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Maintaining equilibrium in the private equity ecosystem as larger players set sights on smaller deals

15 November 2019

SMEs and private equity firms used to focusing on big deals will both have to adapt if investments at the lower end of the market are to work, says Claire Madden, Managing Partner at Connection Capital.

What to make of the news that major private equity players are increasingly training their focus on smaller deals as they look to deploy huge unspent pots of capital? According to Refinitiv, the data provider, transactions valued at below $500m are at a record high, making up almost a third of deal-making by value. It’s been clear for a while that private equity firms have vast amounts of cash in need of a suitable home. And while there have been a number of big-ticket deals this year, it seems that, for now at least, the lower-mid market is where the action is. But is this trend really good news for small and medium-sized businesses (SMEs), or for those large private equity funds entering this space?

Risks vs. rewards

According to the British Venture Capital Association (BVCA), small management buy-outs (MBOs) outperform their larger counterparts. For private equity investors then, there is significant potential for attractive returns in these smaller deals – but there are a number of pitfalls to be aware of.

One is that, in order to invest at this level and keep within funds’ minimum investment rules, there’s a very real risk of over-funding. The high multiples that are typically being paid for investments at the highly competitive top end of the market need to be adjusted down at the lower end, to take account of the greater level of risk incurred in investing in SMEs which may be less mature, have less market share or have a less well-known brand. If higher multiples are paid, higher leverage will be required in order to generate decent returns, putting businesses (and deal structures) under greater strain.

Containing the management team’s ‘cash-out’ element of a deal is also a major concern. In larger private equity deals, teams can be changed and replaced relatively easily, but at this end of the scale, businesses are far more reliant on specific individuals. Often they are run by the founders or key long term members of the team who know the business inside out and are, therefore, not easily replaced. If a deal allows them to cash out too much of their equity in the business, there’s a risk they will have no incentive to stay. In the past, the maximum amount an investor would want to see a business-critical manager cash out is 50% - but now it’s common to see people being cashed out at way beyond that threshold.

That matters because the investment process at this level can often be quite a painful journey for management teams. It may be their first tranche of external capital and they will need to get used to having this kind of stakeholder involved in the business. There will be extra scrutiny and higher standards of governance expected. It’s important to remember that the point of getting private equity investment is that it will be transformational and that business will never be the same again. That should be enormously positive, but the reality can be quite hard for some people to adjust to. With more ‘skin in the game’, it’s worth the effort.

Big vs. small

There’s also a danger that private equity firms that are used to dealing with far larger businesses underestimate how much more oversight and support companies of this size are likely to need. One of the reasons why most of the attention in the private equity space is focused on larger deals is that there is less need to take an active role to support the business to reach its potential. Larger deals tend to be comparatively less resource-intensive and more cost-effective. With smaller deals, there’s far more of an onus on enabling businesses to develop and grow not just via financial input, but through constructive business support.

That requires a specialist model that is ready to offer advice and expertise where needed and seeks to develop an excellent relationship between investor and investee, and there are plenty of smaller private equity players adding this kind of value in this space. Big funds whose portfolios contain a range of companies of varying sizes may not be able to devote the attention that smaller businesses need, focusing resources instead on their larger investments.

SME owners and managers therefore need to consider very carefully who their private equity partner should be. This is likely to be a long-term relationship (three to five years or perhaps longer), which is going to have a major impact on their personal wealth as well as the business they’ve worked so hard for. Alignment between investor and investee objectives is critical, as is trust, openness and an ability to work together to whatever extent (greater or lesser) the business needs. Added to which, unsustainable objectives and risky debt structures may not be a price worth paying, no matter how attractive the offer a prospective investor makes.

No one knows when this market distortion will normalise, but smaller deals are not the natural habitat of large private equity players and that can create tensions in the ecosystem. SMEs and large private equity funds may both see this as a positive move, but each will need to adapt if lasting relationships are to be developed and real value to be created. There’s a reason why this end of the market is dominated by smaller, specialist private equity firms that have carved out a niche, with investment models that are designed specifically to make investments on this scale work, for both parties. Buyer (and investee) beware: make sure you know what you’re getting into, it may not be as straightforward as it seems.

 Russell O'Connor
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