Big buyout firms are returning to middle market

Carlyle Group executives are investing in the private equity middle market as a way to take advantage of what they say is a credit bubble, and the giant firm has lots of company.

While investors appear to be on board with this shift in focus, some observers warn that the flood of new money will drown investment opportunities and, therefore, returns.

Carlyle is investing the last of the $1.1 billion fund it raised two years ago to invest in the middle market. Using cheap debt, Carlyle executives are expanding the portfolio companies by acquisition. An example is Service King Collision Repair Centers, a chain of car-repair shops in Texas that it bought two years ago, expanded nationally and sold in July to Blackstone Group.

Carlyle's investment roots are in the middle market, but it was raising such huge sums that it had to invest in larger deals. Firm executives realized middle-market deals “were falling through the cracks,” said Brooke B. Coburn, managing director and co-head of Carlyle Growth Partners and Carlyle Equity Opportunity Fund, the firm's domestic smaller and middle-market buyout businesses, respectively.

Carlyle is not the only bulge-bracket alternative investment firm to invest in the middle market, usually the territory of smaller private equity firms. The Blackstone Group LP and TPG do, too.

Blackstone Group invests in the middle market through its flagship private equity fund, the $16 billion Blackstone Capital Partners VI LP. The firm does not have a separate middle-market fund, said Peter Rose, spokesman.

“We will invest in middle-market companies if we see growth opportunities and/or opportunities to otherwise transform the company,” Mr. Rose said in an e-mailed response to questions.

TPG invests in the middle market through a separate fund, the $2 billion TPG Growth Fund II LP. Last year, TPG's middle market business joined with Google Ventures to invest $285 million in Uber Technologies Inc., San Francisco, which makes a car service mobile application.

The middle market is a “massive market that can benefit from our industry expertise and global network,” Carlyle's Mr. Coburn said.

It might not be Carlyle's largest business, but it is an important one, he noted. William E. Conway, Jr., co-founder, co-chief executive officer and managing director of The Carlyle Group, chairs the investment committee for the middle market fund, Mr. Coburn said.

This and the $100 million of Carlyle Group money invested in the Equity Opportunity Fund, signals the firm's commitment to the business, Mr. Coburn said.

Still, the extent of the larger firms' middle-market activities is difficult to measure. A few firms such as Carlyle and TPG have dedicated private equity middle-market funds, but most incorporate the deals into their flagship funds.

So far this year, 20 middle-market funds have closed on a combined $16.2 billion, while all buyout funds raised a total $97 billion as of July 1, according to Preqin, a London-based alterative investment research firm.

But this figure might be just scratching the surface of the capital seeking to invest in the middle market.

There is no way of knowing how much capital large and megafund managers have put aside for middle-market deals because most will be doing these deals from their large funds, Nicholas Jelfs, senior analyst and press officer at Preqin, said in an e-mail.

“Although it certainly seems like something that has been growing in prominence, it is unfortunately very difficult to measure,” Mr. Jelfs said.

Investors might not know whether the large firms' flagship funds will be investing in mega, large or midmarket deals because of the wide discretion given to the manager in the fund documents.

”It's hard to specify where investments will be made for a blind pool,” said David Fann, president and CEO of San Diego-based private equity consulting firm TorreyCove Capital Partners LLC. “However, current (limited partner) expectation is for fewer mega and large deals. In part, this is dictated by the current financing market — the current upper-end threshold of buyout deals is $5 billion to $6 billion.”

Carlyle acquired Service King in 2012 using capital from its $1.1 billion middle market fund, Carlyle Equity Opportunity Fund, and $700 million Carlyle Strategic Partners Fund III LP fund, which invests in financially distressed companies.

Bulge-bracket alternative investment firms are expected to continue investing in the middle market and raising new funds targeting the middle market because for most of them, that market is where they reaped their greatest successes, Mr. Fann said.

“Groups are going back to their roots and renewing their focus to the middle market,” he explained.

The investment rationale for investing in middle market deals is that there is a larger universe of investible companies, there is relative inefficiency in how these companies are bought and sold, and there is more opportunity for growth, he said.

For investors, however, returns among middle market funds vary greatly.

“In general, investor return dispersions have been much wider in middle market private equity — so, the investor-return differential for a top quartile vs. a median (performing fund) is much wider in middle-market buyouts than in the large/megabuyout segment,” Mr. Fann said. “It's always about manager selection.”

Even so, investors have been favoring the middle market, where they see more opportunity for returns than in the larger end of the private equity market.

William R. Atwood, executive director of the Illinois State Board of Investment, said the board is moving its private equity portfolio toward the middle market. The Chicago-based board oversees $14.8 billion in defined benefit plan assets.

That shift is driven by the notion that there is greater upside potential in the middle market relative to the large market, he said.

However, there is a lot of money flowing into the middle market, including a growing amount of capital from the mega firms. For example, TPG's last middle-market fund raised $2 billion. That fund makes equity investments of $100 million or less.

“For middle-market transactions of $250 (million to) $300 million in health-care services, we do see larger market players competing for that transaction given the scarcity value of quality health-care services businesses and a very fragmented local provider universe,” said David Alpern, partner of Los Angeles and Stamford, Conn.-based middle-market private equity firm Varsity Healthcare Partners.

Private equity is awash in capital and cheap debt, which does not bode well for returns across all market segments.

“Are there higher prices and lower returns? ... It's a very competitive environment. Leverage and equity are plentiful,” said Greg Long, director at San Francisco-based middle market private equity firm Friedman Fleischer & Lowe LLC. “There's been higher transaction values than what we've seen (before).”

Rich Lawson, CEO and managing partner of Palo Alto, Calif.-based middle market private equity HGGC LLC, said the capital flowing from the megafirms and what he calls emerging megafirms are helping to drive purchase prices to record highs.

“Leverage multiples are as high as they were in 2007 and 2008 ... and there's a tremendous overhang of capital,” Mr. Lawson said. ”It has driven purchase multiples to record highs as well.”

Overall, 2014 is on track to be the best year for private equity fundraising since the Great Recession, said TorreyCove's Mr. Fann.

“What is worrisome is that historically, there was an inverse correlation between fundraising success and overall investor returns,” Mr. Fann said.