Smaller is better, study says, though LPs mainly bypass young funds

Raising a first-time fund is a hard bet, even in a strong fundraising year like 2019.

Limited partners are quicker to re-up with their established managers, who are likely coming back to market earlier than expected to take advantage of the capital flowing through the system.

This doesn’t leave a lot of room for new managers, or even those raising Funds II or III. But a new study suggests LPs would be wise to take a second look at those new entrants, who are likely smaller, more hands-on and working with a much larger universe of potential deals, at cheaper prices, than their bigger, older peers.

Pantheon, examining its own database, looked at deals from 2000 to 2012 and found that small- and middle-market buyouts have, on average, outperformed larger deals, according to a study the firm published in September.

The trick for limited partners is to find those smaller managers that outperform, and avoid the ones the implode.

The study, which included 2,237 total deals, defined small- and middle-market as those deals with entry enterprise value of below $500 million.

Pantheon’s study showed that small- and middle-market deals outperformed large-market buyouts by a total-value-to-paid-in compounded annual growth rate of 5 percent. (The TVPI measurement takes the total value of a fund’s holdings, both realized and unrealized, and divides it by the fund’s called capital, according to Rob Go, co-founder and partner at NextView Ventures, in a 2018 column.)

The outperformance is tempered by the need for LPs to carefully select their GPs. “The small- to mid-market tends to produce more diverse outcomes; the large markets are more reliable,” said Andrea Carnelli Dompe, a vice president with Pantheon and one of the authors of the study. Check out my story here.

Ops improvement: The study cites three drivers of small deal outperformance—more opportunity for operational improvements, especially on companies that haven’t yet had private equity ownership; a much broader universe of deal targets at valuations that are likely cheaper than further up market.

In the high-valuation environment, improving operations is more important than ever if a firm hopes to increase the value of a business. It’s harder to bank on multiple expansion as if the market will take valuations higher than they are now.

For LPs, it would be worth it to take a look at some of the younger funds just hitting the market, especially those from mid-level, next-gen executives hungry to prove their strategies. Getting in on the ground floor of a new shop could mean not only outperformance, but an early relationship with what one day could be the next mega-shop.

—Chris Witkowsky