The Myth of the Underfinanced Lower Middle Market

Over the last year there has been a consistent theme communicated by the larger private equity and alternative investment funds: there is a significant under exploited opportunity to invest in smaller companies. Pursuing a more attractively priced market seems like a perfect solution when facing tepid deal flow and a highly competitive market where substantial capital has been raised.  However, these funds do not appreciate the fact that this price differential exists for a reason.  Investing in smaller companies entails a unique set of risks and this segment is already highly efficient.

The lower middle market has lower acquisition multiples and more expensive financing, but it is more risky for a myriad of reasons.  Smaller companies often find themselves with significant customer or supplier concentration, do not have robust accounting systems, rely heavily on one or two key individuals, have limited ability to invest to maintain their competitive advantage, and don’t have the benefits of economies of scale.  Additionally, one cancelled order or the bankruptcy of a key customer can have a draconian impact on the company.

In my opinion the most significant characteristic of the lower middle market the mega funds are underappreciating is the competition.  It is one of the most efficient markets in the world, despite common anecdotal assertions to the contrary.  There are thousands of lenders serving this sector including banks, second lien lenders, unitranche providers, mezzanine funds, sale/leaseback firms, and other specialty finance companies.  Countless private equity firms and strategic acquirers are actively seeking to buy smaller businesses.  The SBA’s (Small Business Administration, a federal agency) SBIC program has become a massively popular structure and offers a plethora of financing options to creditworthy companies.  It provides heavily subsidized long term financing to specialty and mezzanine lenders that target the lower middle market.  Today there are 300 SBIC's managing $17 billion. 

I view this trend of larger funds turning to smaller company investments as an impulse response to difficult market conditions.  Ironically, Catalus is currently facing the same challenge.  Given the flexibility in our fund mandate we've decided to pursue larger and more creative deal structures, keeping in mind, of course, the grass is always greener…

Passion

Marek's 2012 Review and 2013 Outlook Interview

I was recently intereviewed by AxialMarket for their 2012 Review and 2013 Outlook Report.  You can read the interview below and get the report here.

Tell me a little about yourself and Catalus.

“Catalus is an industry agnostic lending fund that invests throughout the capital structure, including mezzanine, second lien, and subordinated debt. We also offer ‘special situation’ senior debt, which includes alternative opportunities -- unique geographies, business models, industries, or just atypical circumstances. We typically write checks of $5 to $25 million and invest in the US, Canada, the Caribbean, and Europe.”

How did 2012 go for Catalus?

“Depending on how you look at it 2012 was both a great year and a difficult one. From a returns perspective, we're happy with our performance. We are making solid risk adjusted returns for our investors and are very happy with our current portfolio of businesses.”

“From the new capital invested perspective, 2012 has been more difficult. While we did make a few investments, it was fewer in number and smaller in size than desired. Since we are a lender, this was a result of interest rates continuing to compress and the increased flow of capital into debt markets. Debt has been performing well -- it is a very competitive environment.”

“Interest rates have continued to come down throughout the year. While this is good for borrowers, it is bad for lenders. The lowering of rates has gone against the lending community.”

How will interest rates change in 2013?

“It’s hard to say what will happen to interest rates in 2013, but the consensus is that the rates will stay low throughout the year. I still have the hope that the economy will improve and rates will start to rise, helping to normalize credit conditions.”

How did it go for the entire industry?

“M&A was pretty weak in 2012. There were a few glimpses of some larger transactions, but there was no sustained, frequent M&A activity.”

“On the other hand, the high yield credit markets were robust. But this poses a challenge -- how can credit be robust if there are no acquisitions? The answer is dividend recaps, refinancings, and a little M&A. You have this interesting dynamic of a very robust, almost record breaking credit market with an underwhelming M&A environment.”

“Interestingly, the amount of equity going into LBOs is definitely on the rise. PE firms are using less debt and relying on senior debt or unitranche facilities and less mezz or subordinated debt. In order to get that type of capital structure, the firms are relying heavily on high-yield and loan markets.”

Valuations to rise?

“The most recent data seems to suggest that valuations will actually come down in 2013. That could be a result of the uncertainty in economy and regulatory environment -- if you buy a business, you have to price in that risk.”

“In much larger transactions multiples remain high, but as you get into lower-middle market, the multiples are pretty reasonable -- we see a fair amount of deals 5x-7x EBITDA.”

How are you thinking about 2013?

“I don’t see 2013 as a big turning point for activity. However, I do think January will be very busy. After a significant holiday -- like the one this year -- there tends to be a spike in new activity. I think people will return in January to find many new deals and will be quick to jump on them.”

“I am less concerned by the uncertainty than others.  I believe that there will be some clarity in early 2013 -- the two parties cannot continue going back and forth for six months. Once some agreement is made, either positive or negative, activity will continue.”

What do you mean by positive and negative?

“A positive outcome, given the current situation of anemic growth, growing taxes, and high spending, would be the two parties meeting somewhere in the middle.”

“A negative outcome would be if the current stalemate continued and the immediate cuts came into play. The cuts would create a huge drag on the economy. Although, it could create some opportunities for people like us who are willing to look at distressed deals and be opportunistic.”

How will Europe fit into the equation?

“Europe is particularly interesting because there are fits and starts of panic. I think 2013 will see some repeat of the panic of 2012. It was like when Bear Stearns went down -- there was a quiet for six months and then Lehman went down.”

“While there hasn't been any real solution to the European problem, I believe Europe will make its way out of the current crisis. Their dedication to stick with the Euro has helped spur some markets and in 5 or 10 years, recovery will be evident.  They may lose a country or two out of the Euro in the process, but it will likely recover.”

How will Europe impact the US?

“Since we are such significant trading partners, there is definitely an impact, but it all depends on how problematic the situation becomes. There are several countries in recession now. If that spreads to other countries or worsens, it could have a significant impact on the US.”

“We have some industries that have are particularly strong in the US -- like energy and technology. The growth in those areas can help offset some of the pain that we feel from Europe.”

Why tech?

“The US has demonstrated global technology leadership for some time now. There are so many innovative companies just beneath the surface that will likely become immense successes. While not all are success -- i.e. Groupon -- there is undeniable innovation. Technology in the United States is almost perennially a bright spot.”

Anything else I should ask you?

“In any environment, it is an investors job to find opportunity. Whether there is a recession, a bubble, rapid growth, or a stable economy, it is our responsibility to find places where we can invest safely and generate strong risk-adjusted returns for our investors.”

“Our sweet spot is our ability to find unique opportunities that are either overlooked or avoided by the broader market.”

Catalus Capital Closes Four Investments in 2012 and Seeks New Opportunities

Catalus Capital is pleased to announce that the fund made four investments during the course of 2012 and continues to be active in the market. "We're enthusiastic about the companies that we invested in during the last year and about the partners that we are working with," commented Marek Olszewski, the firm's Managing Partner, "we have significant additional capital to deploy in 2013." Catalus benefits from a highly flexible fund mandate that allows it to be an effective alternative financing source.

We're Hiring!

Catalus is growing and we are seeking to add to our investment team. We would love to hear from you if you meet the profile below.

Private investment firm seeking Associate or Analyst to help support investment evaluation, deal sourcing, and other related tasks. The position reports directly to the head of the firm. Responsibilities include analyzing, summarizing, and presenting investment opportunities as well as assisting in deal sourcing, due diligence, and activities related to managing the firm. Experience in private equity, investment banking, bond/loan research, distressed investing, other investment research, or mezzanine/structured lending is required. An ability to work diligently in an unstructured/entrepreneurial environment is essential. The position will allow for significant responsibility in the deal evaluation and investment process. This is an opportunity to get in at the ground level of a growing fund with significant expansion potential.

· 1-4 years of experience evaluating leveraged buyout, growth capital and/or debt financing transactions.
· Ability to quickly and effectively evaluate, summarize and present investment opportunities, often with little direction or oversight.
· Strong analytical skills to evaluate businesses, market opportunities, industries, etc.
· Strong communication skills and keen attention to detail. Applicant will be required to draft investment memoranda, present ideas to the fund’s investment team and interact directly with senior management of potential investments as well as investment bankers and advisors.
· Strong modeling / deal structuring skills. Applicant will be required to evaluate multiple potential investment structures for each potential opportunity.
· Ability to work in a flexible and entrepreneurial environment.

Candidates can submit their resumes to marek@cataluscapital.com.

Europe, Take Three

Last month I went to Europe to meet our local contacts, build deal flow, and establish some new relationships.  I wasn't quite sure what to expect, but came back with some valuable insight.

Bank lending is very difficult to secure (even in the UK and smaller German deals), in business meetings the crisis is talked about constantly, and there is tremendous lack of faith in the governments to get the Continent on sound footing.  As opposed to a large hunger for capital, deal activity has essentially frozen.  Investment funds, and to a lesser extent strategic buyers, are waiting for some uncertainty to be resolved before deploying capital.

I was actually born in Europe (Poland) and have traveled there extensively.  The culture is quite a bit different, which holds true in business as well.  While the people I met with were appreciative of my visit, personal relationships hold more weight than in the US and local capital providers are inherently preferred.  I can appreciate this knowing execution risk is naturally higher with a foreign investor.  I also learned there are only a few hundred private equity firms focused on developed Europe, versus thousands in the US.  There are even less mezzanine and specialty lending funds.  European business owners are not as familiar or comfortable with the concept of subordinated debt that is more expensive than senior but cheaper than pure equity.

I recognize the turmoil abroad, but see the flight of capital as potential opportunity for Catalus.  We're excited to continue pursuing deals in Europe as well as the US, Canada, and the Caribbean.  We encourage you to reach out with any transactions fitting our investment profile.

EV/EBITDA versus PE

An excited hedge fund trader recently emailed me about a “cheap stock” trading at a significantly lower PE ratio (price to earnings) than its competitors.  The Wall Street analysts were recommending it based on valuation and he was a fan of the industry to boot.

It seemed interesting so I looked into it.  Unfortunately, I found another example of oversimplification of valuation leading to erroneous conclusions.  PE is the market value of the company's equity divided by its net income.  It excludes any debt the company has and includes all of the vagaries of net income (as opposed to cash flow).  For every dollar of equity market capitalization this company had there were seven of debt.  Debt included, it turned out to be one of the most expensive stocks in its industry – something Wall Street research had somehow overlooked.

It seems like stock analysts and popular media focus on PE while the bond/debt markets use EV/EBITDA.  I would love to understand why Wall Street leans so much on PE when I’ve found it close to irrelevant in real fundamental analysis (seriously, if you know why or have any ideas, please email me).

There is no one catch-all metric to look at when investing.  One of several I use is EV/EBITDA (EV = enterprise value = equity market cap + debt - cash), (EBITDA = earnings before interest, taxes, depreciation and amortization).  The most important indicator of long-term corporate value is cash flow.  EBITDA is one proxy for cash flow, operating cash flow is another, but neither are perfect.  You also have to look at CAPEX (capital expenditures), working capital requirements, and other impacts.  EBITDA tries to zero in on the health of the underlying cash flow of the business and eliminate irrelevant 'noise' or accounting gimmicks.  Interest is removed because it is the result of how management has decided to capitalize the business and the interest rate environment (if you're using EV it’s not as relevant to the health of the operating business).  Taxes are a consequence of the jurisdiction, any one time tax breaks, and other factors that can be distorted in the short term.  Depreciation and amortization are not cash items and can be the result of a number of factors unimportant to the underlying business (for example, high amortization of intangible after an acquisition).

I’ll leave you with one example.  Take a company that has a market cap of $100, a debt of $1,000, and generates $50 of net income.  Sure, your PE is 2, but this company will likely file for bankruptcy and the equity will be wiped out.  While most cases are not as obvious, just remember when you're buying a stock you're buying both the equity and assuming the debt liabilities, aka EV.