Fight the urge (to cut back on small buyouts)

As inflation rages, and central banks raise policy rates, concerns about the health of the economy have been front of mind. Although the US has so far managed to avoid a recession, many consumers and investors are hunkering down.

When the economy shrinks, consumers respond by paying down debt, saving more, and spending less on nonessential goods. Institutional investors, on the other hand, adjust the “tilts” of their portfolios. They increase their allocations to defensive assets like infrastructure, private debt and real estate, and seek reassurance with larger, more familiar private equity fund managers. Necessarily, this comes at the expense of small, emerging and, by extension, diverse managers, which some regard as riskier than their larger, “more proven” counterparts (Figure 1).

The institutions that reduce their allocations to private equity’s small market during turbulent markets treat this tranche of the buyout market as a luxury good, something that is consumed when the economy is booming. Instead, we think investors should consider it a staple that can bolster and diversify their portfolios regardless of the macroeconomic backdrop. If anything, LPs should lean in.

As global investors contemplate their 2023 budgets and allocation targets, they should resist the temptation to pull back on small-market buyouts. Contrary to what LP actions would imply, we believe the current market conditions and private equity landscape make the small market particularly attractive.

Why now may be the time to lean in

The segment of the market we refer to as small-market buyouts (SBO) consists of private equity GPs that raise funds smaller than US$1 billion while investing in companies with a total enterprise value (TEV) of US$250 million or less. Although there are several benefits to investing in SBO, we have chosen to highlight the ones that are most salient to current market conditions.

Vast opportunity set yet underallocated

The small market is the largest and most dispersed tranche of the buyout market. In the US, which has the largest and most mature SBO market, it is much larger than the middle and large markets combined (Figure 2).

The small market is home to nearly 90% of private companies in the US yet represents only a fifth of the capital raised. LPs’ propensity to cut back on SBO during downturns means there will be even less capital chasing the segment.

As seen in Figure 3, SBO dry powder has increased modestly compared with other strategies, growing at a CAGR of 3% between 2016 and 2021. There is a direct link between capital availability, competition and valuations. While the trend lines for each have been up and to the right across the entire buyout market for many years, SBO has been most insulated from this frothiness and is most attractively positioned from a capital-to-opportunity-set perspective.

StepStone insights: The strength of diversity

At StepStone’s 2022 360 Investor Conference in New York City, Natalie Walker and Jose Fernandez discussed the importance of diversity and highlighted that our data has shown higher returns in more diverse portfolios.