Conventional private equity wisdom casts the lower mid-market as the best place to find outperformance. However, of the sea of lower mid-market managers operating in Europe, only around 5 percent are actually of interest, one investment consultant tells PEI.
Among this elite 5 percent something interesting is happening. As the top performing managers roll the wealth they have accumulated from one fund on to the next, it grows exponentially. If the same manager chooses to raise a successor fund of the same size – often praised by investors as a hallmark of “discipline” – then the GP commitment accounts for an ever-larger share of the total fund.
The allocation available to external investors, therefore, must come down. Essentially, if the elite of the lower mid-market choose to remain there, then they will slowly become entirely private; external capital will have to go elsewhere.
Clearly this is still in the realms of thought experiment; third-party capital has not been locked out of the high-performing lower mid-market. However, there are some real examples where the opportunity to invest is shrinking.
Take Valedo Partners. A spin-out from EQT, this Swedish lower mid-market firm raised its debut fund of SKr100 billion (€100 million; $125 million) in 2006, and it has been a cracker. With eight out of nine assets exited, it has generated a gross multiple of 4.7x, according to an investor. The 2011-vintage Fund II was twice the size and is currently valued at a gross multiple of 2.9x. Valedo declined to comment.
In April 2016, the firm closed Fund III on the same size as its predecessor and will continue to “stick to its knitting” in terms of deal size. For Fund III the team has accounted for around 17 percent of the total fund size, notes the same investor source, an increase from the circa 10 percent of the first two funds.
While it is clear Valedo and other similar-sized outperformers still rely on external capital, it is also clear that some investors in Valedo II have a smaller (or perhaps no) allocation in Valedo III.
There are some compelling reasons why it is unlikely we will see an entire tranche of the lower mid-market closed off to third-party capital. One is legacy – founders want to create something that will outlive them – and another is recruitment – it is harder to persuade ambitious mid-level professionals to choose a family office over a growing firm. There will also always be a natural churn in the market, with new spin-outs in need of capital being born as the market evolves.
The main reason, however, is economic. By raising a much larger fund, a GP is trading the possible bigger multiple they would earn on a small fund (and hence on their own sizeable commitment to it) for more management fees and potentially more exciting carried interest. As one LP PEI spoke to noted, the greater fees and carry from a larger fund will almost always be more attractive.
Clearly there will always be a place for third-party capital among smaller star performers. But for some managers, it may be smaller than investors would like.