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PE funds sniff out enhanced returns in small-cap space

By Jessica Penny
3 minute read

Lower entry multiples and a longer runway for growth are setting up small caps as an increasingly attractive prospect in private equity, an asset manager has said.

Private equity (PE) funds will see superior returns when investing in small and mid-cap companies as opposed to their large-cap counterparts, according to new research from Schroders.

Particularly as PE funds are now being offered to retail investors, historically being available only to institutions and high-net-worth individuals, the asset class is capturing the interest of a greater range of investors.

While PE funds that are well managed and have the right portfolio of investments can generate attractive returns, Claire Smith, Schroders head of private asset sales, said that a large fund size will not guarantee performance.

In fact, Ms Smith said that recent data is showing the opposite.

“Our research shows that, all things being equal, private equity funds that buy small and mid-cap companies statistically perform better than their large-cap peers thanks to a greater number of opportunities, lower entry multiples, and a longer runway for growth,” she commented.

Namely, small and mid-sized PE managers have, on average, outperformed their large PE counterparts, both on a net total value paid in (TVPI) basis for vintages after 2005 and on a net internal rate of return (IRR) basis for vintages after 2009.

Ms Smith added that this trend has not been singular to one geographical region or investment strategy.

“Between 2000 and 2017 across Asia, North America, and Europe, small and mid-sized funds delivered higher net returns than large private equity funds, while small and mid-venture, growth and buyout funds also outperformed their large counterparts,” she noted.

Australia’s super industry, which as of September 2023 held $114 billion in unlisted equities, is struggling to reap the benefits, according to Schroders.

Specifically, big superannuation funds are forced to “put the capital to work” into larger deals due to lack of resources to filter opportunities outside of the large and mega-cap buyout space.

“So that’s where they go, and it’s costing them in terms of returns,” Ms Smith added.

The asset manager further highlighted the risk of compromised growth multiples for investors on the back of significant disparity between capital supply and demand.

Recent data from research house Preqin has shown that fundraising among large-cap funds between 2010 and 2022 grew by 10.7 times while deal flow grew by 3.6 times.

Comparatively, small and mid-sized funds saw deal flow growth of 4.2 times against fundraising growth of just 2.9 times, encouraging lower entry multiples and superior returns.

“These lower entry prices make a big difference. In short, we buy companies at low entry multiples while they’re small or mid-sized, and sell them up market when they’re large caps, ensuring a relatively better return for investors,” Ms Smith concluded.