The evolution of U.S. buyouts from a cottage investment business into a multi-trillion-dollar industry has created what we believe is an efficient marketplace, where information is widely disseminated among sophisticated market participants and price discovery is readily attainable. With increasing fundraising and substantial dry powder of $339 billion, market competition for buyout opportunities is high, as evidenced by rising purchase price and leverage multiples.1 For investors, this efficiency has led to more cyclical and less attractive returns for U.S. buyouts.
In 2003, 48 U.S. buyout funds raised $20.2 billion and the average fund size was $421 million. In comparison, in 2016, 107 U.S. buyout funds raised $123.2 billion and the average fund size was $1.2 billion.2 This exponential growth has created a major financial services industry that amounted to $4.2 trillion in assets and accounted for 21% of all corporate mergers and acquisitions (M&A) in 2015.3
Fortunately, there is a segment of the U.S. buyout market with a large universe of potential target investments, imperfect information, uneven levels of sophistication and less competition, as measured by the number of informed bidders vying for each business or asset. This part of the market is known as small buyouts and we believe it can be quite rewarding for investors that have the expertise and resources to access it.
ATTRACTIVE SUPPLY-DEMAND CHARACTERISTICS
The small buyout space is characterized by funds that are generally capitalized with less than $500 million. These funds focus on small deals, typically companies with less than $15 million in EBITDA (earnings before interest, taxes, depreciation, and amortization), a proxy for cash flow. The market segment is also frequently defined by transaction values, which tend to be less than $100 million. Logically, small funds tend to target small companies while large funds target large companies, as shown in Exhibit 1.
An analysis of U.S. M&A activity in 2015 (a relatively healthy year for M&A) shows that small buyout deals represent significant market share by number of transactions. As illustrated in Exhibit 2, small buyout deals comprised 68.7% of the market by number of transactions, whereas middle-market buyout deals represented 29.9%, and large buyout deals made up 1.4%. Looking at the amount of capital invested during the same time frame and in the same market 2 segments, small buyout deals accounted for only 8.5% of the market by transaction value, while middle-market buyout deals represented 54.2%, and large buyout deals made up 37.3%. Not surprisingly, capital tends to flow to the parts of the market where it can be more efficiently absorbed, as evidenced by the significant amount of capital that targeted a relatively small number of middle- market and large buyout deals in 2015.
What may be more surprising is that there are 177,000 small privately-owned companies in the U.S. that generate $4.6 trillion of total annual revenue and employ 22 million private sector workers. In contrast, there are only 18,000 middle-market companies in the U.S. that generate $4.7 trillion of total annual revenue and employ 18.7 million people, as shown in Exhibit 3. Not only does the small buyout market have a substantially larger universe of target companies, but it also generates comparable annual revenue and employs even more people than the middle market. In other words, when compared to the middle market, the small buyout market has a fraction of the capital going after a comparably sized marketplace with nearly ten times as many target companies.
Moving up from the deal level to the fund level to look at the amount of capital raised by U.S. private equity funds further highlights the supply-demand characteristics of the various market segments. As mentioned earlier, funds capitalized with less than $500 million are considered small and appropriately sized to invest in companies with transaction values of less than $100 million. In 2015, 271 small private equity funds were raised (72% of the total) and 105 funds larger than $500 million were raised (28% of the total). However, just over $39 billion was raised in aggregate by the funds smaller than $500 million (15% of the total), while $226 billion was raised in aggregate by the funds larger than $500 million (85% of the total).4
All of this data highlights the compelling supply-demand characteristics that make the small buyout market significantly more attractive than any other segment, particularly when compared to the middle market. With similar overall market sizes, this comparison demonstrates that the small buyout market has nearly ten times as many companies as the middle market, but only a small fraction of the capital raised to target them.
LOWER PURCHASE PRICE AND LEVERAGE MULTIPLES
Small buyouts have historically outperformed other segments of the buyout space, as shown in Exhibit 4. In our opinion, this long-term outperformance is primarily the result of exploiting the market inefficiencies that allow investors to acquire higher-growth companies at lower entry multiples, and then to achieve multiple expansion at the time of exit.
The compelling dynamics of small buyouts are most visible when examining the valuations that companies trade for in various segments of the market. In 2016, the average purchase price multiple for deals under $100 million was 7.4x, compared to 10.0x for transactions between $100 million and $499 million.5 This means that, on average, middle-market buyout investors paid approximately 35% more for a dollar of EBITDA than small buyout investors. Siguler Guff’s experience supports this overall market dynamic.
One might argue that small companies are riskier and therefore should trade at lower multiples. We would generally agree; however, given the sheer size of the small buyout universe, we believe there are simply more opportunities to find high-quality companies at compelling entry multiples. Additionally, small companies often have the potential for faster growth. While they may have weaknesses such as customer concentration or gaps in management teams, these are also opportunities for value creation, especially for a private equity investor with the resources and knowledge to actively manage and improve businesses.
Purchase price multiple is important, as it can both help protect an investor’s downside and create the opportunity for significant upside through multiple expansion. As shown in Exhibit 5, acquiring a dollar of free cash flow for $6.00 versus $10.00, assuming no leverage, no growth, and no multiple expansion, means that the internal rate of return (IRR) at exit is 16.7% versus 10.0%. By adding conservative leverage to the business (3x EBITDA) and achieving modest growth (5% EBITDA compound annual growth rate (CAGR)), one can reasonably model an attractive 20%-25% IRR and a 2x-3x multiple of invested capital (MOIC) at the portfolio company level, with no multiple expansion. These performance metrics would likely be significantly higher with multiple expansion.
However, returns tell only half of the story. In our view, risk is too often dismissed in the private equity world as investors tend to myopically focus on returns. On an absolute basis, large buyouts often use higher levels of leverage and therefore take on more financial risk than small buyouts. In today’s environment, leverage ratios of 5x-6x total debt to EBITDA are fairly common as large buyout funds need to use significant debt to finance their acquisitions when they are paying 9.5x EBITDA on average. Contrasting the leverage utilized in large buyouts with Siguler Guff’s experience investing in small buyouts, we see that the average leverage multiple in our portfolio is 2.4x EBITDA since inception, or over 50% less than the typical large buyout transaction. While it can be debated whether or not leveraging a dollar of cash flow with $6 of debt (6x) is riskier than leveraging a dollar of cash flow with $3 of debt (3x), the answer ultimately lies in the certainty or riskiness of the cash flow. Nevertheless, given the massive universe of target companies in the small buyout segment, we believe that a sophisticated investor with robust deal flow can consistently find small companies with compelling risk profiles that are comparable to larger companies with substantial market share and strong recurring revenue.
Other sources of risk at the company level may include gaps in the management team, customer concentration, insufficient financial accounting and enterprise resource planning (ERP) systems, and a lack of strategic planning or direction. For an active private equity investor, all of these represent potential opportunities to turn current weaknesses into future strengths and, in doing so, can help set the table for multiple expansion at exit.
HOW TO ACCESS SMALL BUYOUTS
While small buyouts offer compelling supply-demand characteristics, purchase price multiples, risk profiles, and strong historical performance, they can be difficult for many investors to access. How can an institutional investor best navigate the less-charted territory of the small buyout landscape?
Since small buyout funds are typically less than $500 million in size, they are often overlooked by large institutional investors who are unable to efficiently make large commitments to small funds due to internal investment policy concentration limits or the inability to perform proper due diligence. Therefore, it is not surprising that since 2006, small buyout funds have received less than 16% of the buyout capital committed by institutional investors.6 This creates an opportunity for nimble, sophisticated investors, unencumbered by restrictive policies such as minimum fund sizes, concentration limits, and first-time fund prohibitions, to negotiate for improved and, at times, preferred terms and conditions.
In Siguler Guff’s experience, an institutional investor can leverage its size, reputation, and creativity to negotiate with small buyout fund managers for lower fees, co-investment rights, and other preferred terms and conditions. Additionally, for an investor able to effectively source and execute them, co-investment opportunities are plentiful in the small buyout market. Oftentimes, co-investment opportunities arise as small managers are undercapitalized relative to their deal flow opportunities. This represents another attractive market dynamic given our preference for a positive ratio of high quality investment ideas to investable capital, which allows us to help make up capital shortfalls through co-investment.
Similar to small companies, small fund managers can also exhibit volatility, as illustrated by the dispersion of small buyout fund returns in Exhibit 6. Therefore, it is imperative for an investor to undertake a disciplined and rigorous approach to analyzing and evaluating managers in the small buyout space. Track records of small fund managers can be shorter or less complete than their peers in the middle and large buyout market. When managers are forming first-time funds, track record attribution becomes even more critical.
Organizationally, small buyout fund managers typically have smaller teams, fewer resources and are generally less institutionalized than their large buyout peers. Once raised, these funds may require greater oversight from a strong and active limited partner advisory committee (LPAC). Small buyout fund managers can benefit from the experience, relationships and networks of an active institutional investor. LPACs can continually inform investment decision-making, while providing managers with deep insights into the qualities and characteristics of successful small buyout investments.
As previously mentioned, we believe small funds are best positioned to effectively access the small buyout market. However, it is critical that fund managers do not raise too much capital in order to avoid being forced up into the much more competitive middle market. We believe that the ideal small buyout fund size is below $250 million.
The small buyout market is also characterized by a large number of managers who focus on particular industries, sectors or geographic regions where they have accumulated extensive expertise and networks. Therefore, institutional investors can leverage small buyout funds to gain access to investments that are more targeted by industry, sector or geography. As a result, investors can build a diversified portfolio of specialists, rather than a portfolio of generalists.
All of the idiosyncrasies associated with small buyout funds and managers necessitate a significantly more rigorous and time-intensive due diligence process in order to prudently make investments. Institutional investors interested in small buyouts need to allocate significant resources to invest intelligently in the segment.
PRIVATE EQUITY INVESTING AT ITS BEST
Successfully investing in small buyouts begins with developing substantial deal flow. Likewise, we believe that a small buyout fund manager’s success largely depends on their ability to generate a high volume of quality deal flow. To effectively and efficiently access this segment of the market, we have developed an approach that combines working with small buyout fund managers as both limited partners and co-investment partners. We view these small buyout managers as a conduit for accessing high-quality, less competitive deal flow, both in a diversified fashion through fund investments and directly through co-investments.
At the company level, we look for businesses that are established, enduring and generate consistently high profit margins. Across our portfolio, the average company age at the time of investment is over 30 years, while the average EBITDA margin is approximately 17%. We strive to be the first institutional capital invested in these small companies. In our opinion, acquiring family-owned, founder-owned and owner-operated businesses provides a greater opportunity to invest at a lower entry multiple and to add significant value during the holding period. In targeting these types of businesses, we also seek significant seller rollover in order to enhance alignment of interests.
Small businesses typically seek outside capital when they hit an inflection point, often after experiencing many years or decades of success. As the owners of small companies reach inflection points, such as succession or estate planning, they naturally seek liquidity in return for a lifetime of sweat equity. However, these companies are not large enough to take public, they cannot access the high-yield bond market, and cash-out refinancing is typically not allowed by banks. After years of hard work spent building their businesses, creating jobs, and in many cases becoming pillars of their communities, one of the only real solutions for these company owners to create liquidity is the sponsorship of a private equity investor.
At the same time, we believe private equity is well positioned to help business owners monetize and/or plan for the successful transition from family-owned businesses to independent professional organizations. Since these companies are not large to begin with, small buyout investors are focused on creating value through building and growing the businesses, rather than layering on excessive debt or breaking them up.
Structurally and perpetually inefficient, we believe the small buyout market offers the most compelling risk-return opportunity in U.S. private equity. Market data proves that small buyout fund managers are underserved and target-rich. Furthermore, managers are able to source less competitive deals that translate into more attractive purchase price multiples, greater downside protection and higher returns.
With small buyouts, institutional investors can access more targeted funds where their interests are better aligned with managers and where their capital is working to improve and grow companies. Executing a successful small buyout investment program requires significant resources to generate and evaluate substantial deal flow. It also requires a willingness and ability to consider smaller and less developed fund managers, the sophistication to structure and negotiate value-added partnership agreements, and the investment acumen to leverage substantial co-investment opportunities. Although small buyouts are not easy to access and require significant resources to prudently target, the compelling investment opportunity available in this part of the market is worth the effort.