefore, we identify areas where GPs can seek to improve their effectiveness but we stop Lower Middle Market Private Equity White Paper Page 16

17 short of assuming that the data will reveal general answers to the mysteries of investment performance. Strategies for improved sourcing and value creation remain more of a puzzle than a formula and that, fortunately, is why there is still room for outperformance in private equity even as the markets become more transparent and efficient. Our Firm RCP Advisors is an independent sponsor of private equity funds-of-funds, secondary funds, and co-investment funds. RCP s investment activities are focused exclusively on North American lower middle market buyouts. Our Philosophy RCP Advisors believes that there are unique characteristics to lower middle market buyout investments that may result in superior investment performance compared to the larger end of the buyout market. Our Funds As of June 30, 2014, RCP Advisors manages approximately $4.0 billion in assets under management* and manages over 160 partnership investments with over 90 general partners. RCP Advisors 100 N. Riverside Plaza Suite 2400 Chicago, IL Tel: *AUM is calculated based on aggregate committed capital to all of the funds advised by RCP Advisors and includes non-discretionary accounts. Any opinions expressed in this White Paper are being provided for informational purposes only and are not meant to be construed or relied upon as investment advice. Information obtained from third parties is believed to be reliable, but no representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of such information. This White Paper is not to be construed as an offer to sell or the solicitation of an offer to buy any security. Any such offer or solicitation can only be made by means of the delivery of a confidential private placement memorandum, which contains a description of the significant risks involved in such an investment. The information contained herein is as of August 1, 2014, unless otherwise noted. Copyright 2014 RCP Advisors, All Rights Reserved. Lower Middle Market Private Equity White Paper Page 17