Hidden gems

Private equity’s growth and maturation are clearly welcome developments for the industry itself but also for its investors which have, by and large, achieved out-performance relative to public markets in all major regions, as we explored in some of our previous articles. Indeed, in a recent survey of investors, 90% said that private equity performance had met or exceeded expectations over the past 12 months (source: Preqin). Yet the same survey also found that these investors are anticipating lower returns from the asset class in the past – their expectations have fallen from 14.1% in IRR terms in June 2015 to 11.6% in September this year (2018).

This reflects a recent trend: capital concentration in larger funds. The amounts raised by the private equity industry since 2013 have been phenomenal. In 2017, it raised US$453bn, a record sum and significantly higher than the US$226bn raised in 2012, according to Preqin. Looking beyond the headline numbers, however, it’s evident that much of this capital has flowed to the large, multi-billion dollar funds, such as those raised by Apollo Global Management (US$24.7bn), KKR (US$13.9bn) and CVC Capital Partners (€16bn). This has led to a marked rise in the average private equity fund size, from US$156m in 2015 to US$492m by 2017, Lyrique analysis shows.

The unprecedented rate at which capital is gravitating towards the mega-funds is clogging the system, leading to rising competition and pricing in the large deal space. This clearly affects returns – the higher the initial price paid, the harder it is to sell later down the line at a profit. It is also exacerbating the long-run disparity in returns between larger and smaller funds. Between 2005 and 2016, average TVPI (or total value to paid in multiple, a measure of the value created by a private equity fund) for funds of below US$500m was close to 1.53x; for those above US$4.5bn, it was less than 1.46x, Preqin figures show.

Part of the explanation for this is market’s efficiency for larger deals. Large transactions are well known in the market and intermediated by M&A advisors, making them highly competitive. There are also far fewer of them. At the smaller end, by contrast, the universe of deals available is naturally far larger. Yet, with so much capital allocated to the mega-funds, funds targeting the smaller end of the market face challenges in money to deploy in this deeper and wider pool of investment opportunities.

The deals available in this space are arguably more interesting. Many smaller funds (with US$500m or less) target businesses that are not readily saleable and are too small to be advised by the M&A houses. Often, these are long-established businesses run by a founder reaching retirement age who no longer has the appetite for fast growth and increased risk. These businesses characteristically lack transparency and have not received adequate investment for several years.

The beauty of targeting these rough diamonds is partly lower initial investment prices. It is also partly because, given investment and an infusion of new ideas and a fresh strategy, or perhaps improved systems and the recruitment of a CFO, these businesses can increase in value significantly. By removing inefficiencies in the business, cleaning up reporting and acquiring several companies, smaller funds can create assets that are attractive to strategic acquirers or other private equity houses with ample cash to deploy in larger deals.

The value of this kind of heavy lifting in small businesses is clear. Deals involving lower initial enterprise values have a much greater likelihood of achieving home runs than those with higher price tags. Investments in smaller businesses are almost twice as likely to generate a 3x return multiple or more than those valued at over US$250m.

With less competition between these funds for deals than there has been historically, smaller funds are becoming increasingly attractive. The return differential in net IRR terms between top performing smaller to medium-sized funds and the mega and large funds used to be negligible 15 years ago. Today, analysis shows the differential is around 5%.

The last few years has been a benign economic environment, conditions that tend to favour larger private equity players. Returns are higher for larger funds during times of economic expansion, as we’ve seen over the last few years, while Preqin data suggests that strong stock market returns boost mega-funds’ returns far more than those for smaller funds. This attests to the greater capacity for creating value in smaller businesses across economic cycles – after all, it’s much harder to turn around an oil tanker than it is a fishing trawler. Therefore, smaller funds tend to outperform larger ones in more difficult times, as the chart below demonstrates.

As we move into a different part of the cycle over the next few years, it’s likely that history will repeat itself, with smaller funds outperforming their much larger counterparts.

Smaller funds, often targeting specific countries or niches, can be difficult to find and take as much time to assess as a larger fund. Yet with the right resources (internal and/or external), investors accessing these hidden gems may find that they don’t need to adjust their return expectations downwards by quite as much as the Preqin data suggests is currently the case.