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Hot Topics in the Middle Market > Categories
Fundraising at highest point since 2007 — middle-market opportunities
It's no secret that 2017 has seen a “boom” in the fundraising space, with capital raised at an all-time high since 2007.  While this is a positive for fund managers and investors, alike, both should keep in mind the impact this increased activity has on the market, specifically with respect to fund managers’ ability to attract investors and what this increase means when it comes to eventually deploying available capital.
Competition to attract investors
Despite an increase in the number of funds being raised, including first-time funds, the vast majority of fund managers have expressed that there is more competition than last year to attract investors to their funds. Many fund managers rely on a solid base of repeat-investors who have been satisfied with the fund’s prior key terms and economics. But, with the increase in the number of funds, fund managers may need to pay more attention to the terms they offer investors and be more willing to negotiate such terms in order to maintain their historical investor base and attract new investors. In this regard, investors (and fund managers) may want to be mindful of the investment limitations given the larger fund sizes and increase in available capital.
Available capital
Along with the increase in the number of funds, there is a significant increase in the amount of available capital, which could lead to greater competition for deals, and, in turn, higher pricings for such deals. Therefore, investors should consider middle-market exposure—which could preclude  potential overpriced valuations—by targeting companies not typically on the radar of the mega funds and not as likely to go through an auction process. And, while the mega funds have seen an increase in the overall size of such funds, middle-market funds account for a greater number of final closes, thus far, in 2017, so there are ample opportunities for investors.


Searching for bigger returns? Think smaller.
As the private equity industry matures and competition for middle-market acquisition targets becomes super heated, some private equity firms are moving downstream into the lower brackets of the middle market in search of additional opportunities and higher returns. Though not without risks, the lower middle market provides opportunities for outsized returns to those private equity investors willing to roll up their sleeves and take a hands-on approach to operational improvements.
First and foremost, the lower middle market simply offers a greater number of potential targets. There are approximately 350,000 companies with annual revenues between $5 million and $100 million, while there are only 25,000 companies with annual revenues between $100 million and $500 million, and only a few thousand companies with annual revenues in excess of $500 million. The lower end of the middle market also has the most new entrants. New companies are constantly being formed, maturing, and looking for growth capital.
The lower middle market presents opportunities for smaller, more specialized private equity investors who focus on specific industries and have significant operational experience. Lower middle-market deals can be difficult because target companies often lack sophisticated infrastructure, operational experience, and/or experienced management teams—all of which are critical for a business’ ultimate success. Private equity investors (with management and operational experience in specific industries) are able to leverage their industry knowledge to grow these companies, scale up operations, and increase revenue. Private equity investors in the lower middle market must be willing to step in as CFO, or CEO, and must recognize that these investments are operational partnerships, not just financial transactions.
In part, this shift toward the lower middle market is being driven (as are other recent trends in the private equity industry) by structural changes in the private equity industry itself. As first-generation private equity firms mature and the original general partners look to retire or limit their contributions, some are branching out and opening up their own smaller and more specialized shops. These general partners already have a track record of successful deals and often focused much of their career on a specific industry. The lower middle market offers abundant opportunities for these newer, smaller shops to buy attractive assets at potentially lower multiples.
Transactions in the lower middle market are not, of course, without risk. Competition remains high and valuations, currently around seven times EBITDA, are the highest they have ever been—according to the alternative asset analysis firm Preqin’s 2017 report on the lower middle-market. Additionally, low EBITDA-generating companies face difficulties entering the market and are often too small to retain an investment bank to run a full auction process. Lower middle market deals often use a compressed deal process—offering limited exposure to the seller and management and limited opportunities for diligence. If multiple suitors are involved and transaction expenses spiral out of control, the economics of the deal may become unworkable. Finally, because of their smaller size it can be difficult for lower middle-market private equity firms to provide the significant management, operational, and back-office support their targets often require.
Despite these challenges, acquisitions of lower middle-market targets can be an attractive alternative for private equity firms looking for increased deal opportunities in today’s highly competitive market.
Middle-market PE firms selling minority stakes to outside investors
In the past, large bulge bracket private equity firms like the Carlyle Group, the Blackstone Group and Providence Equity Partners sold minority stakes to outside investors as a method of raising capital and fueling growth. Recently, this phenomenon has migrated down to middle-market private equity firms, with those firms increasingly selling minority stakes in the firms themselves (as opposed to limited partnership interests in their fund vehicles). Why?
Capital to grow
Middle-market private equity firms, especially those with smaller portfolios and less operating history, generally do not keep a lot of cash on hand. Sale of a minority stake gives private equity firms a balance sheet boost and instantly deployable capital, providing the resources to pursue deals they otherwise could not take on. Furthermore, similar to firms in other industries that recently struggled to grow organically, private equity firms struggled to grow solely from returns at the fund level. The capital raised by selling a minority stake allows private equity firms to seek add-on acquisitions for portfolio companies, explore other business lines, test novel investment ideas that they can later apply at the fund level and acquire other private equity firms. Finally, by selling a minority stake, private equity firms can raise capital without the headache and expense of a public offering.
Generational transfers
As the middle-market private equity industry matures, the general partners of firms founded in the 1980s and 1990s are transitioning out. A minority stake sale at the firm level provides these general partners with liquidity and lowers their risk profile. Moreover, as the old guard general partners transition out of the firm, younger general partners may have trouble covering their capital commitments at the fund level. Selling a minority stake can supply the capital necessary for the next generation of general partners to raise new funds.
Deepening ties with investors and limited partners Historically, minority investors in private equity firms have been current or former fund limited partners. Selling a minority stake in the firm to a long-time fund limited partner allows both the private equity firm and the limited partner to develop a deeper institutional tie. Private equity firms look for minority investors with industry expertise, deal sourcing networks and value beyond their capital. Limited partners are attracted to minority investments in private equity firms because their investment maintains a steady stream of income from profits and distributions and avoids the fees associated with investments at the fund level. Becoming a minority investor at the firm level could also open up additional investment opportunities at the fund level. Minority investors must be aware, though, that capital invested at the firm level may be tied up for long periods of time and, unlike investments in a fund, there is no express future liquidity event to look forward to.
As the middle-market private equity industry becomes increasingly competitive, more and more middle-market private equity firms will look to raise capital through minority sales. This capital will help the next generation of general partners raise funds, close deals and grow their firms.
Cannabis businesses and investors march forward at NP roundtable event
Significant challenges and opportunities in the recreational and medicinal cannabis industry, including the legal and regulatory status of cannabis, banking problems and investment activity, were identified and discussed at Nixon Peabody’s June 13 Hot Topics event in Boston. Panelists leading this interactive roundtable event included Shanel Lindsay, Ardent Cannabis; William Luzier, Marijuana Policy Project; David Rheins, Marijuana Business Association; and Roger Tilton, full_tiltON ventures, llc. After a roundtable discussion several marijuana businesses looking for investments pitched their businesses to the attendees. Nixon Peabody’s Philip Taub and Rudy Salo led the discussion.
Legal & regulatory status
While eight states have legalized marijuana sales to adults for recreational purposes, and over a half a dozen states (and counting) have legalized sales of medical marijuana, marijuana remains illegal federally under the Controlled Substances Act and under international treaties executed by the United States. Although federal regulation of illicit drugs rests primarily with the Justice Department, the Federal Health and Human Services Secretary also holds powers that restrict marijuana and the rescheduling of it under the Controlled Substances Act. 
When President Donald Trump appointed Jeff Sessions as U.S. attorney general, Sessions’ well-known stance against marijuana cast uncertainty over the marijuana industry. However, despite his stance, Sessions hasn’t done anything concrete to pump the brakes on the marijuana industry. In addition, Congress’ amendment to the federal spending bill prevents Sessions’ department from cracking down on legal medical marijuana programs.
Nevertheless, the Trump administration has taken an adversarial stance toward marijuana, which has brought a chill to the burgeoning cannabis industry. Still, investors, including attendees of our event, are willing to invest in the industry.
The inability to use traditional banks continues to hamper the cannabis industry, though state chartered banks and credit unions have been able to moderately fill the banking gap. Banks that were considering banking in the industry and trying to follow the Treasury Department’s Financial Crimes Enforcement Network, or FinCEN, guidelines for banking marijuana, have been concerned that the attorney general’s opposition may increase enforcement against the banks that do provide services to the industry.
Investment activity
During the pitching round of our panel, several businesses shared their proven success and their need for additional capital to get to the next level. The businesses that pitched were from all over the United States, including Washington, Colorado, New York, California and Massachusetts.
It was made clear that investors must have a pretty high risk tolerance because there are plenty of challenges unique to the marijuana industry. On the other hand, legal marijuana sales in the U.S. are projected to surpass those of ready-to-eat breakfast cereal in 2019, according to estimates by certain industry group.
With nearly sixty people attending the event, interest and activity in this sector are undoubtedly growing. If you are interested in attending our ongoing Hot Topics in the Middle Market series, contact
Wall Street vulture funds now playing the long game

Similar to the private equity community’s shift towards longer hold times and the concept of patient capital, Wall Street vulture funds, and other members of the distressed debt investment community, are pushing out their investment horizons in search of stability and greater returns. Vulture funds typically seek profits by buying the debt of distressed companies, selling off the remaining assets and then rapidly moving on to the next target.  Historically these funds have offered investors quarterly, or even monthly, opportunities to withdraw their money. In the past this has proven an attractive model to those investors looking for more liquidity. However, a recent article in the Wall Street Journal notes that some vulture fund managers, in the search of greater pay offs, have begun preaching to their investors the benefits of longer investment time horizons.

Though longer time horizons render capital less liquid, they allow fund managers to target less fungible assets that may take longer to produce returns. Longer investment time horizons also lessen the chance that early and intermittent withdrawals of capital will sink the fund before it produces returns. In fact, early withdrawals have forced several notable vulture funds to shutter their operations in recent years. Now, it appears there has been a shift in the industry. The article notes that vulture funds launched in 2016 were more likely to demand their investors agree to a lower frequency of redemptions and expect longer investment terms. In fact, nearly forty percent of vulture funds in 2016 offered annual redemptions, as opposed to zero percent in 2015 and nine percent in 2014.  Vulture fund managers are able to sell their investors on longer horizons and less liquidity as fund structures necessary to achieve private equity style returns.

Finally, vulture fund managers hope their shift towards longer investment horizons will raise the asset class’s standing up alongside higher returning options such as private equity funds and real estate investment trusts. Doing so would allow vulture funds to attract more capital from pension funds, sovereign wealth funds and university endowments that typically have longer term outlooks and larger checkbooks. Perhaps one day the asset class may even shed its carrion bird moniker.    

PE managers eyeing 401K plans
Fortune reports that Tony James, the CEO of PE powerhouse, the Blackstone Group thinks that 401K plans should be investing in private equity funds the way endowments and pensions do. 
While noting that James' suggestion may be self serving, the author points out that retirees face similar problems to pension funds insofar as they are being hurt by low interest rates. As a result, it might make sense for 401K plans to take greater risks. 
Nonetheless, investing in PE is far from a sure thing.  The author notes a recent Fortune piece citing evidence that PE funds performance has not been what it once was.
Trends in public pension investments in private equity

Over time, public pension funds have become significantly underfunded. There are a lot of factors that explain this. Some are poor planning by the pensions, such as decreasing investments after periods of strong returns; overly optimistic promises to pensioners; changes in demographics; and stock market fluctuations. As a result, pension funds are now $2 trillion underfunded.

Additionally, typical pension investments, such as safer, low-interest bearing investments, are not providing the returns for pension funds to address their unfunded liabilities. So pension funds are under pressure to provide stronger returns from other asset classes, including private equity.

But investing in PE comes with some downsides. For one, management fees are higher than with other asset classes, which digs into the profitability of the funds. Over the past decade, fees have increased by 30%.  There are also ongoing monitoring and strategic costs related to PE investments that are greater than other asset allocations.

These high investment costs have not led to great returns. For example, one study showed that New York City’s biggest pensions would have done better had they invested in a stock index fund rather than PE.

So what are pension funds doing about this?

For starters, many are questioning their PE investments, and asking for justification for the high fees. Pension funds are pressing funds to provide more transparency of their fees and are looking most closely at their most expensive funds.

Some pension funds are also making private equity investments directly, rather than through a separate PE fund. Pensions are looking at co-investment opportunities, which allows for direct investment and often without management fees or with lower overall fees.

Pension funds are decreasing their allocations in private equity as compared with other asset classes.  One article notes that pensions have reduced by one-half their allocations in PE in 2017. Pensions are also decreasing the number of funds that they invest in. The New York City pension fund invests in over 200 funds, which is a huge amount. They intend to decrease that to 60 funds.

Pensions like the Illinois State Board of Investment are
looking to index funds rather than PE and hedge fund managers. They feel that investment returns are the same over the long term, at a fraction of the cost. And they don’t need to monitor the performance of individual investment managers.

Most notable for PE funds, in some cases, pensions are trying to bring as much work in-house as possible. This may be impractical for most funds, given the cost and difficulty to obtain the talent needed to carry out complex investment strategies. Pensions are trying to reduce their reliance on pension consultant firms, which larger pensions pay tens of millions of dollars per year, and are hiring their own consultants at lower rates than what they pay outside firms.  Particularly large funds have also considered buying a PE firm or creating a separate entity that would make its own investments.

As a result of recent challenges and competition among PE fund managers, commentators have opined that pension funds will likely continue to seek more favorable fees and reevaluate their PE investments. This may mean that PE funds will face more difficulty raising capital, and will have less cash to carry out investments. However, despite these changes, commentators think it is unlikely that public pension plans will exit private funds as an asset class in the near future, given the ability of PE to historically outpace returns of other investment classes and the need to cure unfunded liabilities.

Cybersecurity for private equity: strategies to avoid being the next cyber target

On May 23, 2017, the Association for Corporate Growth hosted a webinar on Cybersecurity for Private Equity – Strategies to Avoid Being the Next Cyber Target, which was presented by security experts Kaleigh Alessandro, Bob Shaw and Matt Donahue, each with Eze Castle Integration. The panel of security experts discussed today’s cyber threats, strategies to protect a company from cyber attacks, ways to mitigate vendor risk and the human factor involved in all cyber attacks.

The cyber threats that exist today will be different tomorrow, as this is an evolving and ever-changing landscape. Some current cyber threats are malware / ransomware, social engineering / phishing scams, espionage / cyber terrorism, hacktivism, insider threats and cybercrime. Any company that handles sensitive data is at risk, and may be a victim of, the foregoing cyber threats. If a private equity firm falls victim to such cyber threats, then it will face various risks including business, operational and reputational risks, regulatory risks and investment risks.

For a company to protect itself from cyber threats and cyber attacks, a company needs to implement layers upon layers of security across the company to protect itself from, and decrease the risk of falling victim to, a cyber threat.  The main security layers are identify, protect, detect, respond and recover.  There are various mechanisms that a company can implement to detect current weaknesses and protect against future cyber threats, including:

Performing internal vulnerability assessments to determine weak links in a company’s network, which assessments should be completed at least on an annual basis;

implementing technology safeguards (such as requiring strong passwords that are changed often, backing-up data, managing and implementing patches from Microsoft and other vendors, updating older operating systems, encrypting data and communication and having a VPN for remote access);

having a written security policy in place which will be helpful when training employees;

implementing a data governance platform so that a company can determine which employees access files and what such employees do with those files; and

training all employees on the company’s policies and procedures around cyber security and on the most up-to-date security threats.

Cyber security detection and protection within a company should be ongoing and constantly evolving. With respect to recovery from a cyber attack, the response plan should be realistic and should involve internal staff across the board of a company, as well as outside counsel.  A company should test its response plan by running through such procedures to make sure that employees are well-prepared for a cyber attack and that the response plan is achievable upon implementation. This response plan, like cyber security detection and protection, should be continuously updated and reevaluated.

A company should also mitigate vendor risk as much as possible by implementing a process or checklist for third party IT security due diligence, as a company needs to understand what weaknesses its vendors have and how such weaknesses are being addressed as well as the business continuity and disaster recovery plans that have been implemented by such vendors.  In addition if a vendor’s IT security policies change, then the company should be receiving a notice with respect to such changes.

There is a human factor for every cyber threat, and a company should train its employees so that they are aware of the procedures and policies that are in place around cyber security.  A company needs its employees to understand that they each have roles and responsibilities with respect to cyber security and they will be held accountable to comply with such roles and responsibilities to ensure that the company is protected from the ever-changing landscape of cyber threats.

Family offices — direct investment trends, opportunities and challenges ahead
Nixon Peabody and FTI Capital hosted a Hot Topics dinner on family offices and the direct investment trends and opportunities and challenges they face on Thursday, April 4 at the rooftop dining room of the NoMad Hotel in Manhattan. The event was attended by a broad range of family offices and other private investment offices, comprising investors based in the United States, Europe, Asia, Latin America and the Middle East. Dick Langan and Greg O’Shaughnessy of Nixon Peabody moderated the discussion together with Glenn Tobias of FTI Consulting.
The private investment office participants kicked off their discussion with a recognition that many families made their money in privately owned businesses and understand:

• how properly run businesses are managed; and

• what it means to have a long-term investment horizon.

Thus, it’s no surprise that family offices are increasingly characterizing themselves as private investment offices based on their focus on investment decisions for the family.
The participants acknowledged that, in this low-interest rate environment, increasing attention is being paid to direct investment. It is well-documented that family offices (private investment offices) have had a major increase in acquisitions. The following statistics should be no surprise:

• Almost 70% of family offices engage in direct investing and in 2015 out performed buy-out firms with average return of 15%
• 80% of family offices are involved in some form of co-investment and more than half of all family offices are looking to increase their allocations to co-investments
• 62% invest in private equity with allocations to private equity over 20% but many family offices are moving to direct investments
• 13% invest 20%–50% of portfolio assets in private equity
• 40% of family offices investing in private equity also invest in direct assets
• 56% plan to increase direct private equity investments in the next two years
The logic is that families that do not have an over-riding need for liquidity can achieve superior long-term performance if they are patient and even absorb unrealized short-term losses as the investment matures. The “buy and hold” approach (or “patient capital”) of family offices is not only attractive for the family office but oftentimes for the companies they’re backing. Family offices take the approach that it’s a “marathon not a sprint.”
The participants emphasized that their private investment offices have a disciplined, long-term investment approach by investing in high quality companies with low turnover, strong management teams and an ability to withstand down markets. High quality companies turn their operational strength into substantial free cash flow to support further growth and distributions to shareholders. Based on low returns today, families are making larger commitments and direct investments.
In addition, the family office representatives exchanged ideas on approaches to deal sourcing and how they are able to demonstrate their commitment to an “invest and hold” strategy in order to present a compelling offer to sellers of businesses. The participants also discussed the due diligence process, including the timing and the depth of the process. Many participants stressed the need to undertake comprehensive due diligence that includes but goes well beyond a financial and quality of earnings review but also includes a review of industry competition and markets as well as management competencies.
The growth of public benefit corporations creates both opportunity and challenges for private equity firms

Last week’s announcement that Danonewave, the newly merged entity of WhiteWave Foods and Danone's North American dairy business, has reincorporated to create the world’s largest public benefit corporation (“PBC”) is the latest sign of the growing mainstream acceptance of the PBC governance model in the United States. Over the past seven years, the number of U.S. companies organized under PBC laws have grown dramatically, and with it, the interest of private equity firms. PBCs are for-profit companies that are legally organized to achieve social goals as well as business ones. Some private equity investors see PBCs as a means to strengthen the long term stability and accountability of target companies, while others remain wary of this largely unproven corporate business model.

By law in all 50 States, the sole directive of directors and officers of traditional for-profit corporations is to maximize the shareholder’s financial returns. Therefore, all corporate actions must be justified in terms of creating shareholder value. In contrast, PBCs are designed to codify additional social stakeholders, values or missions in a company’s certificate of incorporation. In principle, the PBC model provides a company’s leadership with legal protection to consider the impact its business has on society – in addition to shareholders’ economic interests

Since the first PBC law was introduced in Maryland in 2010, a total of 30 states and the District of Columbia have enacted some form of PBC statute. Today, there are approximately 3,600 PBCs in the United States. Some of the largest and well known private PBCs include, Kickstarter, Ben & Jerry’s, Patagonia, Altschool, Seventh Generation and Warby Parker.

Proponents of PBCs can point to several factors that make the governance model attractive to private equity investors:

Sustainability: By moving away from a traditional shareholder-centric model, PBCs are arguably more likely to favor business strategies focused on long-term and sustainable value rather than riskier short-term gains that are prone to volatility. In turn, companies with strong sustainability practices will provide steady and reliable cash flows for investors.

Greater Transparency: PBC statutes include extensive reporting requirements to allow shareholders to track a company’s social mission performance. In addition, most state PBC statutes (with the notable exception of Delaware) require PBCs to publish periodic public reports. These reporting requirements giving investors access to more information that will allow them to assess the strength of a company’s management and its impact on stakeholders beyond just its shareholders.

PBCs Draw and Retain Talent. Fusing a social mission into a company’s corporate purpose can give PBCs a leg up in the war to draw and retain a talented workforce by attracting prospective employees who identify with a PBC’s social mission and by motivating existing employees. This may be particularly important in the recruiting and retention of millennials. A recent study by the marketing firm Fast Company found that 50% of millennials would take a pay cut to work for a company that matched their values.

However, PBCs are not without detractors in the private equity world. First, skeptics can point to the fact that there is essentially no empirical data demonstrating that PBCs create more responsible, or more profitable, businesses. Without proof that the governance model works, it is hard for some to see why adding a “second bottom-line,” is worth it when it is already hard enough for businesses to be successful. Likewise, given that that PBCs are less than a decade old, there is little understanding about how shareholder litigation stemming from a PBC board’s actions in light of inevitable conflicts between a PBC’s social mission and its shareholders’ pecuniary interests will be interpreted by the courts. The lack of PBC-specific case law means that the outcome of litigation between PBC stockholders and directors is less predictable than that of shareholder litigation against traditional corporations. For these reasons, many private equity firms are content to avoid PBCs for the time being.

Still, while there are both practical and legal issues associated with PBCs that have yet to be resolved, private equity investments in PBCs can be expected to continue grow into the foreseeable future. This past February, another significant milestone in the evolution of PBCs was reached when Laureate Education, the U.S.-based for-profit college chain, completed the first PBC IPO, raising $490 million for the company. As evidence of the success of the PBC model increases along with the number of PBCs incorporated in the U.S., the economy of scale, if nothing else, is sure to result in more private equity investments in PBCs.

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