Global lower middle market private equity

The global private equity (PE) market has grown in astounding ways since the turn of the century. Over the past decade, $1.9 trillion has been raised globally across more than 3,000 distinct funds, as shown in Figure 1. PE firms that once executed on rather straightforward and easy-to-understand business models have in many cases grown into multi-billion dollar asset management behemoths pursuing a range of private capital strategies. 

Today, one need look no further than the public markets (ironically) to find some of the most well-known global PE firms in the industry, including Blackstone, Carlyle and KKR. In the U.S., firms that were built on the back of a middle market generalist model of buying small companies across a range of industries are increasingly focused on more specialized investment strategies and complex financial engineering to generate returns from much larger deals. Similarly, in Europe, many of the largest players in PE – such as CVC and Bridgepoint – are now a far cry from their traditional roots as the PE arms of large banks. And in Asia, a region undergoing dramatic growth, large pan-regional powerhouses are juxtaposed alongside a remarkably diverse collection of local venture, growth and PE firms. 

What has driven the immense growth of the global PE market? The answer is rather simple: returns. Across nearly all long-term time horizons, private equity has outperformed the public markets and generated strong returns on both an absolute and risk-adjusted basis. As shown in Figure 2, global PE returns have outpaced the public markets over all long-term time horizons. Moreover, investors that are able to successfully identify and access top-quartile managers stand to benefit from considerably greater returns. This strong performance, coupled with the persistent low interest rate environment across the globe, has boosted interest in PE and driven growth of the asset class. 

The search for outperformance

Beyond PE’s headline returns, there is further outperformance potential if one can identify and access top-performing managers at the smaller end of the investment landscape. Indeed, upper-quartile funds sized less than $1 billion have outperformed their larger peers at the top quartile by nearly 600 basis points (bps) over a 10-year period, as shown in Figure 3. 

However, capturing the outperformance potential of top-quartile smaller funds is a complex endeavor, in part because of the sheer quantity of firms and funds focused on the lower middle market globally. Of the more than 3,000 funds raised since 2007, nearly 90% have been sized at less than $1 billion, as shown in Figure 4. While many of these firms are headquartered in the world’s best-known financial centers – Hong Kong, London and New York – many of the most interesting smaller PE firms are located off the beaten path in cities typically not known for finance, such as Austin, Barcelona and Jakarta. 

At the same time, investors who are able to successfully identify top-performing smaller managers are often confounded by the deterioration in returns that occurs as these managers scale up in size and migrate to more efficient segments of the market. Indeed, the so-called “persistence of returns” argument, which holds that top-performing PE managers have a high likelihood of delivering sustained outperformance in the future, tends to be trumped over time by the negative implications of fund size growth on performance. Importantly, this phenomenon applies to every region globally.
 

Anecdotally, one can see this erosion of returns by looking at the pattern of performance for a sample of well-known private equity managers anonymized in Figure 5. Over time, this particular group of general partners (GPs), whose earliest funds were quite small, have gone on to raise more than $260 billion across more than 110 funds and substrategies, often with deteriorating return profiles.[1] They have all certainly come a long way from the small funds on which they built their brands. 

The upshot of all this is that investors need to be forward-looking and nimble if they are to have success navigating a more mature and efficient global PE marketplace in search of outsized returns. Limited partners (LPs) simply cannot look in their rearview mirrors when making investment decisions in this asset class. 

The global lower middle market landscape 

One of the most interesting aspects of the lower middle market is its fragmented and diversified nature. There is no shortage of regional complexities, sector strategies and specialized investment approaches that must be understood. 

Globally, the lower middle market is similar from one region to the next in that there is a vast pool of investment opportunities from which smaller managers with a regional focus and/or niche expertise are best positioned to access differentiated deal flow. In much the same way an American family selling its business in the Midwest is often loathe to do business with a “New York investment banker,” sellers in Asia are unlikely to embrace a large global generalist firm as the proper caretaker of their business. When investing in these smaller companies, smaller managers with a local presence typically have a strong advantage over their panregional peers. 

North America 

The North American lower middle market has the largest and most diverse range of PE players. As the asset class has matured, top managers have increasingly tended to differentiate themselves through expertise in specific niches. This expertise is often borne out through industry specialization, where investment teams bring focused operating capabilities and sector-specific insights to portfolio companies. This is an especially successful approach in complex and dynamic industries such as healthcare, technology and financial services. 

Managers often further differentiate themselves via a regional orientation. While not nearly as complex as the geographic differences elsewhere in the world, certain regions within the U.S. lend themselves to differentiated sourcing approaches that enable managers to see unique deal flow that is not broadly intermediated. 

Beyond sector or regional approaches, the North American market also has a number of smaller PE managers focused on distinct investment styles such as buy-and-builds or turnarounds. These strategies tend to be far more specialized than traditional leveraged buyouts, allowing managers to differentiate on unique investment competencies that are hard for other managers to replicate. 

Europe 

In Europe, the smaller end of the PE market is also highly fragmented, but it is further influenced by distinct local norms, laws and even attitudes towards PE. While there are certainly sector and strategy specialists similar to those seen in the U.S., the top-performing managers in Europe often differentiate themselves via a country-specific focus. 

Despite the rather developed nature of the European market, small managers are able to capitalize on their regional presence to generate unique deal flow. The importance of being local cannot be understated given the differences in culture, language and (often) laws across borders. 

While many European cultures are open to partnering with PE investors and embracing the business plans and management change that typically follow, others have little regard for institutional investing. Regions such as the UK and Nordics tend to be rather institutionalized and well intermediated, with top funds differentiating themselves through not only a local presence but also sourcing and operational capabilities. 

Other countries tend to be highly tied to specific sectors, such as oil production in Norway. And in still other areas (especially parts of Germany and Southern Europe), owners of small businesses often don’t want to be seen as selling out to PE but rather partnering with well-regarded regional firms in order to maintain local credibility. Similar to the U.S., there are also distressed and turnaround specialists who differentiate themselves via expertise in local law and bankruptcy process. 

Asia 

Asia is a juxtaposition of both emerging markets (such as China, Southeast Asia and India, where relatively strong markets for venture capital and growth investing feed emerging opportunities in lower middle market buyouts) and developed markets (such as Japan, South Korea and Australia, where there are well-developed lower middle market buyout opportunities). 

The Chinese market – the largest by far within the Asia-Pacific region – tends to be dominated by venture and growth investing, although buyout investing continues to grow as successful entrepreneurs monetize their companies, and as state-owned enterprises continue to become privatized. Within China itself, there is increasing complexity as increased rates of team turnover are resulting in high-quality lower mid-market GP spin-outs from larger domestic and international PE firms. In India, the lower middle market PE opportunity is somewhat tempered by the ease of public market listing and the resulting tendency for private companies to command extremely robust valuations. Further opportunity and regional complexity can be found in Southeast Asian countries such as Indonesia, Singapore and Malaysia, where lower middle market investment activity continues to grow. 

In Japan, there are significant opportunities in the lower middle market, particularly relating to corporate spin-outs and generational transitions in family-owned businesses. In South Korea, where local families and entities tied to large conglomerates have historically dominated the corporate landscape, firms are now emerging to focus on niche situations such as the tax implications of generational change, turnarounds and corporate spin-outs. In Australia, the buyout market is most similar to that seen in the U.S. and Europe. Interestingly, Australia benefits from being one of the most institutionalized in Asia, with strong exposure via the services sector to the rising consumer phenomenon coming out of the region’s more emerging economies. 

Unlocking value in the lower middle market 

The origins of lower middle market investments can take many forms. Some are successful founder-run businesses in search of first-time institutional capital to manage generational change or to fund growth initiatives, while others may be more complex transactions involving local bankruptcy law or non-core divisions spinning out of larger corporations. Given the sheer volume of deals at this end of the market (as shown in Figure 6), it is a segment of the investment landscape that tends not to be well-intermediated, with a legitimate opportunity to find the elusive “proprietary deal.” 

Furthermore, this is a part of the market that sees robust transaction activity regardless of macroeconomic trends, credit availability or public market volatility. The lower middle market is a vibrant ecosystem where small business owners are constantly looking for some combination of liquidity, financing to fund growth initiatives and operational assistance to improve their businesses. 

Globally, lower middle market PE managers tend to generate investment returns via two fundamental value creation initiatives: growth and multiple expansion. Driving tangible change in underlying portfolio companies requires PE managers to have a specialized skill set coupled with day-to-day involvement with the company’s operations. These specialized skills can include everything from granular operating expertise to an ability to execute on complex financial transactions. 

While the use of leverage – a staple of larger PE investments – is within the playbook of lower middle market managers, it is generally not a core tenet of value creation. In fact, it isn’t unusual to see little, if any, debt in smaller PE investments. Deals that do take on leverage do so generally 1-2 turns[2] below the average of larger deals (as shown in Figure 7). This lower debt burden makes lower middle market investments less susceptible to balance sheet risk and generally offers more operational flexibility and financial stability. 

What most, if not all, successful lower middle market private investors have in common is the capability to fundamentally improve and grow businesses. Smaller companies are often under-managed and sub-scale, presenting significant opportunities for value enhancements. Growth can come from a variety of channels, including sales and marketing initiatives, product extensions, entry into new markets and add-on acquisitions. 

Means of building value often include expanding product/service offerings, enhancing operational processes and systems, augmenting management teams, redefining corporate strategy, identifying profit margin improvement opportunities and building new industry partnerships/verticals. Opportunities for even deeper restructurings exist in distressed and turnaround situations. By spearheading these types of changes, PE managers can institutionalize their portfolio companies, help them gain scale and improve operating efficiency. 

When it comes time to exit an investment, lower middle market PE managers are often able to realize multiple expansion - that is, the ability to sell a business at a higher valuation multiple relative to the purchase price multiple at entry. On the back of the value creation initiatives previously discussed, PE managers stand to benefit from selling a larger, better run and more diversified business – all of which drives a premium multiple. Further, there is no shortage of exit alternatives for smaller deals, whether it be selling to strategic buyers, financial buyers or the portfolio companies of larger PE firms. 

However, much of the fundamental attractiveness of lower middle market investing relates to the inefficiency in this segment of the market, which allows managers to buy companies at compelling valuations in the first place. Indeed, the lower middle market consistently offers the best relative value due to favorable supply/demand dynamics and the simple fact that many deals are not widely shopped in competitive auctions. As highlighted in Figure 7, the smallest deals (less than $25 million of enterprise value) tend to trade at purchase price multiples that are three to four times less than at the larger end of the market. 

Considerations for accessing the global lower middle market

While there are myriad benefits to investing in the global lower middle market, investors must be cautious and thoughtful when considering PE manager selection. To this point, several key factors should be top of mind when building a global portfolio. 

First, the PE universe is immense, with nearly 3,000 funds raised over the last decade. Nearly 90% of these funds are sized less than $1 billion – a common proxy for the lower middle market. 

Second, while smaller funds have outperformed larger funds, the dispersion of returns within the lower middle market is considerably wider. As highlighted in Figure 8, the spread between top and bottom quartile sub-$1 billion funds is 2132 basis points (almost twice the dispersion of larger funds). 

This dispersion can be attributed both to the general complexities of lower middle market investing as well as to the wide range of quality across PE GPs. Investors seeking to capitalize on the return potential of small-cap PE will be sorely disappointed if they select the wrong lower middle market manager. 

Third, adding to the importance and complexity of global manager selection is the fact that the persistence of returns in the PE asset class is eroding. The approach of backing managers with strong historic returns no longer guarantees future success. In fact, a recent study by Cambridge Associates showed that 84% of the top ten top-quartile funds across a recent nine-year period were managed by emerging or developing funds (Fund I-IV),[3] rather than well-established “proven managers.” Given that 64% of funds that have come to market since 2007 are either Fund I or II (as shown in Figure 9), it is important that investors are well plugged into markets across the globe and constantly monitoring new fund formation. 

Finally, and perhaps most importantly, PE fund investing in the lower middle market is a relationship business that requires on-the-ground, local presence in order to achieve the most success. Regardless of geography, the best-performing managers will rarely seek out investors; instead, investors must find them. For this reason, it is essential to develop relationships with firms early in their evolution before others are knocking on their doors. 

Additionally, the global market is comprised of a complex network of interconnected but regionally diverse countries where rule of law and the keys to successful investing vary across borders. It is vital to back managers with both relevant skills and strong local knowledge. It is not hard to appreciate the vastly different skills needed to invest globally. Whether performing due diligence on an opportunity in China, structuring a deal in Indonesia or taking a small company private off a public exchange in Poland, the requisite skills are unique and specialized. Thus, investment teams building global portfolios must understand the cultures, speak the languages, meet with managers regularly and have the perspective of monitoring the investment landscape through multiple cycles.  

Summary

The global PE landscape has evolved immensely over recent years, driven by the strong return profile of the asset class. Regardless of where they are located, managers investing in the lower middle market have shown an ability to outperform their larger brethren – a trend that improves further for investors who can identify and access top managers. However, to capture the return potential of the lower middle market, investors must understand the nuances of the global PE market and have local teams with deep regional networks. These relationships, together with an understanding of local markets, allow investors to access the best performing managers and have the opportunity to generate consistent outperformance. 

Given all the complexity associated with lower middle market investing on a global basis, appropriate diversification and portfolio composition across both geographies and strategies are key risk mitigation tools. Pairing this with a thoughtful manager selection approach opens the door to partnering with top-performing PE firms and the potential for alpha generation. 

[1] Preqin and Aberdeen Asset Management analysis. For illustrative purposes only

[2] A turn of leverage refers to a company’s debt-to-EBITDA leverage ratio. For example, three turns means the company’s leverage ratio is 3x. EBITDA is earnings before interest, taxes, depreciation and amortization.

[3] Cambridge Associates – The 15% Frontier (July 2016).

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