Private equity funds focused on buying small companies generally outperform funds buying larger companies, with more attractive investment opportunities and lower entry prices available in the small- and mid-cap universe, according to an analysis by fund manager Access Capital Partners.
Philippe Poggioli, managing partner at Access Capital Partners, commented: “Small-cap buyout funds potentially offer investors better returns than larger funds. This outperformance results from small-cap fund managers’ access to more investment opportunities, lower valuations at entry, more opportunities for value creation, and the potential for greater earnings upside on sale”.
“Historically, small and mid-sized companies have presented lower entry multiples for buyers. According to statistics from Access Capital Partners, S&P, Unquote, Epsilon Mid-Market Index and Clearwater International in June 2021, the average multiple paid for companies with an enterprise value (EV) of less than €250 million has been around 20% lower than the earnings entry multiples for the largest companies (typically above €250 million EV) bought by buyout funds over the past 10 years,” he added.
“A main factor explaining this discount is that the small-cap private equity segment is less intermediated, and deals are often sourced via exclusive networks rather than competitive auctions,” said Poggioli.
The small and mid-cap segment makes up the bulk of the private equity space, accounting for 98% of all private equity funds on the market and 90% of total buyout transaction volume in Europe.
Access’ analysis reveals that small and mid-cap funds in the top quartile, i.e. those with assets under management of less than €1 billion and an average size of €275 million, outperformed larger funds (with more than €1 billion and an average size of €7 billion) on a total net value for capital invested (TVPI) basis.
Explaining the more attractive returns, Mr. Poggioli said that smaller companies are generally less mature than larger target companies in terms of efficiency and business development, and offer greater potential for growth and expansion than buying larger companies.
“As a result, inbound private equity investors have more room to drive growth by strengthening and complementing management teams, improving operations and financial controls, introducing new product lines, expanding internationally, or increasing sustainability to capture long-term strategic value. In contrast, investments in larger companies have in the past relied heavily on deleveraging to achieve returns,” he said. “We expect our small-cap buyout funds to generate net internal rates of return (IRRs) in excess of 15% over 10 years. Our funds have also demonstrated much lower volatility of returns than listed markets across cycles,” he added.
“Across the private equity market as a whole, returns for small-cap buyout funds are strong. According to Access’ analysis covering 518 European small- and mid-cap private equity funds with AUM of less than €1 billion over the vintages 1999-2021, funds in the top quartile generated an aggregate net IRR of between 15% and 43% per annum depending on the vintage, while the 2007 vintage was most affected by the major financial crisis, but performance remained solid at 15%,” he said.
However, the dispersion of returns is higher among small and mid-cap managed funds than among their larger counterparts.
“Therefore, investors need to apply a rigorous due diligence process when selecting small and mid-cap funds to generate superior performance,” he said.
“Nevertheless, small companies are ideally placed to serve as platforms for buy-and-build strategies, enabling consolidation and external growth. As a result, fund managers are increasingly committed to these strategies which, if properly executed, are a good way to deploy capital at reasonable valuations, promote revenue and cost synergies and create value. These enlarged businesses are more attractive to potential acquirers and investors, and therefore command a higher multiple on exit than on acquisition,” said Mr. Poggioli.