Private equity is now a very mature industry. The global buyout market has grown to roughly US$5tn, up from US$2.5tn in 2019. Much of that capital has flowed into the mid and upper ends of the market, and as a result there’s a little bit of a mismatch in the lower end of the market where there’s less capital chasing better opportunities. Simply put, there are more small companies than large ones.
On the buy side, first you’re going to get better pricing because there’s just less capital, and less intermediation. You’re going to be buying opportunities and usually at a better price point than the mid and upper part of the market. Secondly, in more cases than not, you’ve got a better chance of partnering with a founder – people who’ve built their businesses over years and are now looking to take some capital off the table. They are also trusting you with their life’s work, and they also want to make a significant return of capital, so they’re going to not maximise price at that individual point in time, instead they are going to look to partner with the right manager who’s going to work with them to continue to scale their business and obviously generate a great return on the capital they leave in – whether that’s 30, 40 or 50%. So, the alignment is a lot better than buying it from somebody else, who just wants to maximise price.
Another attribute of the lower end of the market is there’s a better chance of being the first institutional capital into these companies and, as a result, the first institutional playbook. Companies that grow in size and scale usually get there because they’re doing something right, and after multiple owners much of that low hanging fruit has been optimised by somebody else.
When you’re partnering with a founder in a US$100m business – a founder who has got that business to a certain level but needs help optimising the ‘go to market’ function, or the top of the funnel for sales leads, or the finance function, or the product roadmap, or doing mergers and acquisitions (M&A) – when you’re the first institutional capital coming into a business, that low hanging fruit accretes to that that playbook which was being used for the first time.
So, one of the reasons we like the lower end of the market is this dynamic. In our last few co-investment funds, we’ve been the first institutional capital in about half of the companies we’ve invested in – a remarkable stat given how mature the private equity industry is.
Moving on to beyond the buy and more into the sell – obviously, you have to return capital back to investors. That is the kind of main point of private equity. The exit dynamics on the lower end of the market we have found to be easier than in the upper end of the market. For example, if you start out with a business valued at US$100–140m, you only need to grow it to US$300–400m to generate a 3x+ return. At that size of company, there are more exit options: strategic buyers, other private equity firms, and growth investors. These companies just aren’t big enough to require so much capital, and there’s just more buyers out there.
Larger businesses face more constraints: debt packages are important so these businesses are going to be affected by interest rates, the IPO window is important and if this is shut for a period of time – like it seemingly has been – that is going to be a tougher way to exit, and, as you go up market with larger businesses the buyer pool also shrinks.
From both a buy and exit perspective – and an operational playbook perspective – that’s why the lower mid-market offers the best opportunity to generate strong returns. In our most recent co-investment fund, 40% of the companies we invested in had no debt at the time of acquisition.
We are buying healthy, growing businesses that can generate those types of returns through playbooks that are operational value add, with favourable exit dynamics and avoiding the big leverage game that can get you on the wrong side of interest rate cycles.
