As of May 2010 U.S. private equity funds have $445 billion in dry powder to invest according to Cambridge Associates, an independent research firm for institutional investors and private clients.  The largest amount since 1998.

After attracting record amounts of capital for three years starting in 2005, the number of private equity transactions plummeted as debt financing dried up. As a result, much of the money private equity groups raised over the last four years remains uninvested posing significant challenges for private equity groups and their investors and opportunties for savvy business sellers.

Private equity groups are feeling tremendous pressure from their limited partners to put this money to work and to generate returns on their investment. 

Interestingly, the overhang seems to be most concentrated in larger and more recent funds.  Half of the overhang is concentrated in funds that have raised $5 billion or more in capital. And more than 75% is concentrated in funds that were raised between 2007 and 2009. As a result, large, new private equity groups have the greatest challenge and the greatest opportunity ahead of them -- investing this overhang in a way that generates compelling returns for investors.

The overhang is less significant in private equity groups that focus on smaller businesses in the middle market and lower middle market.  Just 12% of the overhang is concentrated in funds with less than $1 billion. In addition, transaction volume did not drop off as much in that market.

What does this mean to business owners and potential sellers? 

First, we expect valuation multiples to continue to increase as competition for quality companies increases.  This is good for sellers but could potentially erode the return on investment to the private equity group's investors.  This emphasizes the importance of working with an investment banker who can create an auction environment and use competitive forces to maximize the value of the client's company.

Second, we expect private equity groups of all sizes to show renewed interest in small and mid-sized companies as they revise their business models to adapt to the market and generate higher returns for their investors.This suggests that it will become important for investment bankers to contact private equity groups who may not have traditionally looked at smaller deals.

Third, we expect companies with histories of strong growth despite the recession, to command significant premiums in the next six to twelve months as private equity groups seek to back high performance companies instead of turnarounds. This emphasizes the importance of preparing a professional packaging of a client's company to emphasize past performance and future potential in order to maximize the company's value.

Fourth and last, we expect more and more traditional private equity groups to provide debt capital to middle market companies as they adapt to the new market conditions and play the role of senior, non-bank lenders.  For companies looking for growth capital, private equity will increasingly be a viable option.

If you own a small to mid-size company and would like to understand your options, please feel free to contact the MidCap Advisors office nearest you.