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Three Trends in Middle Market Private Equity Harbor View Advisors The New Reality for the Middle Market With persistently low interest rates and public equity market indices hitting record highs, investors have increasingly turned to private equity funds in their search for returns. In this low-return environment, private equity funds have enjoyed unprecedented fundraising success, accelerating the decades-long surge in private equity assets and new fund formation. The post-recession environment, with its surging private equity assets and accommodative credit markets, has intensified the trends. With so much capital in the market, financial buyers and strategic acquirers compete in rapid-fire auctions, driving valuation multiples higher. The current environment has also encouraged growth in new fund formation. With the proliferation of first funds, the median fund size fell to historic lows in 2015. Global private equity assets have grown dramatically, increasing from $30 billion to $4 trillion in the last 20 years. By year-end 2015, uninvested dry powder in private equity portfolios stood at a record $1.3 trillion. The Declining Median Fund Size The Proliferation of Global Dry Powder Source: Preqin 2015: MORE SMALL FUNDS In 2015, approximately 35% of funds raised were below $100 million, compared to fewer than 25% in 2006. $1.3 TRILLION IN 2015 The new record in uninvested dry powder within global private equity portfolios. The round of mega-funds raising their latest buyout vehicles in 2016 tempered the fall of median fund size, but it is clear that middle market managers must contend with a crowded market with ample players looking to put capital to work. As private equity markets have grown and matured, the market for private assets has become more efficient. In this competitive environment, private equity firms face a greater challenge to generate investment returns. According to Professor Steven Kaplan at the University of Chicago, average IRR fell from 22.4% in the 1980s to just 16% in the 2000s, with realized multiples of invested capital dropping from 3.7x to 1.7x. Operating budgets of smaller funds require managers to face the competitive environment armed with lean teams. The teams must source, close and manage investments, while fundraising and maintaining relationships with investors. They face a challenging paradox: Gone are the days when returns could be generated primarily through deal sourcing. Today's private equity investors must complement effective deal sourcing with post-transaction strategic and operational improvements in order to meet return expectations. How do investors drive returns through strategy, execution and operational improvements with a leaner team, amongst a widening competitive field? On the following pages, we explore three trends that firms are implementing in response. 1 Three Trends in Middle Market Private Equity 01. The Rise of the Specialist Newly founded, smaller funds and established firms wishing to gain an edge are gravitating towards industry specializations. Industry focus can also differentiate an investment brand in a crowded market and establish the firm as the buyer of choice. Often, the industries where firms choose to specialize are a product of the founding principals' backgrounds as former operators or deal professionals in the space. In a widening competitive field with expanding valuation multiples, sellers receive compelling offers from a range of financial buyers. Sellers increasingly favor a buyer who brings more than just capital to the table. A buyer's industry expertise and track record of success are important factors to a founder who plans to retain an ownership position post-transaction. By choosing an industry that principals know and are known in, they are able to leverage their experience and network in sourcing and screening transactions. 02. The Age of the Operating Partner In a market that rewards specialization and demands efficiency, firms are increasingly leveraging operating partners to build value within their portfolio companies. Still, other firms have adopted an executive-inresidence model, where they specifically search for an opportunity to place the executive in a permanent leadership role. Operating partners are typically proven business leaders who play active roles through the lifetime of a given investment, either as board members or operators. With operating partners in the mix, firms can jump start their expertise in a specific industry. Leveraging operating partners also allows fund managers and deal professionals to focus on sourcing and closing new investments in portfolio companies and strategic add-on opportunities. Some firms opt to bring operating partners in as fulltime members of the team, while other firms utilize experienced executives as external advisors. 2 Harbor View Advisors 03. The Ascent of Outsourced Consultants Private equity firms are more frequently engaging outsourced functional consultants when sourcing and evaluating prospective investments and managing current portfolio companies. Consulting during due diligence may include: • Product comparison studies • Industry evaluations and outlook Before making an offer, private equity firms engage outside consultants to assist in evaluating investments. During due diligence, firms bring in consultants once the deal team completes initial analysis and determines that the investment is compelling. • Technology assessments • Accounting, tax and quality of earnings reports • Customer satisfaction analyses More and more, as competition intensifies and sellers can dictate strict process deadlines, firms are required to bring on consultants in earlier stages, often before exclusivity is granted and in heated auctions, prior to LOI submission. Consulting post transaction close may include: Post transaction close, firms bring in consultants at different stages to evaluate, recommend and implement strategies for growth. • Market mapping • Technology roadmaps • Pricing analyses • Supply chain optimization • Exit readiness assessments Conclusion Private equity firms have risen to the challenge of competing in today's complex deal environment where they are required to do more with less. Harbor View Advisors provides outsourced services to private equity firms ranging from market studies, market readiness assessments, add-on acquisition sourcing and transaction execution services. Establishing industry specializations, leveraging operating partners and engaging outsourced consultants have emerged as three trends in response to this competitive and challenging environment. To learn more about Harbor View's consulting, corporate development and investment banking services, visit www.harborviewadvisors.com. We expect firms to continue to employ creative solutions as they work to source and close investments and build value within their portfolios. 3 Harbor View Advisors, LLC 822 A1A North, Suite 200 || Ponte Vedra, FL 32082 || P: 904.285.4278 harborviewadvisors.com