LPs backing away from small buyouts could miss the exit party

Despite strong performance, the small buyout segment is receiving less capital from limited partners. As is usually the case, LPs are content to stick with their deepest relationships in uncertain markets.

Happy Friday LP folks!

This is Chris, your groggy journalist heavy into a book called Dark Victory: MCA, Reagan and the Mob. I don’t know how much of it is true, but it makes for compelling reading.

A recent report from StepStone Group titled Pound the Table for Small Buyouts makes the case that LPs should be focused on this segment for its return potential and clearer paths to exit.

Small buyout funds sold 5.9 percent of their investments through the first three quarters of 2023 and nearly 9 percent in the LTM period ended in the third quarter of 2023, the report said.

“SBOs have generated more exits than other buyout strategies over the past two years, and during that period, the exits have generated some very attractive returns,” the report said.

Performance has also been strong. The small buyout segment in recent exits generated an aggregate gross TVM of 3x. Nearly a third of deals realized since Q3 2021 produced a 3x or higher multiple, the report said. “SBO’s return dispersion is greater, but LPs have been compensated for bearing this risk.”

The report, published in April, shows that despite strong performance, the small buyout segment is receiving less capital from LPs.

As is usually the case, LPs are content to stick with their deepest relationships in uncertain markets, which usually means larger, more established firms. Small buyouts share of fundraising has grown at a CAGR of 5 percent over the past decade, roughly a third at which large firms have gathered capital, the report said.

Small buyouts segment includes the emerging manager side of private equity, which itself has seen a dramatic reduction in the flow of LP capital. This has created extreme market stratification between firms that can attract capital and everyone else.

But, there are ways for newer and smaller shops to push through the morass. Many talented GPs who are setting off on their own paths are choosing the deal-by-deal route as a way to build up a portfolio of investments that can prove their strategies.

As well, firms that are fundraising are using the seeded primary method – investing while fundraising, so LPs that commit can invest alongside the manager, and potential LPs can get a view into what the portfolio will look like.

As this side of the market struggles to find capital, several firms have closed or have emerged as raising pools to specifically target the small-cap side of private equity. One recent pool is from HighVista Strategies, which last year acquired abrdn’s US private equity operation, closing its tenth US PE fund on $675 million, beating its $550 million target.

The fund is among several others raising capital to back small and emerging managers, including independent sponsors. While capital flows into the small buyout world have slowed, several firms see the opportunity to fill the gaps.

We will be exploring these topics in depth in our June issue of Buyouts. Meanwhile, if you have any thoughts on this, hit me up at christopher.w@pei.group or find me on LinkedIn.