Measured by institutional investor demand for exposure to them, European middle market buyout funds are enjoying something close to the best of times. In a number of recent cases, investor demand – even in these more capital-constrained and cautious times – has substantially outstripped the supply of available commitments in new funds raised by these firms. These positive outcomes, and the extent of investor demand, have sometimes surprised even fans of these firms.
As always in private equity circles, the terms require some definition. In this context, ‘middle market’ applies to country-specific or regionally focused funds ranging from €100m–1bn in size, completing transactions with values ranging from €25m–400m.
Several factors have contributed to the recent popularity of this sector among private equity investors:
o Most investors (especially US-based ones) sought first, over the last decade, to allocate capital to larger, normally pan-European, buyout firms – a natural step given that such firms typically had established track records, made the effort to market themselves to investors, and could absorb significant commitments. These investors, with relationships and sufficient exposure to bigger firms in place, are now turning their attention to the middle market and its players.
o In contrast to the auction-dominated, and financing-sensitive, larger market, the middle market for buyouts across Europe is perceived as a less competitive sector. Its firms are more dependent on long-standing personal relationships in generating deals, and medium-sized acquisitions can often be completed on terms reflecting imperfect markets.
o Middle market buyout firms, concentrating as they normally do on investments in established companies in understandable businesses, have benefited from investor aversion to unproven technologies, poorly executed start-up strategies and cash-burning companies after the dot-com bust. Put another way, a reliable record of two times capital gains and 20–25% internal rates of return over the long term – seen in 1999 as dull – now appeals to investors who experienced the promise, but not the delivery, of much higher returns at the late stage of the last bull market.
o With the passage of time, more and more European middle market buyout firms can demonstrate solid 10-year track records, ones established by teams matured by deal-making and investing experience through the cycles. These firms are usually now all the more credible as providers of capital on their home turf, as private equity has gained acceptance as a financing and exit alternative, and as the partners’ relationships with sources of deals have deepened with age and experience.

Limited exits
In the past, investors commonly resisted European middle market buyout exposure because of concerns about the limited diversity and availability of exit ‘routes’ for medium-sized companies. These concerns did have some basis – compared to the US, in Europe public markets for small to mid cap stocks were far more limited in size and scope, and IPOs of medium-sized companies, until the boom of 1998–99, did not occur at anything approaching the pace of NASDAQ new issues. Now, in the midst of a full-throated bear market, public market demand for previously saleable larger new issues has proven (at best) capricious. Meanwhile, even in an uncertain economic environment, many European middle market firms have managed to sell (profitably, and often for cash) portfolio companies attractive to consolidating trade buyers or to private equity firms adding on to bigger ‘platform’ assets they control.
o The euro has fundamentally been good news for European middle market buyout firms, at least in terms of international investor interest in them. Allocations are far easier to establish and to monitor in one currency, and a past source of incremental volatility in investment returns – currency movements over time – has diminished substantially. In both respects, southern European private equity markets, in particular, have been major beneficiaries of the euro. Not too long ago, Americans interested in Spanish exposure, for example, could only assess returns in a currency they understood after dividing the peseta by numbers as uneven as 149 (the average US dollar/peseta exchange rate in 1998). And, while it is still early days, the euro should encourage transparency in pricing and ease in transacting, thereby contributing to an increased pace of cross-border markets.
o Finally, and not least, middle market buyout firms are experiencing more popularity because more sources of institutional private equity capital either have increased their focus on their sector, or been established with investment mandates concentrated on it (particularly funds of funds, which – thanks to their defined strategies – face pressures to meet specified allocations within predetermined periods of time, leaving them less flexibility to invest opportunistically).
If, at a macro level, a major feature of the European middle market buyout scene is increased investor demand, at a micro one this can translate to oversubscribed funds, particularly those offered by the most desirable players.

Desirable qualities
Desirability is usually defined by a combination of the sponsoring firm’s track record, the quality of its investment team, its maturity and stability as an organisation, its intent broadly to go on doing what has worked well in the past (measured by geographic concentration, sector expertise, size of transactions, investment style or a mix of all these factors) and finally its self-discipline in raising only the capital necessary to finance its strategy for three or so years.
Investors are especially attracted to firms that resist the temptation to raise the capital they could, as opposed to the funds they need, at times when a surplus of demand would give them the latter option. Self-discipline of this sort keeps management company profits at tolerable levels. This normally means that the investing teams concentrate on long-term equity gains (often hard work to generate, but which benefit investors as well as themselves), rather than losing some drive as shorter-term income – salaries and bonuses (earned only by the team) – rises in line with the increased fee streams larger funds produce.
Yet, almost by definition, the firms that meet all, or most, of these standards have gratified investors, eager to continue supporting their successor funds, leaving little or no room for new entries on the limited partner list.

Building exposure
Given these market dynamics, how should an institutional investor proceed in building direct exposure (as opposed to via a fund of funds) to the best European middle market buyout funds?
Before considering details, investors should come to terms with two important considerations:
q First, they should start an investment programme concentrated on this sector only if committed for the long term and willing to devote resources to follow it properly. Gaining exposure takes time. Expertise is required to identify, track and evaluate the best firms and to know when to move decisively to obtain commitments to them.
q Second, they should construct a disciplined strategy, perhaps one divided by phases, as suggested below. Clearly the details of a particular investment strategy matter rather less than its definition of long-term goals, its assignment of appropriate resources and its consistency in implementation.
Thereafter, a multi-year approach to constructing a high-quality, diversified portfolio of European middle market buyout funds could involve the following phases.

Phase 1 – research
q Survey the market in each western European country with an established private equity culture and a reasonable set of local middle market buyout firms; identify the players to follow, either through informal means (industry journals, websites, conversations with intermediaries or investors) or formal engagement of consultants or specialist advisers.
q Be prepared to look out two to three years, estimating when the most desirable firms will return to the market to raise funds. Design a flexible capital allocation plan that allows the ability to under- or over-commit in a particular season, as justified by a shortage or an excess of attractive opportunities.
q Meet the investment teams at each firm. Be prepared to expend old-fashioned shoe leather calling on them fairly regularly. Establish a rapport, form impressions, observe behaviour and listen to deal histories as they are made, rather than when a settled story is polished for delivery at fund-raising time. This is a business driven by people – their talents as well as their egos.
q Determine key ‘sort’ criteria that will be used to construct a portfolio. At a macro level, will allocations broadly follow the size of each European economy, for instance, or the state of development of its private equity market? At a micro level, which of the characteristics sought in a firm to back for the long term dominate the rest – the past track record or a thoughtful future strategy, for example? Establish in advance the most important investment criteria and sort the universe of firms to identify those most suitable for a place in a long-term portfolio. This will help in moving rapidly to seize opportunities.

Phase 2 – implementation
q Form relationships with the firms at the top of the ‘wish list’ in phase 1. Treat them as partners, not adversaries, from the start. Most such firms resemble family businesses rather than faceless institutions. The quality and extent of personal interaction counts. Be prepared to market your own institution, after identifying the core qualities that make it a preferred investor. Typically, the general partners of small- to medium-sized firms are not particularly interested in ‘bells and whistles’ like co-investment programmes. Instead, they are primarily focused on doing deals. They are most attracted to investors with long-term access to capital themselves, as well as those that will support them in good times and bad, minimising the strain of fund-raising and demonstrating a long-term perspective and sound judgment when problems arise.
q Consider pre-negotiating a commitment to a forthcoming fund, even a year ahead of it coming to market. Complete due diligence well in advance (subject only to a material change in performance or the stability of the firm) in exchange for reasonable exposure, ideally protected from ‘scale-back’ in the event of over-subscription.
q While maintaining its integrity, ensure that your investment process concentrates on core issues. Recognise that managers of smaller firms often do not have the resources to cope with what they see as excessively invasive or detailed questions. A helpful gesture might be to fill in as much of your own questionnaire from already available materials before sending it to the firm. In particular, understand that manager selection is more art than science. There is a fashion among investors for highly quantitative, retrospective analysis requiring data (on criteria such as EBITDA multiples prevailing at various points during the time a former investment was held, not just at its entry and exit) that was not necessarily captured at the time, as investors did not then require it. Reconstructing such data places extra demands on the general partner, and the utility of the analysis – especially about exited investments where the end results are known – is limited. On the margin, a general partner with the luxury of an over-subscribed fund may choose investors using the quality versus the quantity of their questions as a key means of assessing them; in the process, they are often drawn to select more thoughtful and more focused investors as new backers.
q Think creatively of means to be deemed an existing investor (they are typically favoured by general partners), perhaps by a tactical purchase of even an insignificant secondary position in a prior fund when it arises. This kind of small step may be necessary, given the imbalance of demand for and supply of exposure to the best firms, a factor that leads directly to phase 3.

Phase 3 – compromise/
wider horizons
q If faced with disappointment, perhaps by being offered positions in funds that do not match a minimum portfolio allocation that makes economic and administrative sense, the solution may be compromise. This can take various forms. Become more general partner-friendly by dropping insistence on certain terms and conditions. Or invest in a number of players in one country, for example, that collectively provide desired levels of exposure, bearing the consequent extra costs of administering additional partnerships.
q Consider investing in first-time or spin-out funds established by experienced teams. Clearly there are special risks, particularly when a new team has not been tested collectively, and certainly the due diligence demands of ascertaining who was responsible for which deal at what firm in the past can be intensive. However, these funds – simply because they are beginning their corporate lives and do not yet have a loyal investor constituency – offer the opportunity for more substantial exposure. Also, their teams can be especially motivated to prove themselves as profitable investors, offering the prospect of exceptional returns over time.
q Evaluate the pan-European groups operating in the middle market that can accommodate larger commitments and should benefit, if their internal communications are well-managed and their team incentives properly structured, from the trend towards cross-border consolidation. In some instances, they can generate appropriate transactions from their internal networks, executing add-ons to their own portfolio companies with extra efficiency. Be willing to accept, in making commitments to these groups, that they will manage intra-European allocations to countries and deals themselves (rather than allowing the investor to do so via a portfolio of country-targeted funds), and also that there can be variations in the quality of the underlying country teams.
q Expand the definition of middle market equity exposure to include mezzanine transactions (which typically carry equity warrants), thereby including a variety of successful, established firms in Europe concentrating on this sector.
The substantial macro trends that are generating rising institutional investor demand for European middle market buyout funds show little prospect of diminishing, while the number of elite, established firms that invest these funds is not growing at a matching pace. Investors prepared to commit time and effort to a disciplined investment strategy, to be patient and to remain flexible in pursuit of their goals should be rewarded with both short- and long-term gains. In the nearer term, they will enjoy considerable intellectual stimulation in assessing markets and firms, and in developing effective strategies to obtain exposure to them. In the longer term, the combination of less perfect markets and talented, motivated professionals investing in them should produce highly desirable returns.
John Barber is a director of Helix Associates in London