Last year, Ardian, the French independent private equity firm, joined forces with Seven Mile Capital Partners to launch a North American direct buyout business focusing primarily on US industrials. The business unit, overseen by Vincent Fandozzi, Head of Ardian North America Direct Buyouts, includes the whole Seven Mile Capital Partners team, retained in full, and adds to Ardian’s buyout arsenal by focusing specifically on investment opportunities in the lower middle market.
At a time when valuations are getting toppy and capital continues to flow into the private equity space – according to Pitchbook PE firms across North America & Europe attracted USD212.6 billion across 214 funds through August 2017 – finding investments at the right price and with the right growth potential is becoming trickier than ever.
That being said, the lower middle market is pretty substantial, both from a deal flow investment opportunity side and with respect to the number of PE firms covering that space.
“It is a much bigger market in terms of the number of deals – though not in terms of dollar value of the deals being done,” says Fandozzi. “We are, however, seeing valuations continue to rise in the lower middle market, just as we see in the large-cap buyout market, but there are segregations between lower and upper middle markets. Valuations have not risen quite so much in lower middle markets.”
Anyone taking a generalist approach to private equity investing is likely going to encounter problems in this challenging market. Some people get seduced by rising valuations and assume they can buy a good company at a reasonable price on the expectation that all boats rise with the tide.
Specialist PE managers with a demonstrable edge in one, maybe two sectors, are far better placed to navigate today’s markets and seek out compelling buyout opportunities with good earnings multiple potential.
“No longer is it easy to go and buy a good company, back the management team and hop on for the ride. Private equity managers are expected to do more than that,” says Fandozzi.
“We focus on industrials in the lower middle market. When thinking about valuations, I think it’s more important to be sector-focused. Having deep knowledge in the sector, experience and the capability to understand what the drivers are of that particular sector really helps you to pick through those companies that are interesting investment opportunities versus those that are later stage companies, trying to access a favourable sellers’ market.”
Knowing what the macroeconomic drivers are within the industrials sector helps guide the Ardian North American buyout team and stick to its guns. This ability to remain focused on the task at hand, and not get swayed by potential opportunities in other parts of the market, is actually a critical advantage; not just for Ardian, but any PE management team with sector specialization.
As Fandozzi says, in this higher market valuation climate, it is helpful knowing how to differentiate between high quality companies “and what I would refer to as later stage ‘me too’ type companies”.
The more interesting investment opportunities are those that require PE managers to roll their sleeves up and get involved in the strategic direction of a company, and help transition it out of the lower middle markets. “You need to be selective. What am I paying for here? Am I paying for something that I can use as a base to grow and add to?” says Fandozzi, who expands on the investment thesis by adding:
“The industrials we look at are primarily US domestic-based companies but most of those we are looking at today are either producing or sourcing their raw materials globally. Frequently, the global environment comes in to the investment thesis when considering how well a company is doing, even though they are US-based companies.”
Ardian operates a number of mid-cap buyout funds. The most recent, Ardian LBO Fund VI, raised EUR4 billion in four months, underscoring the extent of LP demand for these strategies. An additional EUR500 million was raised for co-investment opportunities. Factor in that the
Ardian Expansion Fund IV closed at EUR1 billion in June, and on aggregate Ardian has a EUR5.5 billion platform, one of the largest in Europe, to invest in small to mid-cap companies.
The European team, which now includes 36 people, has deep knowledge of investing in European companies with an enterprise value of up to EUR1.5 billion. Given that some of the US industrial companies that Fandozzi and his team look at will have European exposure, that ability to share ideas and expertise with the European buyout team is a clear benefit.
“We’ve been formally a part of Ardian for over a year now and it’s been a fantastic relationship for us, since joining from SMCP. Everybody in the Ardian team, from Dominique Senequier down, has been supportive in our efforts to build out the North America direct buyout business.
“We talk to them about what they are seeing in the markets and likewise we share our views with the European team on the sector trends we are seeing here in the US. As we look at investments we will often ask if one of the European team has particular experience or knowledge, and whether they can make introductions to help do the diligence.
“That has been invaluable to us,” says Fandozzi.
The US team spends a good bulk of its time looking at companies in the EBITDA range of USD15 to USD30 million.
Those are the companies it feels it can transform, working with the management team to influence their growth trajectory. After all, it is not just money that private equity brings. There are many other tools that lower middle market companies can use to take them to the next stage of growth: how does the company make money, what are its KPIs? As they transition from a lower middle-market company, they need better systems and controls in place to manage that growth.
In short, a PE investor brings professionalism to the company.
“Private equity helps these companies think more strategically, in essence,” comments Fandozzi. “This is much more possible at the lower mid-market end of the industry compared to the large-cap buyout market.
“We are very excited about the investments we have made this year. However, we’ve also taken the opportunity to exit some portfolio companies in a market that is receptive to selling at present.”
Industrials is a large market in and of itself. As such, there are a lot of companies who have no clear value-add proposition. They may be servicing a particular part of the market, they may be local and oftentimes, they tend to be founder-owned and operated. Many struggle to compete in the North American market, let alone a global market. The requirements to be more competitive are much greater.
“Many of the investment opportunities we see are companies that have done fine operating the last five or 10 years. Most of them are great local businesses but lack the scale to be taken to a national level. There’s no strategic advantage to the company,” says Fandozzi.
Ardian does like owner-operated businesses but the question it has to ask itself is, ‘What is differentiating this business and what is this business’s strategic advantage?’
“If there’s nothing to build on or grow, we step back from those types of opportunities,” explains Fandozzi.
Any direct buyout opportunity must also have a strong cash flow component.
Fandozzi says that a lot of time, the team sees companies whose cash flows are quite weak; indeed, when valuations get higher the quality of companies (and their cash flows) coming to market tends to be lower.
“People are trying to take advantage of the higher valuation climate and we see that the cash flow profile really isn’t that great. If they haven’t been able to make money in the market the last five years they’re not likely to in a more difficult environment,” he says.
Asked about the co-investment trend that has become so obvious in the last couple of years, Fandozzi observes that aside from the additional capital that LPs bring to the table, frequently they bring specific knowledge that can help when getting a deal over the line.
“I think GPs are looking for more knowledgeable partners to co-invest with, and from the LPs’ perspective, they are looking to put more dollars to work without incurring fees, to keep costs down.
“Ultimately, you’ve got to recognise how co-investing could be beneficial to both parties as opposed to not offering any co-investment opportunities at all; that’s not a workable solution,” concludes Fandozzi.
