Produced in partnership with Schroders as part of ‘The Adviser’s Guide to Investing in Alternatives’. Download the full guide here.
Founder-led and family-owned businesses are commonplace in private equity, particularly in the small to middle market, which consists of companies with an enterprise value of up to $1 billion.
For the past 15–20 years, this space has been the sweet spot for private equity investors. On average, private equity funds that focus on the small to mid-market have outperformed their large cap peers.
This quashes the misconception, in some corners, that the SME private equity market is a speculative and risky place to be, and that large companies outperform their SME counterparts.
In the SME segment of the market, attractive buyout opportunities abound. As the name suggests, a buyout refers to the acquisition of a controlling interest in a company. The majority of buyouts involve mature, highly profitable businesses. Many are decades-old founder-led or family-owned businesses that need a succession solution and capital for growth. They are not start-ups or risky ventures.
Families offices and high net worth investors (HNWI) get it, evidenced by their strong and growing support for the asset class, and alternatives, in general.
For many HNWIs and ultra-HNWIs, the family business represents a significant chunk of their wealth, and the wealth of friends and colleagues. They have seen, first-hand, the many potential benefits of private investment, including superior returns to public equities, lower volatility, and diversification through exposure to a broader mix of sectors and industries, and companies at various stages of the business cycle. Not surprisingly, family offices and HNWIs are among private equities’ biggest cheerleaders. Their long-term investment philosophy and approach, which often spans generations, is compatible with private assets.
A broad and deep global universe
While the case for incorporating private equity into a diversified portfolio is generally well known and understood, there are also risks to consider.
Like every company, private companies face a myriad of challenges and uncertainties. In addition to investment risk, there’s also interest rate risk, liquidity risk and valuation risk.
Investors should choose managers with the ability to invest in a broad global universe.
The global private equity universe is exponentially broader and deeper than the domestic market. Wholesale investors also stand to benefit from changing supply and demand dynamics.
As a consequence of their enormous size, institutional investors like superannuation and pension funds need to allocate big chunks of money to asset classes in order for that allocation to have a material impact on overall portfolio performance. This generally restricts them to the large and mega cap buyout space.
According to Preqin, fundraising among large cap funds increased 10.7x from 2010 to 2022 while deal flow only rose 3.6x. In other words, there was three times as much money as there were deals in the large cap space.
The result of this supply and demand imbalance is higher entry multiples for investors, adversely impacting overall growth multiples. On the flipside, in the small and middle market, deal flow increased 4.2x from 2010 to 2022 while fundraising only rose 2.9x. This dynamic is creating tailwinds for private equity investors, enabling managers to buy small or mid-sized companies at lower entry multiples and sell them later, when they are larger. While size is not an indication of performance, all things being equal, funds that buy small to mid-cap private companies statistically outperform their large cap managers because they benefit from factors including a greater number of opportunities, lower entry multiples and a longer runway for growth.
Claire Smith is head of business development, private markets for Schroders.
This is an edited abstract from the Professional Planner Adviser’s guide to investing in alternatives. For insights on opportunities in private markets, download your copy here.
