March 5, 2020: Azalea Capital is pleased to announce that Will Lucas has been promoted…
Ben Wallace, a Partner with Azalea Capital, recently spoke with Andy Jones of Private Equity Info about how Azalea sources new investments as well as trends within private equity.
Which deal channels are you closing?
Historically, most of the transactions we’ve closed are with companies we pursued directly or where an advisor has made a limited number of qualified introductions. The number of advisors covering the lower middle market has certainly increased over the last 10 years or so, but we continue to see value in having both a direct outreach to companies in select industries as well as maintaining an active relationship with the advisors covering our target market.
Is valuation a factor at play here?
It’s not so much about valuation, as the market is generally efficient enough for business owners to have a sense of what their company is worth. At Azalea, we mostly focus on majority recaps with business owners and entrepreneurs who are looking for a like-minded partner. We are almost always the first outside capital to be invested in their business. Therefore, we place a premium on chemistry and alignment of interests. Given those priorities, we are more successful in situations when we can have face-to-face interaction with the seller early in the process.
Does it feel like the private equity market has become more competitive in the last few years?
The amount of undeployed capital chasing investments in privately held companies continues to grow each year. I think the capital overhang for private equity is over $700 billion at this point. However, the vast majority of private equity dollars are focused on transactions north of $100 million in enterprise value. We continue to view the lower middle market (under $100 million in enterprise value) as an attractive area to look for risk-adjusted return opportunities.
What does the deal funnel look like at your firm?
Our investment focus is generally on companies with $10-100 million in revenue, in the greater southeastern United States (Texas to DC to Florida), with a primary focus on three sectors – aerospace, industrial, and consumer products. Given these filters, each year we review around 600-700 deals to seriously consider around 50 opportunities, with the goal of closing 2 or 3 investments per year.
What typically filters out companies from your funnel?
Our primary filter is whether we can add value to the opportunity and demonstrate a differentiated approach with the seller through our industry focus and the proven operating executives we can bring to the table. Once we determine an opportunity matches one of our focus areas, we will begin to overlay other filters such as,
- Seeking a Partner – does the owner want to sell 100% and walk away? Or, are they interested in a second bite of the apple by retaining an ownership stake in the company and helping transition the business to the next generation of management? We generally expect the owner/seller to continue to be involved at some level to help transition the business. In a small to medium-sized business there’s just too much institutional knowledge tied up with the owner for them to walk away immediately after closing.
- Geographic location – how easily can we get there, given the amount of face time we will need to have with the company in the early years of our partnership?
- Business model – does the company have a defensible, scalable business? If we double or triple the size of the business in the next few years, will it be attractive to a strategic buyer or the broader private equity universe?
- Valuation – are the owner’s valuation expectations reasonable given the size of the company and the industry in which they operate?
- Other issues – what are the gross margin trends in the business, is there a customer concentration, what capital investments are required to grow the company?
How do you prefer investment bankers approach you with an investment opportunity?
It’s always preferable when an advisor has pre-qualified our firm and our approach to be a good fit for their client either due to our industry preferences, a previous investment experience, or the way we approach partnering with business owners. Initially reaching out by email is probably the most efficient as it allows us to capture the opportunity in our CRM and track which intermediary relationships are regularly sending us opportunities.
What are some turn-offs to how some investment bankers approach you with a deal?
When we receive a teaser via blind copy email and there’s no personalization to the communication, it’s a bit of a yellow flag. If it appears the banker hasn’t reviewed our investment criteria and we’re one of a few dozen groups receiving the email, it indicates this is likely not where we want to spend a lot of time.
Indication of a good opportunity?
By contrast, when a banker calls or emails and says “Hey, I noticed you guys did a deal like this a couple of years ago or I can see you have interest in this sector,” that certainly captures our attention. It shows the banker has spent time trying to find the best possible fit for his client and is running a more personalized process with groups who have relevant domain expertise or some common objective with the seller.
Post deal, what does equity sharing for management look like at your firm?
We almost always offer existing management (and/or the operating executives we bring into a deal) the opportunity to co-invest alongside us on the front-end. Also, we usually set aside up to 10% of the equity ownership in the form of incentive stock options for the existing management team or other leaders that will join the company over the life of our investment.
Thoughts about the private equity macro environment?
Private equity’s role in the capital markets continues to mature. As we discussed earlier, the effects have been most readily seen in the middle and upper ends of the middle market (companies with enterprise values between $250 million and $2 billion). Over the next 10 years, private equity will play a larger role in the lower middle market – sub $250 million enterprise value deals.
With a slow growing economy and in a rising interest rate environment, I think we’ll see company valuations come back to more reasonable levels over the next 2-3 years.
What are some transaction issues you face in closing a deal?
Most deals tend to have one or two hot button issues, whether it’s the working capital target or the one-time nature of certain EBITDA adjustments. However, we always attempt to take a thoughtful, win-win approach to resolve these issues. We believe the solution has to be fair for the seller and fair for the buyer.
At the end of the day, as long as the seller is committed to finding a reasonable solution and moving towards closure, there are very few issues we can’t resolve. Remember, almost every investment we make is a majority recap where the seller is involved in helping run the company post-close as well as remaining a significant shareholder in the business. We genuinely want our new business partnership to get off on the right foot.
If you could find and close more than 2 – 3 deals per year, would you? Or is that the capacity for your firm to assimilate?
Certainly. We have the bandwidth and execution processes to do more deals and our institutional investors are always seeking co-investment opportunities. The constraining factor is finding the right opportunities which match our investment criteria and are available at reasonable valuations.