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Introduction
The drivers of alpha in middle market buyout companies can hold great appeal for private equity investors.
In addition to being less concentrated and more fragmented than the large-cap market, buyouts (mid-market) tend to have high growth potential, motivated management and more significant opportunities for value creation through operational efficiencies.
In contrast, large-cap buyouts, while also a compelling investment opportunity, historically have a higher correlation with overall market beta and can be more susceptible to macro economic effects (e.g. interest rates).
Each has a well-earned place in private equity (PE) portfolios. However, while diversification is important when allocating, it is not as simple as merely including both mid- and large-cap buyouts in your portfolio. Both can provide compelling returns, but these returns come from different risk drivers.
This piece explores the different risk factors that dominate large-cap and mid-market buyouts. It argues for the need to weigh an appetite for returns driven from operational and managerial risks, which are more prevalent in mid-market deals, against the returns emanating from market and financial risks more inherent in large-cap investments.
Once the decision to allocate to mid-market is made, manager selection is important. Although the mid-market sub-sector can offer higher median returns, there is more dispersion in manager performance than in large-cap managers. Investors who diligently seek out managers who can demonstrate proof of concept, strong networks and sourcing ability can potentially reap significant rewards.
The what: defining mid-market
While definitions differ, we see the sweet spot of the mid-market typically including companies with enterprise values ranging from US$100 million to US$500 million. Companies in this range are generally sufficiently mature to weather economic challenges while remaining agile, adaptable and offer significant scope for growth.
The why: the appeal of the mid-market
Profiting from mid-market investing requires understanding and managing the operational and managerial risks associated with companies progressing along the maturity curve.
We characterise these risk levers as more operationally focused than in large buyouts.
For example, companies often come with a ‘small company premium’, stemming from growth potential and a motivated, typically smaller management team focused on shoring up the company’s foundations. The potential for geographic expansion is also a possibility. These levers have the potential to result in greater revenue and earnings before interest, taxes, depreciation, and amortisation (EBITDA) growth in smaller companies.
Additionally, mid-market buyouts can provide more exit opportunities compared to large-cap investments due to the size differential, creating more avenues for potential alpha generation. As illustrated in Figure 1, in recent exits, more than a third of deals since Q3 FY21 (3Q21) have delivered a total value multiple (TVM)1 of 3x or higher.
