The march of the US mid-market

The mega-market was undoubtedly a net beneficiary of the covid crisis. Investors flocked to big name brands when in-person meetings were impossible and as underwriting the unfamiliar became a challenge. However, the mid-market appears to be attracting more attention in this latest period of economic tumult.

Of the LP respondents to Coller Capital’s Global Private Equity Barometer: Summer 2023, 82 percent said they expect mid-market buyouts to offer good investment opportunities to GPs over the next two years, with a further 81 percent saying the same of lower mid-market buyouts. Indeed, 42 percent of investors plan to increase their exposure to the lower mid-market, and 38 percent to the mid-market, according to Rede Partners’ latest Liquidity Index.

Chief among the benefits extolled by the mid-market’s advocates is the attractive entry valuations available. Mike Larsen, a managing director in the private client practice at Cambridge Associates, says global median purchase price multiples in the mid-market and small-cap market are 8.8x and 7.1x, respectively, compared with 9.3x in the large-cap space, creating greater opportunities for multiple arbitrage given that median multiples at exit are 10x for the large-cap segment, 10.7x for the mid-market and 9.2x for small-cap companies.

“The lower mid-market and mid-market also offer higher revenue growth,” Larsen says. “Median revenue compound annual growth rate in the small-cap space is 10 percent, while EBITDA CAGR is 13 percent. In the mid-market those figures are 8 percent and 10 percent, while in the large-cap space they fall to 5 percent and 7 percent.”

“The lower mid-market typically benefits from lower entry valuation multiples,” adds Eric Deyle, a managing director at Eaton Partners, a subsidiary of Stifel Financial. “There is also more room for growth with accretive bolt-ons, and more value-creation opportunities. Lower mid-market companies also tend to have less debt on the balance sheet and as a result are more nimble and better positioned to adapt to market disruptions. These are the reasons why LPs are gravitating towards mid-market funds today.”

Meanwhile, Stewart Kohl, co-chief executive of The Riverside Company, which focuses on the smaller end of the mid-market, points to the resilience and ongoing appeal of companies in this segment: “The best companies have proven to be resilient through cycles, have faster growth rates and an unusually attractive risk-reward proposition given their lower growth-adjusted purchase price multiples.”

Land of opportunity

The US mid-market also benefits from an abundance of potential targets: “With approximately 200,000 companies that comprise roughly a third of the private sector GDP in the US, the mid-market provides a target-rich investable universe. This allows investors to find solid, high-performing companies at relatively attractive valuations,” says Young Lee, a partner and co-president of mid-market investment firm Audax Private Equity.

There are often more value-creation levers available to private equity investors in smaller businesses. “There is the ability to drive margin improvement through operational management, supply chain management, IT implementation, data science, better enterprise reporting and acquisition integration, for example,” says Larsen. “There is revenue growth through better sales and marketing, improved CRM [customer relationship management], business development, digital marketing and go-to-market strategies. Then there is enterprise-level value creation, including talent management, organisational improvements, ESG implementation, cybersecurity and financial planning and analysis.”

Audax’s Lee agrees that mid-market companies are well positioned to benefit from value-creation initiatives, “particularly when you’re supporting high-quality platforms, with catalysts for growth, and executing against a proven investment thesis such as buy and build, which performs across all economic cycles”.

By the time companies have reached the mega weight class, by contrast, they are already incredibly well managed. “They have been refining their margin improvement strategy for, in some cases, decades,” Larsen explains. “They have reached a level of maturity where revenue growth is lower. The enterprise is already managed at a world-class level and there is less low-hanging fruit to target. That all means there is greater reliance on the final value-creation lever available to private equity firms – capital markets. Mega-firms tend to rely much more heavily on financial engineering, which has, of course, become more challenging in today’s macroeconomic environment.”

Another significant advantage of operating lower down the size spectrum relates to the breadth of exit options available. “Large and mega-managers are sitting on a huge amount of dry powder, which can be used to acquire companies in the smaller segments,” says Larsen. “That is an always-on exit path, unlike the IPO market, which can open and close on the whims of a multitude of macro factors.”

“If you invest in a large-cap fund, you have to hope that the IPO market will remain open or strategics will remain willing to get their wallets out,” adds Matt Swain, global CEO of Triago. “Of course, in tough times, strategics put their wallets away to focus on their own stock price, and IPO markets close. That means the DPI of those larger-cap managers can come under real pressure, unless they are doing dividend recaps, which are much more challenging in a high interest rate environment.”

The consolidation trend

While there is a trend towards investors consolidating their manager relationships, this no longer appears to mean a trend towards scale, says Eaton’s Deyle. “LPs are tending to consolidate their core relationships at the upper mid and larger end of the spectrum, recycling those allocations back down into the lower mid-market and first-time managers, taking sizeable anchor positions and then growing with those firms over multiple funds.”

Swain agrees: “Groups are cutting the number of relationships that they have, but they are keeping their top-tier mid-market and, in particular, lower mid-market managers because statistically those managers outperform. We are seeing a lot of the big-name mega-funds come on to the secondaries market. We are not seeing nearly so many lower mid-market and mid-market brands.”

“Groups are cutting the number of relationships that they have, but they are keeping their top-tier mid-market and, in particular, lower mid-market managers”

Matt Swain,
Triago

Underwriting smaller managers requires a different emphasis, however. “You need to focus on team cohesion and operational, functional and domain expertise,” says Deyle. “What gives this mid-market firm the right to win off-market transactions? Does this firm have a repeatable value-creation playbook?”

“When you are [conducting due diligence on] managers in the mid-market, you will often not have as much prior knowledge of the infrastructure within the firm,” says Drew Schardt, vice-chairman and head of global investment strategy at Hamilton Lane. “You therefore need to spend more time understanding the institutionalisation of the organisation, the incentivisation schemes among professionals, and the nuances of the strategy and track record.

“There will inevitably be less familiarity on these matters when a manager is raising its second or third fund, when compared with a mega-fund that is raising fund 20, even though these mid-market firms are often run by professionals with long and distinguished private markets histories.”

The onus on investors’ underwriting skills tends to be greater in the mid-market than it is for larger managers. “Investing in a Blackstone fund is a pretty safe bet,” says Swain. “But the spectrum of good versus bad is a lot wider the further down you go in size.”

Return dispersion is much greater at the lower end of the market, adds Larsen. “The highs are higher, but the lows are lower, which means investors are rewarded for diligent manager selection, but the consequences of getting that selection wrong are severe.”

And this is not the only challenge associated with investing in smaller funds. Swain says: “If you are deploying a large cheque into a top-tier lower mid-market fund, capacity can be an issue. Managers are also concerned about LP concentration risk and so you can find that you get cut back even in today’s challenging fundraising environment.”

Timing can also be an issue, Swain notes. “Lower mid-market managers often don’t offer a wide product suite, which means if you are trying to get an allocation into a particular firm, you may have to wait two years or so. That is very different to a mega-cap firm, which will almost always have some kind of fund in the market that can give you that exposure.”

Larsen adds that GPs are inherently ambitious: “Left unchecked, most would choose to raise ever larger funds. If you are an LP that wants to sustain lower mid-market exposure, that means it is necessary to keep reinventing your portfolio.”

Despite these challenges, the appeal of the mid-market seems unlikely to wane. Deyle believes that the current appetite we are seeing for mid-market funds is a continuation of a long-term trend: “In general, risk/return profiles tend to be more attractive in the lower mid-market, even though there is a greater dispersion of returns.”

Swain, meanwhile, expects to see high-net-worth investors flooding into the larger-cap space in search of outperformance as the democratisation of private markets takes hold. But he believes that institutional investors will continue to push into the mid-market and lower mid-market instead. “Investors are able to exert more influence with managers in that space. They have greater control in the LPAC and in drafting the LPA. They may also potentially get a small fee break. Above all, these investors want to get closer to the assets and that is what they are able to do with these smaller funds.”