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.)
Small- and mid-market deals outperformed large deals across most vintages, including during the years of the global financial crisis. Smaller transactions also significantly outperformed large deals in vintages 2003, 2008 and 2012, the study showed.
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.
The study cites three main factors driving small- and mid-market deal performance as compared to larger buyouts. One is that smaller deals usually require some level of operational improvements.
“The current high valuation environment may reduce potential prospects for achieving significant multiple expansion upon exit, placing even greater emphasis on achieving operational improvements,” the study said.
Smaller companies may present more opportunities for improved processes because they have fewer resources and less experienced management teams than larger companies. This gives a small- or mid-market GP the chance to institute best practices, improve corporate governance, strengthen the board, recruit new management and bring on new suppliers and customers, the study said.
Larger companies, especially those formerly owned by private equity, may have already gone through such upgrades, the study pointed out.
“The smaller companies tend to be more inefficient and further from being optimized,” Carnelli Dompe said.
Other factors potentially driving the outperformance of these deals is that GPs in this segment have a broader universe of potential deals from which to choose, the study said. As well, valuations lower down-market have historically been more attractive than up-market, the study said.