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Magnifying returns from small investments: why looking beyond mid-to-large size private equity deals can be rewarding

29 August 2016

Magnifying returns from small investments: why looking beyond mid-to-large size private equity deals can be rewarding

As we enter 2016, private equity appears to be in rude health. Confidence in the asset class has seen capital inflows surge and attractively priced debt is readily available for deals of a certain size. But while much of the attention has, as ever, been focussed on the large-to-mid-sized PE sector, the smaller end of the market remains relatively unloved and overlooked.

From an institutional investors’ viewpoint, this neglect is understandable: smaller deals don’t garner the headlines and fall well beneath their notice. But for family offices and wealthy, sophisticated private investors, the smaller end of the market (£5-20million enterprise value MBOs) may be where the best opportunities lie.

Investing in a sector largely ignored by the majority can be a smart investment strategy, if done for the right reasons and in a disciplined manner. In contrast to the mid-to-large end of the market where so much money is chasing so few deals, pushing up entry multiples, at the smaller end a dearth of capital means valuations tend to be much more sensible. The availability of high-quality investee companies with significant growth potential seeking investment tends to be greater, so for investors, there is potentially more choice and less competition. And unlike many mid-market secondary buy-out deals, investors aren’t paying a premium to buy out earlier PE investors.

So far, so straightforward but there are good reasons why more investors aren’t flocking down this route. That’s because it’s not that easy either to access or to make work effectively, given the deal size to deal cost ratio. Similarly, the skill sets required to invest at this end of the market are different to those in the mid-large cap sectors. That doesn’t mean it’s impossible, by any means. With the right strategy and expertise, targeting this sector of the market can be well worth it.

Investors who can find an investee company with a sound business model and growth potential, in which they can deploy their capital efficiently and support the business to the point where it’s an appealing prospect for a secondary buy-out or trade sale, could achieve a double whammy: multiple arbitrage versus that paid on the way into the original investment plus attractive profit figures driven by growth in the business. This is where you get into highly attractive returns territory. In our view, there are several key factors involved in getting this right.

Consistent, quality deal flow is driven by relationships, not just numbers

Fundamental differences in the way large-to-mid-size and smaller deals are transacted mean that smaller PE players have to take a different approach if they want to generate consistent, quality deal flow. At this level, relationships are key – both to sourcing and securing deals.

Identifying suitable investment targets can be challenging, as many smaller fund managers simply don’t have the bandwidth to promote their offering with dedicated origination teams. Therefore, having a network of trusted contacts (corporate finance advisers, HNWIs, other PE funds) who can act as introducers or even become co-investment partners is invaluable.

When it comes to sealing the deal, price is not necessarily the main driver. Whereas in the mid-large deal market where majority stakes are being acquired, price and deliverability tend to win the mandate as the vendor is driving the decision, usually via an auction process or similar; at the smaller end of the market the dynamics of the deal are very different. Yes, price is important (as is deliverability), but these are smaller businesses, where the management team is critical to the stability and success of the business; arguably more so than in a larger, more established company. As a consequence, the management team has far more influence in who it transacts compared to its influence in a larger, vendor driven process. Therefore, the on-going relationship with investors, the trust built up with the management team through a process and the extent to which the management team feels the business will be constructively supported mid- to long-term - is just as vital.

Transacting the deal: experience is everything

A key issue for PE players targeting smaller deals is that, notwithstanding their size, due diligence still needs to be sufficiently thorough. How to do this without overloading what is usually a small management team, causing them to take their eye of the ball or saddling the transaction with excessive due diligence fees which eat into investment capital, is a fine balancing act. Having the right mix of expertise and useful contacts is key as is a commercial approach to the inevitable challenges that pop up in smaller businesses.

The ability to be flexible in the way transactions are structured is also essential. Each investment prospect will have its own unique opportunities and challenges, and it’s important to be able to structure deals accordingly. This is where some traditionally structured VCT or PE Funds can fall down: fitting in with their rules or indeed with tax mitigation schemes may mean that the deal is not actually structured in the most efficient, effective way for the business/management team.

Since institutional fund investors don’t tend to operate in this space, family offices and HNW private investors need to find another way in, either directly if they have the expertise to do so, or through a specialist investment business with the skills and experience to target this sector of the market effectively.

Buying quality assets at sensible prices isn’t easy in today’s excitable private equity market, where competition is tough, funds have significant capital overhangs to spend and entry multiples seem to be spiralling ever upwards, but investigating opportunities at the smaller end is one way to beat the crowd. Here, the market is far less susceptible to prices being fuelled simply by the need to deploy capital, but investors seeking out value in this space need to be pro-active, innovative and smart. For those who know how to make it work, it can certainly be very rewarding.

By Claire Madden, Managing Partner of Connection Capital LLP


 Russell O'Connor
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