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Easy credit, looming cycle continue to drive US middle-market PE M&A activity

Middle-market M&A activity in the U.S. will remain frothy for at least another 12 months, driven by an abundance of equity looking for deals and accommodating credit markets, among other forces. What happens after mid-2020, though, remains an open question.

The number of lenders targeting the middle-market segment has grown exponentially in recent years, helping create the current favorable lending environment for private equity funds. While deal flow is expected to continue at a brisk pace in 2019, many middle-market players on various sides of the table have started preparing for what they predict is a coming downturn.

SNL Image

A panel discussion at ACG's InterGrowth
conference included (from left) Michael Milani, Baker Tilly; Tom Aronson, Monroe Capital; Tony Nitti, RubinBrown; and Chris Willis, Industrial Opportunity Partners.
Source: Jacob Slaton for the Association for Corporate Growth

At ACG's InterGrowth conference, held May 6 to 8 in Orlando, Fla., the consensus view among the event's participants was that a downturn will likely not arrive before mid-2020. "I think everybody's going to continue to be very aggressive, and that goes for both equity funds as well as, frankly, lenders," said John Newman, a principal with Norwalk, Conn.-based Capital Partners Holdings Inc., which is investing out of a $600 million fund, during a panel discussion. "I think that's driving the market just as much as the proliferation of equity capital."

Karen Davies, managing director and group head of Columbus, Ohio-based Huntington National Bank's private equity banking vertical, told S&P Global Market Intelligence that on the debt side, everyone is playing: Direct funds, debt funds and private equity funds that have established mezzanine funds. "Everyday there's a new lender showing up," she said. "There's no lack of competition." On good deals, she said, pricing is very aggressive.

The pendulum has swung in favor of private equity sponsors, said Tom Aronson, managing director and head of originations for Chicago-based private credit asset management firm Monroe Capital LLC, which focuses on the lower middle market. "Terms being requested and dictated are surely aggressive, and we're accommodating the best we can," he said on a panel. In an interview, he said that while leverage has crept up a little bit, sponsors — especially larger ones — are primarily seeking extremely flexible terms along with other accommodations.

"It's almost getting out of hand, as to the asks that private equity sponsors are looking for," he said. "That's why we stay away from some of those."

Michael Milani, executive managing director and principal with investment banking firm Baker Tilly Capital LLC, also observed that in the sales transactions he has worked on, private equity funds are having no issues accessing the credit markets. There are plenty of lenders at the senior and mezzanine level willing to put capital to work at still "reasonably aggressive pricing."

Persistent froth

The deal market has been frothy for three straight years, Davies said. The number of first-quarter global middle-market private equity M&A announcements was down about 15%, but activity picked up in March and April, she said. Davies expects strong activity for the remainder of 2019.

"There's over a trillion dollars of dry powder that private equity firms have to put to work, and their LPs want them to get it put to work before a cycle," Davies explained. "So they're still paying top valuations to unload some of that dry powder and get it in sooner than later." She also pointed to private equity firms gobbling up corporate divestitures as companies look to whittle down to their core businesses.

"I think all of us would like to see a little heat taken out of valuations in the market," she said.

In terms of industries, "there's still lots of love for healthcare and technology, those are the biggest multiple transactions. But general middle market, industrials have been very popular," she said.

As competition for deals remains high, larger private equity firms are starting to come downstream to the middle market looking for opportunities, said Chris Willis, director with Evanston, Ill.-based Industrial Opportunity Partners LLC, which invests in middle-market manufacturers and distributors and is currently investing out of a $450 million fund.

"It's exacerbated by the fact that the credit markets are so wide open, as well," Willis said.

Calm before the storm

While a downturn is likely a year or so away, middle-market players are planning with a cycle in mind. Willis said he assumes any business he looks at right now will experience some kind of cycle in the roughly five-year ownership period.

"How deep of a cycle, who knows, but we are stress-testing our models to see what a business can bear," he said. "We are being very careful about the capital structures we put in place, about the lenders that we work with. We're also leaning much more heavily on operating principles to drive value creation through operational improvements."

Monroe Capital is raising an opportunistic fund targeting $1 billion and has built a team to work on those transactions that may arise as a result of a downturn. He recalled that Monroe was able to take advantage of dislocation in the debt market in 2009. "We're just trying to set up and not believe that everything is rosy all the time," he told S&P Global.

Davies said lenders are seeing a lot of portfolio runoff as private equity firms look to exit investments ahead of the cycle. "So you're running 3x as fast to keep up with the runoff, and I think the spaces that are really active are going to stay really active. Where there's opportunity for consolidation and roll-up — healthcare, dental, veterinary — [areas] ripe for consolidation, that's going to continue to happen."

Lenders like Huntington will be highly cautious heading into a potential cycle, she said. They are not going to double down on things that are highly cyclical, such as automotive and building products.

"Don't go out on a limb and take structures that you never would have done before. Stick to your knitting," she said. "We are paying attention, we're watching, looking at the portfolio more actively, month over month versus quarter over quarter, just to make sure we're not missing anything."

Potential fallout

Bruce Hernandez, partner with New York-based Spire Capital Partners LLC, predicted a coming divide. Looking at the macro picture, he said, some things are overleveraged, and some deals are going to go bad.

"It takes just a pocket of stuff to change psychology, so I think you will see some of that psychology over the next year shift," he said. While he does not anticipate the most extreme downturn, Hernandez said his firm has been building more defensive capital structures in its investments.

The 2020 U.S. election cycle will bring political uncertainty that can affect the M&A landscape. Milani noted that M&A slowed down in the last election cycle and picked up again after Trump was elected. He said "quite a few" private company owners are concerned — "rightly or wrongly" — that Democrats will gain predominance in the coming election.

"So we do believe there may be some M&A forces at work accelerating people to do transactions this year and next year, and that may lead to some uncertainty in terms of number of deals in the market in 2020," Milani said.

When the downturn comes, Aronson said, it will happen quick, and it will happen fast and furious. "But for now, we're all fighting hard for deals, and we're going strong."