The transition of the last two years from over-leveraged excitement to economic fallout recently led one European placement agent to draw parallels with previous cycles. Our current state of affairs, he said, reminded him of 2003, citing a low interest rate environment, the effects of fiscal stimuli and the pending recovery. He noted, as many before him have, that this combination of factors will result in fantastic investment opportunities, especially for those able to capitalise on growth without relying on debt.
Conventional post-crunch wisdom has it that this should be music to the ears of those in the mid-market: the army of managers with sector or geographic specialism who can point to a track record of hands-on, low leverage deals. By contrast, the trend could play less will with those at the large and mega end of the fund spectrum.
There is evidence to suggest LPs have developed a yearning for the mid-market, which could make fundraising for these firms easier (or in this environment perhaps “less painful” would be more accurate). A Coller Capital survey conducted in the latter half of 2009 suggested that LPs had indeed fallen out of love with the mega and into the arms of the mid. Over the next two years, said European LPs in response to the survey, growth capital and the mid-market would be the place to invest.
It is easy to understand why investor sentiment has swung so heavily in this direction: it reflects a general perception that large cap funds have seen the death of their golden goose – cheap and abundant debt – and now have to deal with legacy investments labouring under unsuitable capital structures. Lower mid-market funds, on the other, can apparently go about their business as usual in a low-valuation environment.
The aforementioned placement agent, who happens to raise capital predominantly for mid-market funds, says it was during 2003 and 2004 that his business really took off, when a number of forward thinking European LPs – funds of funds such as LGT, Partners Group, Lombard Odier and Access Capital – identified certain regional lower mid-market firms as good bets. His hope that this cycle will produce a similar outcome, as the next wave of fund investors is turned on to the lower mid-market, seems to be slowly bearing out as he registers increasing interest in the segment.
There are reasons, however, to think twice before forsaking large-cap private equity managers for their smaller peers. One is quality. Unpopular as it may be among one section of our readers, there is a school of thought that says there is a “size selection bias” at play in the life cycle of a GP. It dictates that quality among smaller fund managers should be harder to find. In other words, the better a manager performs, the more money it can raise. Ultimately it will chase larger deals and leave the mid-market for more sizeable prey.
The validity of this point is, of course, debatable. Certain mid-market managers – those who have truly “stuck to their knitting” – can easily point to past performance that merits further LP support.
The “size selection bias” does, however, lead on to the wider issue of risk/return profile. Investing in smaller companies is a riskier business than investing in vast, established businesses: something that should be considered when weighing mega-buyout funds against mid-market alternatives. On the whole the large funds have invested in – albeit at high prices with too much leverage during 2006 and 2007 – large, solid businesses.
Some LPs are already of the mind that the criticism of mega funds over the last 24 months could have been vastly overstated. If secondaries pricing can be taken as an indicator of LP appetite for certain vintages and strategies, faith in mega funds’ ability to pull through looks to be on the increase.
At certain points last year secondary interests in mega-funds from the ’06 and ’07 vintages were being sold for as little as 30 cents in the dollar, according to market insiders. “In March last year, you couldn’t give them away,” says one LP. Now, however, the market has moved on and the same LP reports that he is receiving unsolicited inbound bids priced at a more modestly discounted 70 cents in the dollar for his large-cap fund interests. “I wish we had been smart enough to buy at the time,” he laments.
As long-term investors in the asset class frequently point out, one of the keys to a successful private equity programme is maintaining steady investment throughout the cycle. Switching dramatically between mid-market and mega fund may well lead to disappointing results.