Figure 1: Return volatility by asset class. Source: Pitchbook Benchmarks to Q1 20221.
The figure above shows how the median annualised return for private equity is above that of the other asset classes analysed. Furthermore, the return dispersion of private equity highlights the asset class’s limited downside risk, showing the highest lower quartile of the entire selection despite an upside potential surpassed only by venture capital. In conclusion, private equity offers higher returns with less volatility than other asset classes.
However, when we refer to private equity, we are really talking about a field that includes a wide range of transaction profiles. Because private equity involves investments in the entire universe of private companies, this asset class includes transactions with varying characteristics and returns.
Therefore, if we look at the different segments that make up this asset class, we find that returns also vary slightly depending on the size of transactions.
Figure 2: Net multiple on invested capital by fund size. Source: Qualitas Insight.
In particular, funds focused on smaller transactions (the “Lower Mid Market” funds) offer a uniquely attractive risk profile, as they exhibit the highest median net return, the second highest bottom quartile (i.e. very low downside risk) and the highest upside potential compared to other private equity segments.
These three factors together suggest that in this market segment there is an asymmetric balance between risk and return – key elements that tend to go hand in hand in investing.
To understand the differences in the return characteristics of each segment, we analyse the three main value levers by which the returns generated by private equity managers can be segmented: (i) the operational growth of the company (which in this case we measure with EBITDA), (ii) deleveraging through the repayment of debt with the cash flows generated by the company and (iii) the arbitrage of valuation multiples between entry and exit.
Figure 3: Value creation waterfall according to the weight of each lever (multiple on invested capital). Source: Qualitas Insight.
Operational growth
Operational improvement understood as an increase in operating profit is the main lever of value creation for smaller private equity investments. In addition to the value generated by this lever “per se”, operational improvement also has a positive impact on the other two levers considered in this article.
The function of operational improvement as an element of value creation in this market segment is best understood by observing how its contribution to returns tends to decrease with increasing transaction size. This is the natural consequence of the fact that the target companies of larger transactions are, generally, more mature and with limited growth potential. Private equity managers in the higher end of the market are, therefore, forced to explore other options to enhance returns.
Conversely, Lower Mid Market companies present multiple growth opportunities both organically (international expansion, new product launches, implementation of new strategies, professionalisation of organisation and processes, etc.) and inorganically (consolidation of the lower market space by acquiring companies that are too small for larger competitors).
Leverage
As a consequence of the above, it is not surprising that the role of leverage in the generation of returns is more important as the size of the transaction increases. While acquisitions in the lower end of the market typically use less leverage (usually below 2x Net Debt/EBITDA and, in many cases, without any financing at all), larger transactions rely more heavily on leverage to support returns.
This higher leverage that managers of large funds are forced to use accentuates the risk profile of investments in the upper segment of the private equity market.
In the Lower Mid Market, debt is typically used to support operational improvement initiatives or to finance activities focused on driving growth or profitability of the company. Debt is more commonly applied at a late stage of the investment where risk is already limited. This increase in leverage over the holding period explains the negative contribution depicted in the figure above.
Multiples Arbitrage
As discussed in the previous newsletter, the valuation multiples of Lower Mid Market companies are lower than those of larger companies. Thus, managers in the lower end of the market who manage to successfully implement their operational improvement plans are able to capture an extra return on exit from higher valuation.
Due to the lower demand in the LMM, managers can obtain companies at attractive valuations, leaving headroom for arbitrage at the time of sale when the asset is in a higher market segment with greater demand.
Notes:
- Historical data for the S&P 500 index, historical data for the MSCI World Small Cap Growth index. Historical annual return volatility for equity indexes. Historical median return volatility for the rest.
- Liquidated fund data reported by Preqin. | Lower Mid Market: <€500MM fund size | Mid Market: €500MM – €1,000MM | Large Funds: €1,000MM – €2,000MM | Mega Funds: >€2,000MM N=1.300.
- Data on realised investments collected in Qualitas Insight (N=1.042). Return constructed with the medians of the variables for each lever.
