Private Equity 2015: Will LP Bets on the “Upper” and “Lower” Middle Markets Pay Off?

Will LP Bets on the “Upper” and “Lower” Middle Markets Pay Off?

November 25, 2014

Despite what may happen by the end of this year in private equity, 2014 will be a year with a strong first half followed by a pullback in the second half. Pitchbook, 3Q 2014 Global PE Deal Multiples & Trends Report. Strong public equity markets and inexpensive senior debt financing persist, for now. Investors started to return to private equity in a big way in 2013, and an impressive number of smaller funds have met their targets in 2014. We also saw a quarter-over-quarter increase in deal activity. Quarterly fluctuations in private equity deal activity often reflect only a shift in fund strategies within the private equity spectrum. So what, if anything, does the about-face of summer 2014 portend for 2015?

First, let us be reminded that 2014 is on track to “set post-crisis highs for both deal flow and capital invested.” Pitchbook, 4Q 2014 U.S. PE Breakdown. Two quarters provide scant evidence that private equity’s resurgence is anything but real. In addition to high prices and perhaps a necessary rest after the first-half frenzy, the second-half drop can be explained in part by a strong stock market that lowered the number of large take-private buyout deals. High prices have reduced platform deals and increased add-on acquisitions, which also reduces quarterly dollar figures. Cheap debt has temporarily reduced the use of mezzanine and, to a lesser extent, second-lien debt. But, of course, equity markets, credit markets and valuations never remain constant, and private equity funds are all about hedging against future macro trends.

Timing is always everything, and private equity fund investors make their bets on longer-term trends rather than quarterly shifts. If and when stock markets begin to adjust, buyout activity in the upper middle market (i.e., $500 million to $1 billion) likely will return. If and when interest rates rise, the recent predominance of “core” middle market activity (i.e., $100 to $500 million in transaction value) may give way to greater lower middle market activity (i.e., less than $100 million). This may explain why limited partner investors increasingly have moved to funds that are focused on the lower and upper ends of the private equity middle market. Pitchbook, 2H 2014 U.S. PE Middle Market Report. If seller pricing expectations persist, private equity funds will continue to look to the middle market (and perhaps, in particular, the lower middle market) for higher returns at lower cost. Private equity groups are raising small follow-on funds out of fear that big deals will be harder to get done.

As for the 2014 second-half drop, private equity investment activity in dollars might be expected to decline when strong stock markets slow upper middle market deal activity. Private equity fundraising in dollars similarly should drop when more, smaller funds are hitting their targets. When buyouts are down, add-ons are up. In 2009, the private equity mix shifted in favor of the lower middle market and squeezed the upper middle market. Since then, the upper middle market has pushed the core and lower middle markets down somewhat. In 2015, the stars may be aligned for an increase in lower middle market activity and the return of mezzanine debt, an uptick in upper middle market deals as equity markets normalize or adjust, and a squeeze on the core middle market where senior debt is the main driver. Private equity fund raising, in terms of fund size and style, seems to support this. But, of course, the 2015 stats will either confirm or disprove these predictions or teach that the shift will not occur until late 2015 or into 2016.

Private equity has enjoyed a post-2008 comeback, but the face of private equity has changed. Smaller funds looking for opportunities in the lower middle market have garnered the attention of investors in search of less correlative, safer, risk-adjusted plays. The lower middle market should provide a dual hedge against an eventual rise in interest rates and a cool down in public equity markets. Nonetheless, new private equity funds focused on the lower end likely will continue to pitch more favorable limited partner terms and greater differentiation.