Boundless opportunity

As international markets emerge from the global financial crisis, private equity is beginning to regain the spotlight, not least in the US.

The strategic position of the US as a global private equity market is considerable. It is a well-developed economy, has large public equity markets, political stability and a government that seeks to encourage equity ownership and investment, (not withstanding the uncertainties of forthcoming financial regulation).

The U.S. was the first to be impacted by the financial crisis and it has also been the first to emerge from the crisis, more quickly than other western economies and with a faster rate of growth. History shows that periods of sustained economic downturn are often followed by periods of innovation, progress and entrepreneurialism. Frankly put, America has an uncanny knack of bouncing back strongly. It was immediately after the Great Depression that the prolonged period of innovation and economic growth took place that helped lay much of the foundation behind today's modern America. 

Graeme Faulds

Economic downturns provide ideal conditions for smaller, more nimble companies to take the lead over their larger competitors, who may struggle to adapt to the changing economic environment. Some of the largest, most innovative companies in the US today, such as Microsoft and HP, were established during downturns.

Private equity has long been a driver of entrepreneurship and growth, with smaller private equity funds the true drivers of growth. Despite the headlines being dominated by large private equity deals and managers, data from Preqin shows that funds under $1 billion have dominated the fundraising market (75 percent of active buyout funds) in the period from 2004-2009 inclusive.

With this trend set to continue, if not increase, there is likely to be a plethora of lower mid-market funds coming to market in the following years. Further analysis of this data also suggests smaller funds provide more opportunity to generate super returns. Specifically, while the median returns for funds below and above $1 billion are similar, the upper quartile return of funds below $1 billion is significantly higher than for funds over $1 billion. Certain quoted indices also substantiate the view that smaller companies offer greater growth potential.

The emergence of fast growing companies following recessions combined with private equity's historical focus on smaller companies could explain why private equity returns in vintage years after recessions tend to outperform other vintage years by a significant margin. We certainly believe the upcoming three to four years have the potential to produce exceptional returns.

Manager Selection

However, the apparent attractiveness of smaller funds is offset by the difficulties of identifying the best managers in a heavily populated universe. The US has the most sophisticated and established private equity market in the world. It has some of the most talented managers in the business and a wide range of funds and strategies to choose from, across a vast geographical area.

Anecdotally, there is also prevalence amongst North American private equity founders to stay at the helm for longer tenures than in other markets. This industry dynamic has encouraged many talented middle managers to look at setting up their own firms. Indeed, of all sub-$1 billion funds raised in the period from 2004-2009 inclusive, more than 50 percent were first or second funds for a particular manager. This suggests a large and vibrant marketplace with excellent opportunities to discover and invest with some of the brightest “emerging managers”.

Given this size and scope, it can be very difficult to identify appropriate opportunities and, more importantly, have the ability to spend the requisite time and due diligence on researching these myriad funds, especially if one lacks pre-existing knowledge of the market and its intricacies.

This vast market can be bewildering to new market entrants and investors looking for exposure to North America should do thorough research. When identifying opportunities investors should look for managers, no matter what their size, with a focus on detailed due diligence processes, consistent strategies, a repeatable investment process and a strong alignment of interests with LPs.

Ultimately, the current U.S private equity environment provides real opportunities for investors to achieve superior investment returns, and we believe this market looks well set for future growth.

Graeme Faulds is a Partner at SL Capital Partners