Article Legal Week Global

Defying the Odds

While the investment activity of Chicago-based private equity (PE) firms is far from robust, Chicago area sponsors seem to be more active and burdened by fewer legacy issues than many firms located elsewhere.

Chicago's stable, well-established PE community has stayed closer to its core competencies and historical focus than many others, with a high percentage of PE firms focused on LBO and management buyouts rather than on venture capital. Chicago PE firms have traditionally relied primarily on basic industries for their work - rather than on telecommunications and technology - and have maintained an emphasis on roll-up and consolidation strategies. 

While these factors caused the Chicago area PE community to experience lower highs throughout the great telecommunications and technology bubble than did many others, they are now allowing that community to experience higher lows. The relative strength of Chicago PE firms during the aftermath of the great bubble appears to be a reflection of its different exposure to general market forces than the national average.
Chicago's PE community grew steadily and matured and prospered over several decades. Its firms resisted many of the associated temptations of the `great bubble' and for the most part stayed within their established areas of core competency and emphasis - for example, most Chicago area PE firms did not expand into multiple classes of fund offerings.
They did not open myriad satellite offices to the same extent as many of the tech-focused firms, principally based on the coasts, who sought physical proximity to early stage companies. Less expansion - fund offerings, offices, personnel - during the bubble has led to less contraction in the aftermath, relatively minimal personnel turnover and enhanced organisational stability.
A large percentage of Chicago-based PE capital is targeted toward leveraged and management buyouts and is not particularly reliant on the venture capital market that has suffered the greatest collapse within the PE asset class. Although many Chicago-based firms historically focused on leveraged transactions did expand their investment strategy to include some startups and early stage companies, most of their investments continued to be in their traditional core areas.
In addition, most Chicago PE firms are generalists and hence were not focused primarily on the niche areas, such as telecommunications and information technology, that have been most adversely affected by the bursting of the bubble. As a consequence, Chicago-based PE firms' collective investment portfolios are generally less troubled, so that the firms can maintain focus on new deals, growth of existing portfolio companies and liquidity events.
In contrast, many venture capital firms are now trapped into spending comparatively more of their time focusing on triage, sourcing the next financing rounds for troubled companies, restructuring over-leveraged businesses and addressing limited partner and personnel issues. Of course, old economy portfolio companies are also experiencing financial difficulties from the weak economy, but comparatively less so than start-up, early stage, telecommunications and high tech companies.
While debt financing remains challenging and valuations are difficult, the current low interest rate environment helps cushion the effect of reduced profitability for highly leveraged companies in the manufacturing, service and other industries, while early stage venture capital backed companies spend inordinate, and often frustrating, time seeking more equity in an effort to reach positive cash flow.
Chicago PE firms are more focused on basic industries with hard assets. While the number of middle market senior debt financing sources and debt-to-equity ratios have decreased in the past five years, senior secured debt lending is still available for industries with hard assets to back the loans. In contrast, it is difficult to obtain debt financing based on projections of future positive cash flows and great, but unproven, expectations.
With respect to the fourth factor, Chicago hosts a number of PE firms that emphasise roll-up and consolidation strategies. The relatively poor economy has not vitiated consolidation opportunities. In the current economic environment, many small firms are struggling and, therefore, ripe for acquisition, especially where the small business' founders can realise some liquidity and participate in future growth opportunities by retaining an equity interest in the consolidating platform company.
Consolidating a fragmented industry often involves numerous acquisitions of small companies that would not individually attract the attention of financial buyers or large public companies. In addition, a consolidating platform company can pursue its growth through acquisitions when public offering markets are weak.
On the other hand, the ability of many previously funded platform companies to continue to execute their consolidation strategy has diminished. Many existing platform companies are in default under their senior lending agreements, require all free cash flow to pay down debt and are dealing with less accommodating lenders.
These economic circumstances have required greater than expected equity infusions from PE firms and caused an apparent cyclical high in PE fund guarantees of portfolio company debt. As a result, previously funded platform companies are experiencing a shortage of growth capital.
Many of these companies were initially financed by a PE firm's prior - now fully invested - funds and often require more equity capital - directly, or indirectly through guarantees - than originally anticipated. Due to inherent actual and perceived potential conflicts of interest, many PE firms are reluctant to continue funding a prior fund's portfolio company with a subsequent fund's capital.
Therefore, the performance of legacy platform company acquisitions are more vulnerable to inadequate expansion capital than LBOs, which are not usually premised on a substantial number of follow-on acquisitions with follow-on financing. On balance, roll-up and consolidation investment strategies are less affected than many others, which is reflected in the Chicago PE community's investment pace.
Many Chicago-based PE firms concentrate more on Midwest investments than do PE firms based outside the Midwest and hence benefit from the its more stable economy and high concentration of basic and service industry companies. Proximity to Midwest companies, of course, leads to greater market information and more Midwest deal sources - regional investment banks, lawyers and accountants - than investors situated on the coasts.
Consequently, due to the generally greater concentration of Midwestern portfolio companies in Chicago area private equity firms' portfolios, Chicago area firms have experienced somewhat less of a decline in quality deal flow than have PE firms on the coasts.
Bruce Ettelson is a corporate partner in the Chicago office of Kirkland & Ellis
This article is reprinted with permission from Legal Week Global.  c April 2003.