Choate Hall & Stewart, On The Private Equity Middle-Market: Competition, Fee Pressure And China

(this article previously appeared on Forbes.com)

With more than 50 attorneys in its private equity practice, Choate Hall & Stewart LLP has completed PE acquisitions and investments for more than 40 sponsors in 45 states and 27 countries, with most deals running between $10 - $500 million. And handling more than $30 billion in middle-market M&A and investment transactions in the past five years, it has earned top national rankings from The Legal 500 for middle-market M&A and private equity buyouts.

Today we hear from three of Choate’s practice leaders: Christian Atwood, a co-chair of the firm’s private equity practice; Kim Kaplan-Gross, a leader in the firm’s fund-formation practice; and Brian Lenihan, a co-chair of the firm’s business department. They discuss, among other things, the PE middle market, competition among funds, client optimism, the future of the market and falling fees and AFAs in the legal industry. Please see a revised and edited (for readability) version of our exchange below.

On Middle-Market Private Equity

Parnell: If we could, let’s start by talking about the middle-market. It’s a term that is thrown around loosely, in my experience. How are you defining “middle-market?” Is it by deal size, types of clients, deal volume? Could you talk to me about that?

Atwood: When we think about the middle-market, you start with the proposition that it runs from $10‒25 million on the low end all the way up to a billion dollars. Now, in terms of where we sit in that and how we think about our clients and how we address that market, most of our clients are doing deals in the $100‒500 million enterprise value space. When we venture below the lower bound, it’s usually because it's a growth equity deal or an add-on for an existing portfolio company. When we're above that sweet spot, it's frequently because one of our clients bought in the sweet spot and then we did some number of add-ons or there was organic growth—there was some sort of activity during the hold period—that happily resulted in an exit valuation above the top end of that range. So, when we're playing above $500 million, it is not always—but frequently—because we are selling at that value.

Kaplan-Gross: On the fund-formation side, I would add that when I think of this concept, it's in relation to aggregate capital commitments of the funds that we work with. And so really it's private equity funds doing the kinds of deals that Christian just described, and those tend to be ones that would have $100 million of capital under management on the low side or up to $2 billion or more of capital under management on the high side. So that’s a very wide range.

On Top of the Market Funds Competing in the Middle-Market

Parnell: There seems to be a level of consolidation in the firms being used by the top-of-the-food-chain funds. Are you seeing those investors being pressured to move down into the mid-market?

Lenihan: Yeah, absolutely, and that sort of dovetails with the investment styles for which we think we have a lot of traction, where we spend a lot of time, and have for a number of years, on the growth side. So, the growth equity strategy—you certainly are seeing bigger PE firms starting growth-focused funds to focus on that part of the market, which is usually technology-enabled companies and companies that are going to have an enterprise value of $150 million and below.

Providence is a perfect example of that. You think of Providence as a mega-buyout firm on the media side, and they started Providence Strategic Growth a few years ago and that has been very successful. And that group is focusing on the lower end of middle-market, technology-enabled companies, as I understand it.

Atwood: Jumping in on that, I think we also see this if we have some of our middle-market buyout clients participating in auction processes. Sometimes some of the players with whom they are competing are told either directly or indirectly by their investment bankers that there are other, bigger funds that could do this as an all-equity deal, so make sure you show up at closing and don't expect to get another whack at it. And also make sure you can show that your financing is locked down and truly committed because if you've got a middle-market fund that’s investing out of an $800 million fund, there's a limit on the size of the equity check that a fund can write. If its competitor is a Vista Equity or a Blackstone or a KKR that's investing out of a $6, 8, or 15 billion committed fund, they can write much bigger checks and worry about debt financing and other pieces after the fact by way of a recap. So, having those guys come down and play in the “smaller” deals creates some competitive difficulties for true middle-market shops.

The story that the middle-market guys have to tell—and I think they tell it relatively effectively, sometimes with our help and sometimes without—is that we actually know this space, we're experts at working in this space, and we know the levers to pull to help grow this company, whereas the big boys can write a big check but maybe don't have the same focused expertise playing in this market. Whether that sales pitch works in any given instance, you don’t know . . . but that’s the story.

Lenihan: I have a specific bias here, because I spend most of my time representing growth-oriented funds that are heavily investing in technology companies, and the volume of activity has been tremendous. One of my colleagues likes to say, “The world is not getting less technological; it's getting more technological.” So those opportunities are going to continue to be there: autonomous cars, crypto-currency, but also the sunset of gasoline-powered cars, so a company like Tesla is going to benefit mightily from that. So, for the funds that are really focused on the technology space, there’s a lot of new investment activity now and there's a ton of M&A activity. So is that going to be the way of the world in the next 10‒15 years? I think so.

On Middle-Market Funds Rising to the Competition

Parnell: So, if you have top-of-the-market funds moving down into the middle-market, it must make it incredibly difficult to compete. What is this doing for the market?

Atwood: I would say, more broadly, I think it is increasingly hard for private equity fund managers to be generalists. I think that in a competitive environment where there's a lot of capital being deployed by a lot of different parties, being able to differentiate yourself in terms of the niche where you are an expert or the vertical where you spend all or a vast majority of your time is really important, because management teams and other sellers of businesses are increasingly sophisticated about the people with whom they're going to partner. If they're doing a private equity deal, you need to be able to talk the talk and focus on healthcare, or software as a service, or oilfield services, or whatever it is.

Lenihan: These areas of specialization are becoming hyper-specialized. So, if you're doing cloud security, you better really understand cloud security and have a handful of companies in your portfolio that are connected to cloud security. It's not just being a technology investor. It’s understanding a particular slice of the technology industry very, very well. I think those are the funds—again, with a bit of a bias, as I will admit the clients with whom I work tend to fall into this category—that seem to do well.

On Building a Competitive Advantage

Parnell: There seems to be a narrowing of legal service providers, at least at the top-of-market funds if not in the middle-market. Are you seeing this as well? How are you competing against other firms and building a competitive advantage?

Lenihan: We have a specific strategy that we have pursued that has gone from the transactional side to the fund-formation side. I don't want to call out competitors by name, but speaking generally, we view our peer group as the largest firms in the U.S. that do this type of middle-market, private equity work. We're Boston-based, so we're competing with firms with a national footprint. Where we've really been able to differentiate ourselves is, at least from my perspective on the technology side, in having really deep domain expertise with strong technical support on the legal side. The lawyers in our intellectual property group—most of whom had Ph.D.s in their field of study— have really helped differentiate us in the marketplace.

Where it used to be that venture capital kind of grew a little bit into the growth equity world, I think you're finding that the firms that maybe started with a focus on private equity—and I’m talking about the law firms, not the investment firms—have done a really good job of taking market share in the growth equity space.

So, it's not necessarily the firms that were doing venture deals, which has become somewhat commoditized, making their way up to the growth equity-type investing. It was really the private equity, the law firm supporting private equity firms, really focusing on the growth side. Christian, would you agree with that?

Atwood: Yes, I would. I mean, I think that doing private equity deals writ large is a specific skill set that is honed through a bunch of repetition. And so firms like Choate, that have been doing it since the 1980s, just by definition have grown up a bunch of lawyers who are now partners and continue to train lawyers who are well versed in what is the market for private equity deals. They see both on the sell side and the buy side a tremendous amount of volume focused on deals being sponsored by private equity funds . . . as opposed to good, large, sometimes international law firms that do a lot of mergers and acquisitions and view private equity as a subset of that. It is a subset, but if you're doing public company M&A or you're doing $10 million buyouts, that is actually a different skill set than executing a middle-market buyout or a growth equity deal. And I think the most successful firms in this area have realized that and have deployed resources and spent money and developed talent with that focus as opposed to a more generalized M&A approach.

Kaplan-Gross: I would add that on the fund-formation side there certainly are plenty of legal service providers trying to service middle-market funds with large-cap fund approaches that are not well tailored to what middle-market and lower-middle-market private equity firms need or want or can best benefit from.

So we, for example, are hyper-focused on middle-market funds and tailoring our services specifically to those needs as distinguished from the large-cap approach. For example, I wouldn’t say our partnership agreements are short, but they are shorter, they're in more plain language, they're more easily understood. What we hope to be providing is a suite of services that will allow our clients to be nimbler as middle-market private equity firms need to be.

On Falling Fees and Alternative Fee Arrangements

Parnell: Private equity funds are really sophisticated legal consumers. I have to assume that they can exert at least some level of pressure on the firms they are working with. Have you been experiencing downward pressure on fees? Has there been any demand for alternative fee arrangements over the past year or two?

Kaplan-Gross: While our clients are certainly sophisticated consumers of legal services, they highly value quality and understand that they need to pay for that. They would rather spend their legal services budgets and receive value for their dollar versus fewer dollars which may come with a lower value level or value proposition. I don't want to say we don't experience fee pressures. We certainly have clients that care about their legal budgets, but I think more important to them is the value that they're receiving, and they're willing to pay for quality service.

Lenihan: On the transaction side, our competitors are really national and international firms, and they're at the highest rates structure in the legal profession. So we're competing against firms that charge our rates if not slightly higher. The clients that seek us out are also seeking out those other firms, and I don't feel like we get a lot of pressure to discount provided that we get the budget right. Because the clients want to know, when they're doing a transaction, what it’s going to cost. And so, if we are good at our job, we should be able to budget it quite well. Where we have fee pressures is where we may not budget as well as we should have, or if there has been some unknown change order that had to come in because of something that was discovered.

I’d also say that, as a one-office firm really focused on partner-level attention, we’re not as highly leveraged as a lot of our competitors. So just by virtue of how we deploy resources, we are probably going to be at an aggregate overall cost that is lower than some of our larger competitors. And our clients are very sophisticated legal consumers. They know that, and they understand what they're getting. They may be paying $1,000 an hour for a partner, but they understand the value that they're getting from that.

Atwood: We hear a lot about alternative fee arrangements in the legal profession, but at least to date that is not something that we typically experience in middle-market private equity deals. Many of our relationships with our clients are decades long, and so there's a lot of trust built up there and a lot of belief in the value that our model is delivering—and that it is designed for the client's best interest as opposed to Choate’s best interest.

If we're being honest with ourselves, I do think there will probably be increased fee pressure on lower-middle-market deals and smaller growth-equity deals, not necessarily because the clients want to pay less, but because there may be some other entrants into the marketplace who are underpricing it or maybe don't actually know it quite as well. And so clients might be taken in by that and think, “Oh, I can do this for less and it’ll be the same.”

My hope is that if we continue to deliver on the value proposition that we offer to clients, and if we continue to be at the top of the market in terms of expertise and knowledge, that the clients, because they are sophisticated consumers of legal services, will be able to distinguish between cut-rate service and what they've come to expect from Choate and the other law firms that they use.

When you are selling, if you have the service offering that we have and that our competitors have, these guys are deploying huge amounts of capital. There's a lot of risk associated with this. They have responsibilities to their investors, and they want to know that it is going to be done right, and there's very little incentive for the human who is making the hiring decision to try to save a few bucks. This is not to say that it gives us an ability to charge whatever we like, but it gives us an ability to sell to them. This is the value, and they see that value. There’s an analogy to hiring a cut-rate heart surgeon—no one’s going to do that. Then there's that old saying that “nobody ever got fired for choosing IBM,” or something along those lines.

It's a similar thing when you have a company with a really important transaction—and every transaction these guys do is very important to them because of the opportunity cost and the amount of bandwidth they have to deploy to get it done. You want to make sure it's done right, and there's a tremendous amount of risk in trying out somebody new who’s either not well versed in the market or with whom you've never done a deal before.

On Barriers to Market Entry

Parnell: It doesn’t seem as though the successful funds are having any problems raising capital. That said, what’s it like for new funds trying to enter the market? Is it really challenging to get capital without a track record?

Kaplan-Gross: I would say, again, the value proposition that a fund offers to investors is super important. Their track record is super important, but it's another place where I would say quality wins. So, those funds that are fundraising at the right times relative to their own investment cycles and have the track record and experience to support what they're selling usually can source the capital they need to keep going. It's not universally applicable; there are challenges, of course. But if the value proposition is there and the track record is there, the capital is there.

There are different varieties of new funds: There are new investors, and there are new funds. The most successful new funds are those that include a team of experienced investors, ideally ones who have worked together before in past lives, where maybe two partners are spinning out from one fund and then one from another. That works. Those are experienced investors. But new investors are going to have a much more challenging time seeking to raise institutional capital.

Atwood: A real-world example of that is, there’s a fund here in Boston that's just announced its final close, I think within the last week or two, that is a new fund composed of a bunch of very seasoned investors. They just raised a billion-dollar fund in not very much time because of the strength of the humans—the investors—who have deployed a bunch of capital in the past.

Similarly, not as recently as this week, but there's a fund that’s about two years old here in Boston called Silversmith Capital Partners that was born of partners leaving some other, very well-known private equity funds. And those founding partners went out and raised not quite $500 million for a group equity fund in a few months based on the strength of their track record.

Now, plenty of other investors out there have been trying to raise funds for a year or 18 months, sometimes longer, and they're kind of plodding along, trying to get to critical mass to get that first close when you hope the floodgates will open. And then you get your final close very quickly thereafter. It’s exactly what Kim said: The better the investor, the easier to raise the capital. Whether it’s your first fund or your eighth fund, it's about the track record of the people who are trying to get the LPs to commit.

On China as a Private Equity Market

Parnell: Now, let’s talk about the best investment value from a geographic standpoint. Obviously, the U.S. has been number one in this category for a long time. China has been becoming more attractive lately. Do you see it surpassing the U.S.?

Lenihan: That's a great question. If I can give you an exact answer on that, I'm going to go and buy some—but I don't. I just think you see these developments today in China where they outlawed bitcoin. At least for the near term, what we hear from clients, and what we see on the ground when we're trying to do transactions outside the U.S., is that the legal regimes, the regulatory regimes, aren't necessarily as supportive as they are in the U.S.

There are some jurisdictions where they're more supportive in one way, and in other ways, they're not. We do a lot of work in Canada, and we see our clients looking up there. The Canadian dollar is priced pretty favorably to the U.S. dollar now, and there’s a lot of great tech companies up there with very good research and development, and so we see clients looking up to Canada.

We have clients doing deals all over the world, in Europe, and we’ve done a deal in Cape Town, South Africa, but they're pretty opportunistic. I think we'd still say the bulk of the deals, at least on the technology side, the transactions are happening in the U.S.

On the Impact of New Regulations

Parnell: Do you think the new administration will be able to reduce regulations? If so, what type of impact do you think that will have on the market?

Atwood: Right at this moment, there's a lot of talk about comprehensive tax reform. I think if you look back historically, it is about every 30 years or so that the tax code gets rewritten. So whether the current political climate will allow people to get over their own egos and come together to forge something that has bipartisan support and can get rolled out is anybody's guess. I honestly don't know.

I do think we need to spend a bunch of money on infrastructure. There are big pools of capital being raised and already raised to support investment in infrastructure, public-private partnerships, and the like. Whether that actually gets off the ground in the next three-plus years of the administration’s first term, plus or minus four years of the second term, if there is one, I don't know. But I think people are placing bets that stuff will happen.

Lenihan: From the technology transaction side, there really aren’t any regulatory roadblocks in the U.S. to doing the types of deals that we do. It's a very robust investment environment now. The only regulatory thing I saw done during the Obama administration that was beneficial was the qualified small business stock (QSBS) rules, where then-President Obama sort of maintained those and then made them more favorable so that there is an up-to-100% capital gains exemption for investments in certain qualified small business stocks. That has had some impact on what we do. We see deals structured to take advantage of that, and it has encouraged certain entrepreneurs and founders who have held their stock for a five-year hold period to take advantage of getting liquidity.

So that has provided some motivation to do a transaction. But apart from that, I don't think, I haven't seen really any type of a regulatory burden on the types of lower-middle-market technology transactions that I do.

Kaplan-Gross: On my side, I would say that, with the change of administration, there was hope that the SEC would pare back its regulatory oversight of private equity firms. The SEC has been quite active this summer with visits, including audits and examinations of private equity firms. So those two things are inconsistent. My sense is that there remains, in any case, cautious optimism around some regulatory recession and loosening, but time will tell. We're not immediately seeing it because the examinations are continuing.

Atwood: There are two things that get bandied about that would absolutely have an impact on what we do. And that is, if the tax treatment of carried interest ever gets changed, it will create work for smart lawyers to figure out how to do what private equity funds have been doing for a while, regardless of how well the tax code is written. I'm confident that good tax lawyers like ours will be able to figure out a way to achieve the clients’ end.

The other piece that you see bandied about sometimes that would have a dramatic impact is the deductibility of interest on debt financing. If that were reduced or curtailed or eliminated, that potentially would blow a hole in the paradigm of how LBOs get done, and that would have to be dealt with.

On Client Optimism

Parnell: So, despite the turbulence both here in the U.S. and globally, the market continues to be really robust. That said, private equity has been on a long winning streak. I have to believe that there will be a correction at some point—there always is. What’s the general tenor among your clients? Are they generally optimistic at this point?

Lenihan: I don't have any clients that are saying, “Oh, we’ve got to get this deal done because we're unsure of the political landscape and the regulatory regime is going to change on us.” I don't hear that; I don't hear that at all. It's just that capital is pretty readily available. There are a lot of great opportunities out there, and we are just trying to find the best portfolio company to put our capital to work in.

Kaplan-Gross: New fund formation has been consistently strong for a while, and I don't see any weakening of that right now.

Atwood: It’s not atypical for there to be a little bit of a summer slowdown. People do like to take vacations sometimes, so August can be a little slower, and then kind of get back after Labor Day. From where we sit, however, there was no slowdown this summer. It was “pedal to the metal” all summer long. Vacations were ruined, and people worked remotely as necessary to get the deals done.

On Perceptions of a Bubble

Parnell: Is it possible that we're in a bubble?

Lenihan: Well, that's a great question. We hope not, obviously, but just based on the pipeline and the level of activity, it doesn't show any signs of slowing down. I don't get the sense that it's a bubble, but I could be wrong.

Atwood: I would say over the last five years—and even more so over the last two years—it is increasingly common to hear from a client who wound up, you know, the bridesmaid instead of the bride. The feedback they got from the investment banker, or that they somehow otherwise came by, was that they were blown out of the water by something else in terms of valuation. And our client is sort of scratching its head at how anybody could pay that much and have the return model not be broken . . . which would suggest that we're in a bubble.

Lenihan: We could be in a bubble, but I’m going to show my bias again here and focus on the technology side. Seeing companies that are getting bought out at a really healthy revenue multiple—and even more extraordinary EBITDA multiples—that when our clients are investing in them they're paying these insane multiples, and then when they're exiting them the multiples may come down, but the growth in that company has been so fast because it's a technology company. If they get the technology right and the client’s investment thesis is correct, those companies will grow extremely fast.

So, I don't want to sound like I've drunk the Kool-Aid, but I have seen where these companies are then getting sold to a Fortune 500 company and you say, “Oh, my God, how are they going to ever really monetize on that?” And guess what? Once it goes on that Fortune 500 platform and it gets deployed on that platform, it's amazing to me how much they are able to grow these companies. It's as if they're turbo-charged once they go into a bigger organization.

Atwood: Over the course of the next few years, maybe a decade, I think there are going to be winners and losers. I think there's a bunch of people who seem to be deploying capital irrationally right now. And those funds might not be able to raise the next fund or the fund after that. Those who are disciplined and stick to their strategy and, you know, pay up when the asset warrants it—and don't when it’s a B+ or A- asset—those are the ones who we’ll still hopefully be representing five and ten years from now.

On the Future of the Market

Parnell: Where do you anticipate the greatest activity over the next four quarters? Will it be in growth funds?

Lenihan: For me, it will continue to be growth equity funds. What about you, Christian? What do you think?

Atwood: You can see at least a full quarter down the line from where we're sitting right now. Based on things that are at the letter-of-intent stage and investigatory due diligence and execution stage, all of our clients, from top to bottom, from growth equity all the way up to the biggest buyout funds, are all busy right now chasing a bunch of opportunities. I don't see anything in the macroeconomic climate or otherwise that would slow anybody's roll right now.

Lenihan: What about on the fund formation side, Kim? What are you seeing now? Are they all across the map? Is it buyout? Is it growth?

Kaplan-Gross: I'm seeing the most activity right now in lower-middle-market buyout, for sure. We've got clients on the calendar through 2018. We’re anticipating when they'll be back in the market based on their current amount invested, future investment in existing companies, forecasting, etc. We've got funds in the market now and others hitting the market throughout 2018. It’s a really robust pipeline.

Lenihan: Technology is really large, and I think mobile, cloud and managed services are red hot. And anything in the security sector is very hot. People can do a lot with technology. The world's not getting less technological, so we keep our foot in the technology market and stay tuned into where the developments are. I think we’ll be OK.