Finding deals for private equity in small-cap companies isn't a problem, but finding great deals and growing them takes a combination of mass marketing, detective work, and hands-on operating savvy.
Panelists looked at the small-cap private equity business at the 10th Annual 2004 Venture Capital & Private Equity Conference, held at Harvard Business School on February 7.
Panelists acknowledged risks in the small-cap space can be higher, but returns are often greater. They also said the sheer number of firms available looking for investors or buyers means that competition for them is often low, preventing auction-type situations that would result in higher prices.
Panelists represented funds in various stages of their life cycles:
- Mark Sullivan founded Lineage Capital as it was spun out of Heritage Partners last April. The fund is a quarter of the way through raising $250 million for small-cap deals.
- The Riverside Co., represented by managing partner Robert Fitzsimmons, has just finished raising its fourth fund at $750 million.
- Winston Partners, represented by Douglas H. Gilbert, has been around for ten years and has $140 million under management along with an $800 million hedge fund business.
- Robert Michalik (HBS MBA '95) founded Kinderhook capital with a former classmate a couple years ago and the company has $100 million invested and $100 million from the Small Business Administration to use as leverage in leveraged buyout situations.
The groups search for companies with $3 to $10 million in EBITDA (earnings before interest, taxes, depreciation, and amortization), with Winston Partners aiming at slightly smaller companies with $8 to $10 million in EBITDA.
| We're very focused on growth, which is much easer to do in the small and middle market than it is with a bigger-sized company. |
| — Robert Fitzsimmons, The Riverside Co. |
"We're very focused on growth, which is much easer to do in the small and middle market than it is with a bigger-sized company," Fitzsimmons said. He said his group ideally likes to do deals with companies that dominate some tiny niche in a market, with $5 to $7 million EBITDA. Then through growth and other acquisitions, perhaps, it tries to drive EBITDA to $15 or $20 million before exiting.
Dynamics of a deal
Fitzsimmons described one deal Riverside did that illustrated the dynamics of small-cap private investing. The fund bought a Canadian company called UniPac in 1996. The company was the number two player in the market for tamper-resistant closure liners, the foil and plastic covers that stretch across plastic over-the-counter medicine bottles.
Fitzsimmons said the fund got a good price in part because the sale didn't attract much attention. It purchased the company for $10 million, five times EBITDA. And UniPac was growing 20 percent a year.
Riverside brought in the head of the third biggest player in the market, and then purchased the division he ran from 3M, for $4 million. Fitzsimmons said his fund invested $14 million to buy a total of $5 million of EBITDA, grew the combined businesses to $8.5 million, and sold it for $67.5 million.
"And that's why we like the small end of the middle market," he said. "There's just all sorts of inefficiencies and multiple arbitrage opportunities."
The panelists agreed that the small- to mid-cap market inevitably requires more hands-on operational intervention by equity groups. Sullivan said he once had to step in when a CEO died three months after his fund had invested. He found himself cutting 20 percent of the workforce and closing plants.
Fitzsimmons said his group, at $1.3 billion in assets under management, is large enough to have hired three operations officers "who can parachute in" when a portfolio company is in need of operational leadership. The group has had to make micro-level decisions on employee health plans and information management systems.
"Personally I've not had to step in and run a company, but I've had to make the decision if a CEO stays or goes," he said. "It's much more hands-on than a bigger deal."
| What you need to do is source from anywhere and everywhere. |
| — Douglas H. Gilbert, Winston Partners |
Michalik, who spent seven years at Thayer Capital, a $1.2 billion equity fund, said the difference between large-cap and small-cap funds is that, "they do financial transactions, we do business transactions, and I think it's a fundamental difference in terms of personalities and skill sets to be in the small to middle market."
"When you're in the small middle market, you've got to massage egos, work with family transition planning, [demands] Lineage is very much in tune with," he said. "The hard part of the transaction often is working with the people, finding a way to create value, and making everyone feel good about how they're handling their business."
The deal finders
Sourcing is significantly different from the big-cap world, too. Separating the good deals from the bad takes more than financial analysis.
"What you need to do is source from anywhere and everywhere," said Gilbert. "At Winston, everyone's a sourcer, including on the hedge fund side."
Winston hits its investors up for ideas and picks the brains of managers who work with them.
Fitzsimmons said his fund employs four full-time deal-sourcing professionals who keep in touch with a database of 5,000 brokers. "It is in a way a volume business. You need to see 200 deals to get 40 visits to get 20 bids and win 2 deals," he said.
"What's so amazing is you're not bumping into each other," said Michalik. "There's not that many people who want to be in the $3 million to $5 million EBITDA market." 