April 2015

Distressed Middle Market Investing: Making Inroads in a Crowded Space

Executive Sounding Board Associates Director Michael Dervis says investors new to the middle market distressed segment should educate themselves on the challenges as well as unique opportunities inherent in this unique sector before taking the plunge.

Mike Dervis, Director, ESBA

Mike Dervis,

Investors are looking for more opportunities in 2015. They face intense competition, steep valuation-to-EBITDA multiples for investment targets, and pressure to deploy funds and generate adequate returns. All of these factors make it difficult to find attractive investment opportunities.

Investors have struggled to find bargains in recent years because large cap valuations have increased dramatically since the 2008 financial crisis. According to Ernst & Young’s Capital Confidence Barometer Report issued in December 2014, the 40.7% increase in value between 2013 and 2014 only saw a 5.1% increase in deal volume, with the value being driven by mega-deals. With an overabundance of capital chasing too few large cap deals, many investors have turned their attention to the larger middle market in hopes of identifying attractive new opportunities to deploy capital. Middle market growth rates have outpaced those of the large cap sector as well as the overall S&P 500, making the middle market sector attractive for investments. According to the National Center for the Middle Market, middle market businesses with revenue between $10 million and $1 billion reported strong 2014 performance with an average growth rate of 7.2% compared to an S&P 500 average growth rate of 4.9%. Middle market businesses are forecast to exceed 6% growth in 2015.

A Hot Segment

The middle market is a hot segment for investors of all sizes and types, from smaller private equity firms to vulture funds to bulge-bracket alternative investment firms. Firms like The Carlyle Group, The Blackstone Group and TPG Capital have moved down market to invest in middle market companies through their flagship funds, separate middle market funds or through BDCs. Smaller private equity firms, which were historically focused exclusively on the middle market, now face mega-competitors who are able to draw on significant resources when competing to win a deal.

Smart fund managers must continue to find ways to differentiate their firms by targeting middle market niches where they have specific expertise and/or can provide added value to achieve a sustainable advantage. In addition to investors chasing high-growth middle market companies, the number of investors focused on acquiring distressed middle market companies requiring financial restructurings and/or operational improvements has grown.

But before jumping into the distressed segment, new entrants should pause to better understand the challenges as well as the unique opportunities that are inherent to this sector.

Cost of Capital

There is still economic fallout today from the disastrous financial crisis. In response to the crisis and to protect consumers, the U.S. government passed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law in 2010. The Dodd-Frank Act mandated changes to bank underwriting guidelines to help improve the quality and performance of their loan portfolios. Since Dodd-Frank’s implementation, the commercial and industrial loan quarterly charge-off average rate has decreased to 0.21% at the end of 2014, down significantly from the quarterly average of 2.30% in 2009, according to Federal Reserve data. This was a positive outcome of the Dodd-Frank Act for banks.

However, the tightened underwriting guidelines resulting from the Dodd-Frank Act caused severe curtailing of credit availability to middle market borrowers with less-than-perfect credit profiles. Middle market borrowers, whether healthy or distressed, do not have access to the highly liquid bond markets as large cap companies do, and did not have the opportunity to lock into long-term inexpensive financing. Non-bank lenders stepped in to meet the needs of these middle market companies, albeit at much higher pricing. In a recent Bloomberg article on the shadow banking industry, journalist Sheridan Prasso estimated the size of the non-bank market at $75 trillion worldwide. Alternative asset managers charge between 8% and 20%, and some mezzanine debt providers require returns as high as 30%. The increase in the cost of capital has placed an even greater financial burden on these already challenged middle market companies.

Winning Opportunities

Business owners and management teams that lived through the tumultuous years during and following the crisis bear the scars of coping with the sudden loss of trusted banking relationships and the havoc it wreaked on their ongoing financial performance. Investors winning opportunities in the distressed middle market are the ones who: understand the mindset of these business owners and managers; can provide a reliable, stable source of capital; and are seen as being able to help sustain and build companies.

Private equity firms, which tend to invest long term and have the intent to buy, repair, grow and exit assets, will fare well in dealing with distressed middle market businesses. Unlike other investors with a short-term investment strategy, the private equity approach allows sufficient time to address capital structure, management weaknesses and fundamental business model issues necessary to realize a suitable return.

Lead Sources

Time is of the essence in dealing with distressed middle market companies. Investors with strong teams of professionals who have operational experience running distressed companies will have an edge in due diligence and deal negotiations and will be able to quickly stabilize a company and implement a turnaround plan following an acquisition or investment. Professionals need to move quickly to right size the balance sheet under the pressure of potential insolvency. If firms do not have internal resources with these skills, they should look to external restructuring professionals for assistance.

Investors should build a network of financial advisors, lenders, accountants, attorneys and other restructuring providers that can be called upon on a moment’s notice. For instance, investors should have access to financial advisors that can provide complex valuation services when the value of a company or asset is contested by a seller or other stakeholder. The financial advisory firm should also have interim management services that can be aligned with the interest of the investor until a permanent team can be put in place, or can assist in the development of a turnaround or integration plan to maximize the return on an investment.

The number of Chapter 11 bankruptcy filings decreased 55.5% between 2009 and 2014, and this trend is expected to continue in the near future. Out-of-court restructurings and prepackaged bankruptcies have become the norm. Due to the high costs of reorganization and bankruptcy, many debtors are developing an exit strategy and identifying investors before entering court to minimize costs and preserve the value of the estate. Restructuring experts are good lead sources, as they are likely aware of opportunities in the marketplace that are a fit for an investor and can provide valued introductions.

Sectors in Turmoil

There will continue to be opportunities with distressed middle market companies for investors in 2015. Baby Boomers looking to retire will likely take advantage of heightened investor interest and higher deal multiples, and sell underperforming or non-performing businesses.

A rise in interest rates, which have hovered near zero since 2008, will likely affect businesses that have borrowed money at floating interest rates. The Federal Reserve is expected to start raising rates in mid-2015 but must move cautiously. If the Fed’s upward adjustments are deemed as too aggressive, then the U.S. economy could be pushed into another recession. But if it does not move quickly enough to raise rates, then a surge in inflation could result.

Investors need to look for pockets of opportunity in industry sectors such as consumer products, retail, healthcare and energy, which are poised for turmoil in 2015. Additionally, businesses in energy producing communities in Texas, Louisiana, Oklahoma, Alaska and North Dakota will likely experience a ripple effect from the decline and ongoing volatility in oil prices. Across industry sectors, companies are expected to continue divesting underperforming or non-core business units or assets while pursuing acquisitions in order to fill any gaps.

Poised for Action

Distressed investors need to understand causes of liquidity events. Generally, financial distress occurs when a company experiences a lack of liquidity to retire its contractual obligation. Any number of situations can trigger a liquidity event, including cyclical downturns, negative secular industry trends, managerial competency weaknesses, credit market illiquidity and the ever-feared black swan event. Investors in the distressed middle market space need to be able to quickly recognize these liquidity events and know how to adeptly navigate through them.

As more investors enter the distressed middle market space searching for opportunities, increased competition levels will drive higher valuation-to- EBITDA multiples and lower returns. Some investors will be forced from the market, as they will be unable to compete. Those able to differentiate themselves; effectively communicate their value; and have the capabilities, expertise and relationships to quickly identify and capitalize on opportunities will be the most successful.

Michael Dervis is a director with Executive Sounding Board Associates. He concentrates on the operational and financial management of distressed companies with a focus on secured and unsecured creditor relations, recapitalizations, cash management, financial modeling, identifying operational efficiencies, refinancing, and strategic planning with executive management.