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Small company buyout funds could deliver more to investors than larger buyout funds

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By Philippe Poggioli
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4 minute read

A fall in interest rates towards the year’s end could prompt investors to increase allocations to private equity and see a rise in merger and acquisition (M&A) activity, with the best returns on offer typically available at the small-cap end of the market.

We expect institutional investors will move away from fixed-income investments towards private equity allocations in 2025 to seek more attractive returns in a weaker economic environment. We are likely to see debt defaults gather momentum given the weak economic outlook, especially in Europe, and this could prompt a more active allocation towards private equity by investors.

Many are likely to turn to private equity funds focusing on the smaller end of the buy-out market (funds of less than € 1 billion). This segment in Europe makes up the bulk of the private equity space, accounting for 70 per cent of European private equity funds raised in 2023 and 80 per cent of all buy-out deals closed that same year.

Importantly, funds acquiring small and mid-cap companies typically outperform funds buying larger companies. This outperformance is the result of a small-cap fund managers’ access to more attractive investment opportunities, lower valuations at entry, more opportunities for value creation, and the potential for greater earnings expansion upon a sale.

Looking at historical data, small and mid-market companies have presented lower entry multiples for buyers. According to statistics from S&P, Unquote, Epsilon Mid-Market Index and Clearwater International as of June 2021, the average multiple paid for companies with an enterprise value (EV) of less than €250 million has come in at around 20 per cent lower than entry earnings multiples for larger businesses being bought by private equity during the last 10 years.

One primary factor driving this discount is that the small-cap private equity segment is less intermediated, and deals are often sourced through proprietary networks rather than through competitive auctions.

Small companies are typically less mature than large companies in terms of how developed their businesses are. This can provide more scope for incoming private equity investors to create value by strengthening and supplementing management teams, improving operations and financial controls, developing new product lines, expanding internationally, or increasing sustainability to capture long term strategic value. In contrast, large buy-out investments have in the past strongly relied on deleveraging to achieve returns.

As an illustration of this, Access’ underlying fund managers have demonstrated solid operational improvement and low reliance on financial engineering, with the leverage component accounting for only 9 per cent of returns. EBITA growth represents 60 per cent of gains while multiple effects account for 30 per cent.

More importantly, smaller companies are ideally placed to serve as a platform for buy-and-build strategies, allowing for consolidation and external growth. As such, fund managers have increasingly been engaging in these strategies, which, if executed correctly, are a good way to deploy capital at reasonable valuations, promote revenue and cost synergies, and create value. Such enlarged companies are more attractive to potential acquirers and investors and thus command a higher multiple upon exit than at acquisition.

Access’ analysis reveals that upper quartile small and mid-sized buy-out managed funds, or those with assets under management (AUM) of less than €1 billion and with a €275 million average, have outperformed larger managed funds (having more than €1 billion with a €7 billion average size in AUM) on a net total value to paid in (TVPI) basis, as the chart below shows.

The analysis covering 518 European small and mid-cap private equity funds with size below €1 billion (€275 million average size) over 1999-2021 vintages, revealed first quartile funds delivered an aggregate net internal rates of return (IRR) ranging between 15 per cent and 43 per cent per annum depending on vintages. The 2007 vintage was the most affected by the major financial crisis, yet the performance remained solid at 15 per cent.

However, the dispersion of returns is higher among small and mid-cap managed funds than among their larger counterparts. As a result, investors need to apply a rigorous due diligence process when selecting small and mid-cap private equity funds to enjoy superior returns. We anticipate our own smaller buy-out funds to deliver net IRR greater than 15 per cent over 10 years. Our funds have also demonstrated much lower volatility in returns than listed markets across the cycles.

Philippe Poggioli, managing partner, Access Capital Partners