Private equity funds are getting bigger, with Blackstone recently raising a $26 billion private equity fund — a worldwide record. But mega funds might not be the best thing for investors, according to new research from Pantheon, an alternative asset manager.
Small and mid-market buyout deals have historically bested large and mega transactions by a compounded annual growth rate of 5 percent. “That might seem small. But over five years, that 5 percent compounds to 30 percent,” Andrea Carnelli Dompé, one of the study’s authors, said in an interview.
Pantheon measured performance in its new study using the total-value-to-paid-in metric, which shows the fund’s total value as a multiple of its cost basis. The research looked at proprietary data on Pantheon deals — as opposed to the performance of the funds — transacted between 2000 and 2012 in the U.S., Europe, and Asia. Pantheon cut off the time frame at 2012 to ensure that deals were mature enough to draw conclusions on. Data on the deals themselves is as of the first quarter of 2019.
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Although Pantheon concluded that small and mid-market buyout perform better, the researchers also found that these transactions had a wider range of returns compared to larger deals, and as such may pose more risks. As a result, investors’ results in this market segment will depend more on manager selection and portfolio construction compared to investors in funds that target larger deals.
Although it’s not an absolute rule, the larger the fund, the larger the deals it has to invest in. For one, smaller deals have little impact on overall returns. In addition, the amount of due diligence required to vet a small transaction is often as much as required for a larger deal, raising the amount of work for the largest funds.
There are primarily three reasons why smaller deals do better than larger ones, according to Pantheon: “Wider scope for operational improvements; larger opportunity set; more attractive valuations.”
Looking at the aggregate number of deals transacted in each calendar year between 2000 and 2012, small and mid-market size buyouts had positive compound annual growth rates every year, except 2000. Large and mega deals had four years of negative returns, although the losses were small. Small to mid-size deals significantly outperformed their larger peers in 2003, 2008, and 2012.
According to the study, improving a business’s operations represent about half of the value that a private equity fund creates for its portfolio companies — and Patheon suggested that private equity funds have more influence over small and mid-market buyout targets.The study also pointed out that current high valuations on companies will make operations an even more important lever.
“Smaller companies have fewer resources, the management team is likely to not have the experience of one at a larger company, and processes tend to be more inefficient,” explained Carnelli Dompé. “All those things are ideal for a private equity manager coming in. They can look at best practices and implement them to optimize operations, strengthen the board, or they may have relationships with suppliers or customers that they can introduce.”
Carnelli Dompé pointed out that these opportunities can exist with larger companies, but many have already lived through most of these improvements.
“In other words, there may be more ‘low hanging fruit’ for PE managers to pick” in small and mid-sized deals compared to large and mega buyouts, according to the report.
Pantheon also argued that smaller companies can benefit more from buy and build strategies.
“At exit there is usually a premium paid in terms of the valuation multiple, on a significant larger earnings base,” the report stated. Although managers target build-ups in all deal sizes, “arguably there may be more scope to make many smaller acquisitions that have an impact on a small business, rather than search for the perfect add-on of sufficient size to impact a large business.”
Small and mid-size companies can also be bought at cheaper prices than large ones. As mid-market companies expand, “this may offer them the opportunity for multiple expansion on exit,” according to the report.
“We do feel based on the data, that there is disproportionate attention paid to the large end of the market, given the performance and attractive profile of smaller deals,” Carnelli Dompé said. “We think it’s a classic case. The big guys are always capturing the most attention, but it’s not necessarily where the opportunities are.”