Investing in the lower mid-market is like boiling the ocean

Industry practitioners agree the best managers in the lower mid-market are producing the best returns private equity can offer – but identifying those groups is not an easy task.

As the largest single private equity market, investors who want comprehensive exposure to the asset class tend to commit the bulk of their capital to North America, observes Andrea Auerbach, head of global private investment research at Cambridge Associates.

Roughly 80 percent of that capital is invested with 20 percent of managers – the big guys at the top of the tree. That leaves around 20 percent in the hands of mid-market practitioners.

However, allocating more capital to the mid-market could pay off for investors.

Auerbach: ‘It’s worth truffle-hunting’

“If you are a return-seeking investor, your radar will naturally direct you to the lower mid-market, because that is where the widest upside dispersion exists,” Auerbach says.

“It’s worth doing the truffle-hunting, it’s worth meeting with and understanding the range of options in that particular tier, because it can be very rewarding to your programme.”

Ethan Vogelhut, head of buyout investments Americas at investment manager Schroder Adveq, agrees that, if an LP has the ability to invest in this part of the market effectively, it should commit significant capital to it.

“You want it to be a meaningful part of the portfolio because it’s such a deep universe and it has high return potential,” he says.

In a perfect world with unlimited resources, says Auerbach, this is where LPs should focus their energy. But it can be a daunting task. By Schroder Adveq’s reckoning, there are almost 1,000 small and mid-market funds in the US, compared with around 100 funds of $2 billion and up.

“The real tension here is do investors have sufficient resources to monitor their exposures and to constantly boil that ocean to find that opportunity?” Auerbach says.

“The amount of energy it takes to monitor a broad and deep portfolio of mid-market managers, if you’re an army of one, can be kind of overwhelming.”

Vogelhut suggests ranking firms into three categories: the industry leaders; the up-and-coming groups; and the lower quality groups.

“You need to have met with a lot of these groups and categorised them that way, and you also have to be open to updating your opinion of groups as some of them prove themselves,” he says.

Auerbach also suggests breaking the market tier down to make it more manageable, perhaps looking at sector-focused funds, regional champions or operationally-oriented investors.

“Depending on the investor’s risk-return tolerance and what they’re seeking, they can build an exposure that will deliver what their programme is looking for,” she says.

Vogelhut points out that a more diversified portfolio will be more robust throughout the macro cycle. “Investors need to be thoughtful about how they spread their investments across industries, geographies and strategies.”

While fundraising has been strong, the numbers show mid-market managers have remained disciplined. The capital overhang in US private equity funds above $1 billion has grown more than 35 percent from $315 billion in 2013 to more than $430 billion at the end of 2016, while the overhang in funds below $1 billion has actually shrunk from a $90 billion peak in 2013 to $70 billion at the end of 2016, according to data from Cambridge.

“When you put [the $70 billion] up against everything else, you see this market feels like it’s not swamped with capital,” Auerbach says.

This discipline in capital-raising can make access an issue, as there’s only limited room for new capital.

However, Auerbach points out that most new fund formation happens in the lower mid-market; the majority of new teams don’t set out to raise more than $1 billion for their first fund. Investing in these new funds can help LPs establish their exposure to this market segment.

“Investors who make commitments to emerging managers in this tier have a ringside seat on where that manager is growing and evolving to,” Auerbach says.

“An LP can start with a great lower mid-market manager who grows its team, expands its skillset and gradually grows toward a different market tier successfully, and that investor gets to benefit from all of that as well. There are a lot of advantages to spending time evaluating opportunities in this tier.”

This is a tried-and-tested approach for Schroder Adveq: “You want to understand the ambitions of each group,” Vogelhut says.

“Many want to grow their organisations, and we understand and support that. We want to find them earlier in their lifecycle where we can be an important part of their story as they become a more prominent institution.”