Given the froth evident across the global deal market, two questions tend to dominate every conversation with investors: when will the current market cycle end? And, when the music does inevitably stop, which strategies will be positioned to weather the impending storm?
Of course, there is no conclusive answer to either of these questions; only speculation. But past trends do indeed present a pattern that at least offers clues as to where investors can find a level of consistency. And it’s not necessarily through doubling down on past winners.
This may be an oversimplification, but over time, most private equity firms that achieve a level of success will generally undergo an evolution that sees them raise ever-larger funds and, then, struggle to produce comparable returns. It may be due to the pressure to put more money to work, new demands on partners’ bandwidth, higher purchase prices or a combination of several factors. If there’s a silver lining, it’s that the move up market creates an opening for new private equity firms and spin-off funds to fill the void. And it’s the inefficiencies of this continual regeneration in the lower mid-market segment that make it among the most attractive to certain limited partners.
To be sure, this trend has proven fruitful. Ample evidence suggests that small is the way to go for bigger returns per dollar invested. According to Cambridge Associates benchmarks, smaller funds, over the past 10 years, have tended to outperform their larger counterparts.
And why is this? While there is no single explanation – after all, every fund has its own unique story – a number of dynamics are at play.
Naturally, smaller buyout and growth-equity funds tend to target smaller companies, of which there are many to choose from. In the US, for instance, more than nine out of every 10 privately owned businesses with annual sales of $5 million or more operate in the lower mid-market (defined by annual revenues of between $5 million and $100 million). The universe of upper mid-market companies (with sales between $100 million and $500 million) represents just 7 percent of this larger pool of potential targets, while the large market and above represents just a sliver, at approximately 1 percent. Globally, the bias towards smaller companies can be even more pronounced, which creates an expansive and diverse pool of assets from which to invest.
Moreover, the upper middle and large end of the private markets have become increasingly efficient. Transactions are heavily intermediated, and with considerable dry powder piling up, competition is fierce. This drives purchase prices higher and narrows the spread between valuation multiples, which are traditionally expected to expand as companies grow in size.
According to Murray Devine’s 3Q18 Valuation Report, for instance, both strategic and private equity deals with an enterprise value below $100 million were fetching a median multiple of 6.6x EBITDA as of the end of the third quarter. Deals valued between $100 million and $500 million, in contrast, were valued at approximately 9.7x EBITDA. This translates into a substantial reward for sponsors able to effect change within their portfolio and grow their assets materially over time.
Notably, within the larger end of the mid-market, the median spread between valuation multiples narrowed as enterprise values climbed before expanding again only for the very largest deals (above $1 billion in value). This not only eliminates a major component to traditional private equity returns – multiple expansion – it also raises the risk that core mid-market companies could face the prospect of multiple contraction when it comes time to sell the assets in three to five years. Not to be overlooked, the higher prices are also being funded by larger debt multiples, which can create more stress to fund debt payments when and if the economy decelerates.
The inefficiencies in the lower mid-market extend beyond the transactions themselves. Sellers of smaller companies, oftentimes the original founding family, prefer to hand over their baby to a buyer they like and trust – not just the highest bidder. In many cases, sellers will roll over equity. Thus, the selection of a private equity partner becomes as much about shared vision and compatibility as it is about the price tag.
The prevalence of family-owned companies in the small and lower mid-market – businesses that have been passed down through generations – often present a real opportunity to quickly and materially enhance EBITDA through implementing institutional processes, upgrading management or pursuing other initiatives to address operational inefficiencies. In contrast, the activity in the larger markets has been increasingly comprised of sponsor-to-sponsor deals. And following multiple rides on the private equity roller coaster, much of the low-hanging fruit has been harvested.
These are just a few of the variables favouring investors in the lower mid-market. Another, less discussed factor, is perhaps more behavioural in nature. Evidence suggests that first-time funds, which are often smaller than the existing base, have performed as well as or outperformed their peers in recent vintages.
This seems counterintuitive. How are the “newbies” beating – or at a minimum, keeping – pace with the more established players? For starters, first-time general partners are often highly experienced professionals leaving name-brand private equity shops to move down-market and focus on smaller deals. Many, too, will typically target a more specialised niche, be it a narrower sector lens, experience with founder-led businesses or something else. While it’s difficult to quantify, there is also a visceral hunger to prove that spinning out was worth the risk. And, of course, interests are often better aligned between LPs and first-time managers, particularly for anchor investors able to provide seed funding.
To be sure, across the spectrum of private equity investors, each limited partner brings a unique and specific mandate. For many of the largest asset owners, who often struggle to find commitments for such massive allocations, their goal may be to write as large of a check as possible, while backing GPs who can beat the benchmark. This speaks to the unflinching growth of the very largest mega-funds. But what’s necessary for the largest investors doesn’t necessarily apply to all. While diligence on spin-out opportunities can be tricky, as attribution is not always clear-cut, partnering with emerging-manager funds early can prove to be a smart move.
And in addition to the potential for outperformance, in the event that there is a swell of investor demand for successive funds, the GP will usually look favourably on its early supporters when it’s allocation time. And this, at least, gives limited partners the option to invest in successive funds when access can be limited for the most successful GPs, particularly those who maintain discipline in scoping out the size of their follow-up funds.
A version of this article was published in Private Equity International.