In partnership with

Here’s Why Over 4 Million Professionals Read Morning Brew

• Business news explained in plain English

• Straight facts, zero fluff, & plenty of puns

• 100% free

See for yourself

Setting the Stage: Small vs. Large Buyouts — Two Different Worlds

Today we are doing a deep dive into some of the data around how small buyouts have performed in comparison with larger private equity deals.

We also unpack some of the key potential drivers behind outperformance.

Before we dive into the data, we should take a second to remember… why do we even care about this topic (small vs. large buyouts)?

There’s a lot of people running around (particularly senior leadership / investor relations teams at the publicly-traded megafunds) saying that private equity is good for individual investors.

The problem… is that private equity is a massive asset class at this point and there is a absolutely huge difference between:

• buying a sub-$100M TEV small cap company in the lower middle market and

• buying a $30 billion TEV company like Medline, which required checks from three (3) separate mega-funds: Carlyle (my old team) + Blackstone + Hellman & Friedman

So when investors / wealth advisors / talking heads on TV / Wall Street public company CEOs say things like:

“private equity is good for individual investors because it:

1. outperforms public markets and

2. increases diversification of a portfolio”

There’s a lot more nuance that needs to be unpacked before we start tossing 25% of our net worth into private equity funds.

Why Should You Care About This?

Our team at Gather Capital is always thinking about private equity investing from the perspective of an individual investor or family office.

We aren’t trying to solve the problems that mega-LPs like sovereign wealth and pension funds have: we don’t need to invest $100s of millions (if not more) into a single fund at once.

That’s a problem that the megafunds solve for mega-LPs. But not for us.

We get to play in a different sandbox and write multiple checks to build out portfolios of smaller, lower middle market funds.

And why would we want to do that?

Because lower middle market / small cap buyouts have some of the most attractive risk-reward dynamics in private equity.

The tradeoffs between small and large PE are quite different.

Private equity as an industry has some of the most talented investors on the planet —many of those world class investors invest at the megacap funds. They are handsomely rewarded for this (in part given the amount of fees you can make on a $20B fund).

But the underlying market and deal dynamics between a small buyout, a large buyout and a mega buyout are vastly different - and this is reflected in the difference in returns profiles for small vs. large deals.

So with that… let’s dive in.

The Case for Lower Middle Market Private Equity

Part I: Performance

Small Cap Buyouts Outperform Large Cap Buyouts

Small Buyouts Enjoy Stronger Net IRRs

I want to keep the next section as “light” on text as possible so you can focus on the data and the charts… but a few key points:

• Small cap deals have the greatest returns dispersion

• This means both the greatest upside, but also the greatest potential downside

• Dispersion can be a good or a bad thing depending on how good you are at “picking” the right deals (if you’re the PE fund) or funds (if you’re us, the LP)

• This dispersion creates the opportunity for alpha through superior manager selection

• Small buyouts also have some of the greatest potential for outsized returns / “Home Run” outcomes

Small Buyouts Have Greatest “Home Run” Potential

Part II — The Drivers

Why Do Small Cap / LMM PE Deals Outperform?

First, let’s look at some of the fundamentals of buyouts at different sizes.

(Small < $250M TEV, Mid = $250M-$1B TEV, Large > $1B TEV)

What are the key differences between small and large buyout deals? Note we also have comparative data vs. small and midcap companies in the Russell 2500.

What does the data say about the difference in fundamentals for small vs. larger buyout deals?

1. Lower Entry Multiples at Entry

   • Higher upstream exit multiples

2. Lower Leverage Ratios at Entry

   • Lower risk of financial distress and exposure to interest rate shocks

3. Greater Room for Operational Improvements and Value Creation

   • Higher Revenue and EBITDA Growth

   • Lower Margins at Entry

For the chart above,

1. Small Cap = TEV < $250M

2. Mid Cap = TEV $250M - $1B

3. Large Cap = TEV > $1B

Its also important to note that the Russell 2500 shown on the charts above refers to a public company benchmark of small and mid-cap companies.

So, small cap PE has more attractive fundamentals (in terms of EBITDA multiple and revenue / EBITDA growth profile) than public peers.

Small Deals Often Have Greater Opportunity for Operational Improvements

For small deals, some of the most attractive outcomes are when a private equity fund acquires the business directly from a founder or family-owner.

This is a phenomenon that makes the lower middle market especially attractive… although there of course can be larger founder-owned companies too.

When a PE fund is the 1st institutional investor, there are often a wide range of operational improvement areas that the fund can tap to improve, grow, institutionalize the company.

Private equity funds can leverage operational expertise and provide added capital and firm resources to enhance the revenue growth and margin expansion trajectories of smaller businesses.

Even if the PE fund buys from another sponsor and not directly from a founder (as may be the case for some of the deals captured in the sub $250M TEV “small cap” category above), clearly there are still clearly some attractive dynamics about smaller buyouts.

What are the some of the potential areas for operational improvements that PE funds can execute in a buyout?

• Professionalize Management Team

• Build out finance functions

• Enhance operations capabilities & best practices

• Modernize systems

• Optimize pricing

• Improve cost structure

• Diversify and reduce concentration

  • Customer concentration

  • Product / service concentration

  • Geographic concentration

• Expand access to capital markets

• Ability to execute on M&A / Add-on opportunities

• The list goes on!

This list of course can apply to companies across size ranges…

…but there is more likely to be operational improvement / value creation opportunities when a company hasn’t been owned already by four (4) other PE funds and the army of consultants from Bain, BCG and McKinsey haven’t squeezed out all of the juice…

Let’s dive deeper on a few of these dynamics:

Entry Multiples

In general, smaller companies tend to be valued at lower multiples than larger companies. This is reflected in the data below from a few different sources.

The implications for a smaller private equity fund are that the fund can:

1. Buy low(er)

2. Sell high(er)

The playbook is:

• Enter at a lower multiple.

• Grow the company.

• Exit at a higher multiple.

The principle tends to apply to potential bolt-on M&A deals as well.

For example, a PE fund can can:

1. buy a company for 6.0x TEV / EBITDA

2. complete tuck-in / add-on M&A acquisitions of even smaller companies at 4.0x EBITDA

3. Combine everything into a platform that now has even greater scale

4. Sell the larger business at an even higher exit multiple: somewhere from 8 to 10 to 12.0x.

5. (This is all a purely illustrative, made up example)

6. This process above is often referred to as “multiple arbitrage”.

Multiple Expansion

As discussed in the Entry Multiple section above:

• By acquiring businesses at a smaller scale

  • The PE can pay a lower lower entry multiples

• By growing the company over time

  • the PE fund can exit at a higher multiple

This multiple expansion can be a powerful driver of returns for a PE fund… because not only has the multiple itself gone up, but you’ve also grown EBITDA… so you exit at a higher multiple applied to a higher EBITDA metric… not bad!

Leverage

Smaller deals tend to take on lower leverage than larger deals, which has a few important implications:

1. Lower leverage helps to lower the risk of financial distress and exposure to interest rate shocks / volatility

2. This also demonstrates how financial engineering (e.g. adding more leverage and paying it down with company cash flows) plays a more important role in driving returns for larger deals…

   • Said another way, smaller deals comparatively rely more on driving operational improvements and value creation to drive returns

Competitive Dynamics & Capital Overhang

The last topic to hit is the underlying market dynamics in terms of:

1) the universe of potential buyout targets and

2) the universe of potential buyers for large vs. small deals.

Its no secret that there is an absolutely MASSIVE amount of dry powder teed up at large (especially mega) private equity funds with a focus on acquiring large companies.

Its also true that:

• there is a massive universe of small companies vs.

• a much smaller universe of larger companies in the U.S.

Meanwhile, the vast majority of dry powder private equity capital is sitting at larger funds that are targeting larger deals.

But I won’t go as far to say that this means the “lower middle market” has less “competition” than the larger companies in upstream markets (middle / upper middle / “large cap”).

Some folks make this argument for sure, but as I’ve essentially argued throughout this piece… the lower middle market has some phenomenal private equity funds chasing deals… so it would be silly to say that the space is just “less competitive”.

So, what are the facts?

• There is certainly a “Capital Overhang” phenomenon where there is significantly more capital upstream chasing fewer targets plays of large deals.

• You can infer what this means for deal dynamics and multiples for large cap deals… highly competitive auctions bid up entry multiples and purchase prices for large deals when there is more money chasing fewer deals.

Meanwhile, these dynamics aren’t a bad thing for the lower middle market and in fact, the capital overhang plays an important role creating attractive exit paths for smaller buyouts.

There’s a lot of bigger fish upstream who want to eat your lunch when you’re ready to exit your small cap deal to a larger fund.

From a purely data driven perspective, its definitely clear that smaller deals are, on average, cheaper when you look at entry multiples (as we did above).

Cheaper doesn’t necessarily mean there is less competition though.

But more competition can certainly play a role in increasing multiples.

So… its complicated.

What is clear is that the lower middle market has some interesting dynamics play out in deals because you may not have pure “economic sellers” when you are buying a business directly from founders / family owners who are parting ways with their prized possession. Its not… ALL… about money.

Here’s one take that I really enjoyed from Peter Lehrman who’s the founder of Axial, a deal platform that traffics in thousands of lower middle market / small M&A deals each year.

Peter argues that LMM deals get done at lower multiples:

• NOT because there’s less competition…

• but because when you’re buying directly from a founder and they are selling their family-owned business… THEIR LIFE’S WORK!…

• there are non-economic factors that founders care about more than price alone.

Super interesting.

That’s all for now.

At Gather Capital, we curate a set of world class private equity opportunities enabling our clients to invest alongside elite family office limited partners.

If you’re interested in learning more about what we do, feel free to:

• swing by our website & create an account (if you haven’t already)

• grab some time on our calendar here

• shoot us an email

We’re looking forward to Talking Shop with you soon.

Sincerely,

Disclaimers & Risk Disclosures

Any data / information shared here has been provided by third parties and has not independently verified. Past performance is not an indicator or guarantee of future performance. All information contained herein shall not be construed as anything other than general educational material for informational purposes only and may not be relied upon for any other purpose.

The sole purpose of this material is to inform, and it in no way is intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits.

An investment in any private fund involves significant risks and certain potential material conflicts of interest. In considering any performance information contained herein, readers should bear in mind that past performance does not predict and is not a guarantee of future results. Investment in private equity involves significant risk, including the potential loss of invested capital. No investment or strategy implies a complete lack of risk. A private fund investment involves a high degree of risk as such investments are speculative, subject to high return volatility and will be illiquid on a long-term basis. Private fund investors may lose their entire investment.