Little big business

While the buyout market in general has slowed significantly, the smaller space has proved comparatively resilient during the downturn, with 31 of 52 UK buyout deals completed this year in the sub-£25m range, according to unquote" data. The sector is still not without its problems, given the uncertainty of the economic backdrop, though anecdotal and statistical evidence suggest the market is on its way back up again, becoming the current hotspot of private equity.

"There has been earnings uncertainty for the last 18 months, but now we are starting to see a general pick-up in activity due to a better sense of pricing. Prices have adjusted to something more realistic," says Simon Turner, managing partner of Inflexion Private Equity.

"From a vendor's perspective, there are a number of things at play as well. Businesses cannot wait forever. The government needs to sell assets and companies need to pay down their debt. These elements are all going to come together."

While Turner insists this does not mean there will be a flood of opportunities at once, there is definitely a recovery at the moment, according to Ali Aneizi, partner at Baker Tilly Corporate Finance, an advisory house specialising in lower mid-market buyouts. "The market is still fragile, but there are growing signs of improvement. We are over the worst and confidence is growing - albeit slowly.

"There's an increase in deal activity and an acceptance amongst vendors and institutions that life needs to go on even though the world has changed," he explains.

Mark Wignall, chief executive of Matrix Private Equity Partners, concurs: "There are signs that a normalised market has returned. This is informed by the trend of sellers becoming more realistic to 2009-2010 prices. The benchmark has changed."

The 31 sub-£25m buyout deals completed this year yielded a total value of £224.14m. "The lower mid-market is where it's at right now, and I think this trend is set to continue," adds Wignall.

Small, but perfectly formed

It seems that small-cap could become the new large-cap. But has the small buyout sector adjusted itself to the new landscape of private equity?

Though debt is somewhat easier to raise for a smaller transaction, it is still - as it is for all deals these days - far more expensive than previously and on very different terms. Banks are more laborious, selective and cautious in their lending process. As such, some buyout houses have now become providers of both debt and equity. Gresham Private Equity is the latest to use its own debt facility to back the £20.75m management buyout of five of Formation's talent management agencies. "It is now a growing feature in the smaller buyout space. Private equity houses are becoming a one-stop shop, providing an integrated funding solution. It's not really surprising given the lack of certainty from traditional debt providers," says Aneizi.

Indeed, Matrix now uses more of an integrated financing structure. "Providing both the debt and the equity is a particularly attractive way to get deals done. With such low interest rates, you can get a decent 10-12% yield on a loan stock. The terms of third-party leverage now are patchy at best," insists Wignall. Matrix has done a number of deals without banks, and began doing so even before Lehman's collapse.

Wignall goes on to say that the traditional structure for small buyouts used to be a 50/50 split between debt and equity, but this has now changed dramatically. "There will be £1m or, at most, £2m of external leverage, if any, in deals we're looking at." Matrix normally does buyouts with enterprise values of between £5-20m.

Inflexion too has shown its innovative skills in raising a new co-investment fund to invest alongside its latest buyout vehicle. The £75m fund, which held its final close in July, is meant exclusively to purchase without the use of debt and to increase the firm's equity component in deals. "This was an unusual product, but overall, LPs responded pretty well. It's a good opportunity to invest in the bottom of the market - it gives us extra fire power. The fund was oversubscribed," says Turner.

But other financing methods are also fast emerging; from vendor partnering to deferred considerations, the smaller buyout market has definitely lent itself well to the current economy.

"These methods are all a result of working with advisers to get deals done rather than attempting to complete transactions on an adversarial basis. It's all a part of people becoming more realistic about the situation. We're realising the environment is what it is, as opposed to what is preferred," observes Wignall.

In fact, Wignall believes that the small buyout industry will begin to witness a trend of private equity firms teaming up to co-invest, effectively removing the need for any third-party debt. Matrix should know, as it recently teamed up with Aberdeen spin-out Maven Capital Partners to complete the management buyout of Westway Cooling.

A right mezz

Mezzanine financing is yet another pattern becoming apparent in the smaller buyout market. "There is definitely a requirement for it, but there aren't that many funders that write mezzanine cheques for less than £10m. There are a few, but no where near the number of equity funders out there," says Aneizi. Octopus Investments and Maven, for example, each operate a £30m Capital for Enterprise Fund, which invest equity or mezzanine funding of between £200,000-2m in SME businesses in the UK.

"Arguably, there is a mezzanine supply-side gap in the lower mid-market. For those looking to raise finance and want to minimise equity dilution, but are struggling to raise senior debt, then mezzanine could be the solution," adds Aneizi.

The problem with mezzanine debt, however, is that the business in question has to have the right profile to attract that type of funding. Aneizi explains that the company must be prepared for the higher costs involved, usually a high yielding loan, which is increasingly combined with warrants. Sometimes, the cost of mezzanine funding is prohibitive in small businesses.

Some in the industry are sceptical of mezzanine: "If private equity pricing is under pressure and there is a need to pay 17% for mezzanine debt, then this choice of funding becomes much less attractive," says Andrew Hayden of buy-and-build specialist Sovereign Capital.

He continues: "This would consequently impinge upon returns unless the prices of businesses come down sufficiently to make up for this. Given that Sovereign can access more cost-effective senior debt, we don't use mezzanine now and we don't intend to."

While Hayden believes it will be quite a while before general market deal flow picks up again, he points out that Sovereign has continued apace, completing four platform investments, six bolt-ons and eight roll-outs in the last 12 months. The firm's success, he says, is a direct result of Sovereign's six-strong origination team, which allows the company to source deals directly, not having to rely solely on intermediaries.

Vendor-financing, unlike mezzanine funding, has been a trend Hayden has definitely noticed in his deal flow. Nowadays, most vendors are selling not to maximise price, but rather because of personal reasons like retirement or divorce. Owner-managers are dominating the vendor market right now, and they are prepared to finance to ensure their companies remain secure in the hands of others. In fact, owner-managers are the reason why there is a continual flow of small businesses in the UK, and why there are so many private equity houses that focus on the lower mid-market.

"The small market has always been strong because the drivers for owner-managers wanting to sell have always existed. The capital gains tax regime is also an incentive to sell your business, especially now with the increased income tax rates," says Wignall.

The smaller buyout space is, thus, a relatively healthy one compared to its larger counterpart, owing to the fact that less debt is used, and as a result, there are arguably fewer deals under stress. Aneizi says that Baker Tilly has closed a deal per month ever since Lehman's collapse, largely a result of the firm's focus on transactions in the £10-50m range: "Going forward, our pipeline is building nicely and is looking good. There are a mix of opportunities we're working on, including MBOs, sell-side mandates and of course, deals involving distressed stakeholders."

The question is whether larger mid-market houses and their investors will attempt to get in the smaller end of the game. Industry professionals are beginning to become increasingly interested in pursuing a career in the lower mid-market because of the varied work and the opportunity to work more closely with management.

"There is evidence of larger buyout houses having more of an appetite for smaller deals, but it is a very different approach. The smaller buyout market is more management focused and there is less room for error. They would have to tailor their approach accordingly," says Aneizi.

Turner is of the same mind: "It will be a very long time before banks will lend to the levels they have previously, so larger houses need to think of new ways to make money. They may have to re-invent themselves, but it will be difficult for larger firms to get into the smaller market and prove they are for real, especially with the banks.

"There's a lot of chat, but it is harder than people think. It seems like a good idea, but are they really hungry enough to go the hard yards to generate dealflow?" It may be that some mid-market houses are gravitating towards the smaller space simply as a way to keep busy in this dearth of deal activity.

LPs, however, are a different story. Investor interest in the lower mid-market is building, especially with the shortage of deals on the other end. Hermes is one of many private equity investors that has recently begun to focus on the UK lower mid-market sector again as a result of the sale of its direct investment business, which has allowed the investor to broaden its remit. Aneizi asks: "If I were an LP, I would certainly reconsider my investment strategy. Key questions are - where are you most likely to get a return and where is the dealflow in this climate?"

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