Smaller businesses remain the lifeblood of the UK economy: agile, inventive and often overlooked by larger investors. Yet amid inflation, rising costs and tighter regulation, identifying which SMEs can truly thrive takes careful discernment, writes Michael Mowlem.
Napoleon Bonaparte famously dismissed Britain as a “nation of shopkeepers”. Intended as an insult belittling the military prowess of the country he would soon be defeated by, the comment can now be seen as a tribute to the entrepreneurial spirit that continues to drive the UK economy.
The private equity ‘food chain’ relies on a flow of growing businesses, all the way from entrepreneurial start-ups that become tomorrow’s first-time management buyouts through to companies going public that will become future take-privates. Close to the smaller end of this chain, where Napoleon might have been referring, is where Connection Capital sees value opportunities in first time buyouts.
Businesses that we consider investing in tend to include those established in recent years to those held for a generation, where the founder is either approaching or post retirement. What many have in common as they seek external capital for the first time is the need to derisk and acquire funds to help grow a business.
The most attractive SME investment opportunities for Connection Capital and our clients are those where the management teams of these UK companies have shown agility, innovation potential and an ability to grow despite limited capital.
The Federation for Small Businesses (‘FSB’) estimates there to be 5.6 million ‘small’ businesses (measured by having fewer than 49 employees) in the UK at the start of 2025, representing 99.2% of the total business population. The same survey defines ‘medium’ size businesses as those with between 50-249 employees and together with Small businesses, SMEs represent 99.9% of the UK business population. Total employment in SMEs was 16.9 million people, 60% of total UK private sector employment. Revenue of SMEs amounted to £2.8 trillion which is equivalent to the entire UK Gross Domestic Product, illustrating great success in export activities.
SMEs show remarkable resilience through periods of market turbulence. Given the numerous shocks to the economy over the past twenty years, the FSB reports only four decreases in sector employment occurring since 2010, all of which have occurred since 2017 – the largest during Covid.
When you consider the challenges SMEs have had to withstand during this period, SMEs have shown an incredible ability to adjust. Challenges that have applied to all organisations in our economy over this period include Employer National Insurance increases, Inflation, Interest Rate rises, Minimum Wage and Living Wage inflation, Covid and Brexit.
It is that agility which appeals to private equity: the ability to quickly evolve a firm’s business model to exploit opportunities that large organisations find harder to do. This value creation opportunity is an attractive feature of SMEs. At Connection Capital we have exploited this on numerous occasions through our portfolio. Recent examples include moving a manufacturing plant, launching new products capable of transforming a profit & loss account, or winning a small number of substantial new customers to increase revenue exponentially. Often these improvements in a small business can result from the hire of one new individual to join an incumbent pool of talent.
There are numerous ways that SMEs can outperform the wider market in creating value.
- SMEs benefit from shorter, often closer supply links and strong relationships with their customer base. We see this in our portfolio where customer relationships can span years. As a consequence, they can develop and sell products and services more speedily than larger businesses.
- New developments in technology are more quickly embraced by SMEs who can adapt their business model to AI, automation and cloud platforms. Tech-enabled efficiency and scalability are key differentiators from larger organisations who, for the right reasons, need to take longer to make equivalent strives in technology.
- Capital structures of SMEs pre-and-post private equity involvement tend to be simpler than larger companies with easily understood and manageable debt arrangements, less exposed to the vagaries of debt markets than larger organisations with public debt obligations.
So where are investors like Connection Capital seeking to deploy capital to SMEs? We consider growth sectors such as technology, energy and infrastructure, healthcare and business sectors, while more recently defence has become an area where investors can determine growth. Irrespective of sector, backing experienced, adaptable management teams with a growth mindset is vital, while Family-owned SMEs must demonstrate openness to change.
Society must protect and nurture its SMEs and the tendency in the UK in recent years to over-legislate and tax is a worrying development. ESG compliance pressures impose a level of reporting and cost on businesses that may be burdensome. Rises in Living Wage, Employers’ National Insurance and the upcoming Employment Rights legislation will all detract SMEs from their principal focus of fuelling the growth of the British economy.
We believe that private equity can continue to play a significant role in supporting SMEs, with the availability of capital and the ambition to invest in order to fuel growth or to enable a well-deserved exit for founders of successful businesses.