STAN JOHNSON: You’ve been with Veronis Suhler Stevenson since 1982. How did you get started, and how has the company developed its current focus?
JEFFREY STEVENSON: We actually started as a specialized M&A advisory firm, focusing on media companies, which back then was primarily publishing, broadcasting and cable. We branched out into private equity in 1987, when we launched our first fund, a $57 million fund. Since then we’ve had four buyout funds and we got into the mezzanine business when we launched our first mezzanine fund in 2005. I think one of the interesting aspects of our history is that we’ve always been specialized. We were specialized before specialization was a trend. And I think that’s increasingly important in today’s and also tomorrow’s environment, as private equity becomes more and more competitive and you have to figure out ways to add value and differentiate yourself. In working with our portfolio companies, it’s more of a hands-on strategic approach than it is purely financial.
VSS focuses on the information, education, media, and business and marketing services industries. What trends have you seen in these areas in the last 12 months?
In media, we’ve seen an amazing fragmentation in terms of the industries. We’ve seen the obvious shift from print to digital. We’ve seen cyclicality in the advertising components of the business, and we’ve seen the secular changes in terms of the migration from print to digital. We’ve also seen the fragmentation of these industries. They’re not the monolithic industries that we started with over 20 years ago —the television, radio and magazine business. Now the lines are blurred. It’s part technology, part content and part delivery. There are lots of different types of businesses and different business models along that continuum.
We have found that the understanding of those business models is much different than it used to be. Understanding the challenges, the risks and the prospects requires a much deeper dive into the industries that they cover. You need to understand the changes that are going on and what’s happening with their customer base. It’s more complex today than it used to be. I think this also goes to the issue of specialization, having a better understanding of these businesses and what to do with the business once you’ve made the investment. How do you value it? And where do you add value over the holding period of five years or so?
You recently acquired System One Holdings. What was attractive about that investment? How do you plan to add value there?
System One is a leader in technical outsourcing and careers, focused primarily on the energy sector. This platform acquisition is a good example for the type of companies we typically invest in. Characteristically they have higher renewal rates, good growth prospects, high conversion of EBITDA to cash flow, and a business that serves fragmented industries where there’s a roll-up of opportunity. In addition to these characteristics, we like System One because of the management team. We feel that they’re an excellent management team to pursue a roll-up strategy. We see them as dominant in their marketplace. System One is focused on being in the power generation outsourcing business, and we think the management team has got a lot of talent to be able to expand into other high-growth potential industries.
What level of due diligence do you apply to new investments like System One? Have your practices changed at all since 2008?
We focus on many of the same things, but because some of the businesses in emerging media segments have different profiles than past VSS investments, a close look at the business model and the industry is even more important than it used to be. Still, a lot of the due diligence is fundamentally the same, and there is a focus on the strengths and weaknesses of the management team. One of the things that we do differently now is we bring in a third party to help assess the management team. We found it interesting that many firms bring in third parties to do accounting, legal work, IT or consulting, but few private equity firms bring in third parties to help with the assessment of management teams.
Understanding the add-on acquisition opportunities and customer concentration is something we’ve always done. Although we have acquired businesses in related industry segments, this is our first investment in the staffing industry, so there’s a lot more due diligence that’s done as it relates to that particular industry. And since their end market is power generation, we will obviously do a lot more due diligence on that industry as well. We ask: What are the trends? Where are the players? Who are the potential customers? What customers have they lost? This is what we look at for any industry that we’re getting into, when you have a business that is a service provider of that industry. Another example would be the Business Information segment, which follows the trends of the underlying served market more so than it follows the trends of the information services businesses. So if its information services for healthcare, it’s going to follow that market. If its information services for the financial industry, it’s going to follow that market.
Sometimes the quality of the EBITDA, after you’ve done your due diligence, is not quite what was presented by the sell-side broker. It results in deals getting re-priced, which, if done successfully, means the deals can close, but if they can’t be re-priced, then the deals abort. Do you see this kind of re-pricing dynamic happening in your market?
Definitely. It seems that the vast majority of deals are getting re-priced. I think that’s because of the uncertainty in the macro environment. More deals that go to market end up not closing, end up being failed transactions. A lot of the bidding that goes on ends up being relatively high initial bids with more scrutiny down the road as the due diligence gets completed. So the initial bidding tends to not necessarily be indicative of where the process is going to end up.
Has the middle market fared better in the current economic climate because it’s less dependent on the capital markets?
The middle market has a number of advantages. If you look at the middle market over a long period, it’s been much more consistent than larger-cap transactions, which end up having a higher level of volatility because of the capital markets. What you find is that there tends to be a very high correlation between purchased price multiples and lending multiples. And in the capital markets, because you have the advantage of liquidity, we’ve seen up until 2007 a substantial increase in leverage. With the increase in leverage has come a huge increase in purchase price multiple. So over the 10 years ending 2007, purchase price multiples for LBOs went from an average of six times to 10 times. That was largely driven by the leverage. This is not the case in the middle market.
Generally speaking and depending on who you talk to, the middle market includes any investment in the range from $50 million to $5 billion. VSS typically targets businesses with less than $500 million in terms of enterprise value. Those size deals tend to not have the same level of access to the capital markets. They’ve tended to be more club-bank deals, which are generally financed and held by the banks in the club and therefore, generally not syndicated. The banks have got to be comfortable with the lending multiple because they’re not going to offload it to some sort of structured syndicate. You really have two very different markets out there.
You’ve got the large-cap market, which today is enjoying a very frothy, high-yield environment, not withstanding lots of uncertainty in the economy. And then you’ve got the lower end of the middle market, deals that are under $500 million, which, despite the fact that there is frothy high-yield market, are finding a very different set of circumstances for their leverage opportunity.
As a result of this, do you expect the middle market to become more attractive?
The middle market is generally more attractive for several reasons. One reason is that you’re dealing with the bottom end of the pyramid, meaning that the availability of opportunities is that much greater because you’re talking about smaller companies. Number two is that there’s more fragmentation in terms of intermediation, meaning that there are far more intermediaries dealing with smaller companies. They tend not to be found in larger financial-institutions; they team with larger-cap companies.
One of the interesting trends we’ve seen over the past few years is that, because of the changes in the makeup of the financial institution market, there have been an amazing number of boutique-style financial firms launched. Just within the industries that we focus on, we track about 150 boutiques. They don’t necessarily cover everything from media to information to business service to education, but they’re covering subsets within that. It’s very different today. It’s no longer 10, 15 different intermediaries that cover everything. Now, due to downsizing at the larger sell-side brokers, it’s pockets of boutiques and pockets of coverage. This means there are more sources of deals.
In the environment that we’re going to be in for the foreseeable future, where there’s relatively little economic growth, the lower end of the middle market lends itself to what I would call consolidation economics—putting like businesses together and leveraging synergies. That’s where we believe value creation will come from over the next three-to-five years from building out platform companies with add-on businesses that complement existing capabilities rather than from organic growth. Middle-market companies lend themselves to that strategy better than large-cap companies. Finally, with the middle market, you’ve got more exit options. If you’re dealing with a business that’s in the range of $250 million to $500 million, you’ve got more options in terms of where you can ultimately sell that business. It could be to another private equity fund; it could be to the public market; it could be to a strategic buyer. Whereas if you’re dealing with the large end of the large cap, there are relatively few exit opportunities.
After you’ve already done some analysis and you go to the bid stage, how much does your knowledge of the industry influence the entrepreneur who’s selling the business?
Price, of course, is the ultimate differentiator, but a close second is the value you can add to that business by understanding the industry. In a situation where all else is equal, it can be a deal clincher to be able to convince the owner and management that you understand the strategy of where the business should be going, and you can bring investment opportunities in addition to capital. I can’t tell you how many management meetings we’ve been in where that’s been a critical factor in terms of our ending up with the deal. It has always surprised me that private equity firms in general haven’t focused more on specialization. I think that it’s becoming a trend, but it’s more of a recent phenomenon.
Do you think this trend toward specialization will continue?
The trend toward specialization is going to speed up. The private equity industry has become more competitive, and the rising tide has gone out in terms of the economic position that the developed world lives in. I see the private equity model headed toward adding more value to your portfolio, and specialization is certainly an important approach there. For us, over our 23 years of private equity, we have stayed with our industry specialization. Our industries have changed, but we stayed with our industry specialization. We’ve evolved with our industries and we’ve stayed with the lower middle-market focus. Those two common denominators are exactly the same as they were 23 years ago. What’s changed for us in terms of our business model is that we’ve expanded geographically. We have businesses in the U.S. and also Europe, where we’ve expanded over the past decade—now 25 percent of our investment activities are in Europe.
The second means of expansion is in asset classes. Historically, we were 100 percent focused on control buyouts—we have had four such funds to date. Five years ago, we expanded to the mezzanine asset class, and we started building out our capabilities in senior debt last year and have a small team of professionals developing opportunities. If you’re going to be specialized, being able to offer a full suite of financing solutions to companies in media and information industries— from equity to junior and senior debt—gives us better positioning. It provides a better opportunity to find situations where that capital, regardless of the asset class, is going to find attractive returns because those companies will think of you first in terms of how they grow their business. The form of the capital will depend on the needs of the company, depending upon its circumstances.
Has senior debt dried up in the last two years?
There is a real lack of supply in the market. The banks have consolidated. You’d be amazed at how many banks we would talk to 10 years ago compared with how few there are today. The need for capital to finance growth is just as great if you’re a middle-market company or a large-cap company. Yet it’s very difficult to find senior debt in the middle market. The leverage multiples are substantially lower, by almost half. There’s not much of a syndication market anymore, so we see a giant need.
Do you see your limited partners pushing the industry toward specialization?
I think LPs are looking for how a fund manager differentiates itself in terms of added value. There are different approaches to that. You could be an excellent distressed debt investor. In our case, our approach is specialization and multiple asset classes. It goes back to the point I was making before about being in a relatively flat economic environment and how you create value in those circumstances. One of the benefits of specialization is being able to work with companies strategically, to help them figure out how to identify add-on acquisitions, how best to think about integration, and how to position the company in terms of an ultimate exit.
How is globalization affecting your strategies? Do you see yourself going to China, India, Brazil or Russia?
We’d love to be in those markets eventually. Those are different places to do business in, and the exact same investment models don’t necessarily apply to these markets. There it’s more of a growth equity model than it is a leverage-oriented model. But there’s no question that in the future, there’s going to be a lot more growth coming out of that part of the world than the developed world. We’d like to head in that direction over time. We find that a lot of our companies are ultimately of interest to multinationals, so in the way we’ve been focusing on the U.S. and Europe for many years now, we’re following the strategic path of the larger corporates. They’re interested in businesses that have a more global footprint. With some of the transactions that we’re doing, we’re trying to position ourselves in the path of where the corporates want to be in terms of their own acquisitions. Ultimately, that will be the highest multiple exit for us. Globalization ends up meaning that you want to position yourself so that you’ve got a global footprint, so that at the end of the day, your valuation multiple will be higher.