Pound the table for small buyouts

Introduction

When we wrote our last paper on small-market buyouts (SBOs), we wanted to remind investors why they should not neglect small-cap managers in the current environment. Hence the title “Fight the urge (to cut back on small buyouts).”

Our thesis was straightforward: Market uncertainty would lead investors to overweight large-cap managers at the expense of their smaller counterparts and, in doing so, forgo an attractive diversification opportunity while injecting a fair amount of beta into their portfolios.¹ Owing to people’s propensity to flock to the familiar when the future looks grim, the outcome wasn’t surprising. SBO fundraising fell by 5%, and the amount raised by large and global caps grew 106% (Figure 1). In total, SBOs’ share of the fundraising pie is nearly a third lower than it was in the previous period.²

During the intervening 12 months, the macro picture hasn’t changed all that much. Inflation, interest rates, geopolitics and lending conditions remain top of mind. Add to that dueling numerator and denominator effects and a marked decline in distributions, and it becomes clear there are a lot of factors weighing on investors.³

We believe these added complexities make SBOs even more enticing. To be clear, the sector’s conservative use of leverage, focus on operational value-add, and relative insensitivity to public market fluctuations—all of which we covered in our 2023 report—still hold water. So in this paper we focus on small buyouts’ recent resilience—specifically their ability to provide liquidity—and the underlying traits that make its resiliency possible: outsize return potential, consistent net cash flows, more stable valuations, and access to credit markets.

Though not a cure-all for LPs’ portfolio woes, for a number of reasons, SBOs can help. Their potential to consistently generate alpha and distributions should be a welcome reprieve for LPs today and is ample reason in our opinion to keep pounding the table for SBOs.

Capital overhang

The rate and scale at which GPs are returning to market have exacerbated the denominator effect. Large- and global-cap GPs have driven much of the dry powder growth. SBOs’ growth, by comparison, has been muted. Despite having a larger universe of companies to invest in, the sector’s AUM has grown at a modest CAGR of 5% over the past 10 years— roughly a third the rate at which large and global caps have accumulated capital (Figure 2).

Well positioned for liquidity

Because they are sitting on a quarter-trillion dollars of dry powder, these larger managers are highly incentivized to deploy capital so they can raise new, fee-generating funds. M&A and middle-market loan volumes have been in a gully, and companies owned by SBO sponsors are a logical destination for that mountain of capital.

Owing to a more stable interest rate outlook, a more positive outlook for M&A, and the healthy amount of dry powder, investment activity is likely to pick up in 2024, so we’d expect a lot of SBO managers to sell to larger financial and strategic buyers.

¹ They’d also risk unwinding much of the progress made toward increasing the number of diverse managers.

² We define small-market funds as those raising less $2 billion; middle-market funds as $2B–7B; large-market funds as $7B–12B; and global funds as greater than $12B. Unless otherwise noted, this definition applies throughout the paper, save for Figure 10, which includes some older data that follows our older classification.

³ The numerator effect explains how changes in private market valuations (the numerator) can lead a portfolio to be over/under-allocated to private markets; the denominator effect explains how changes in public market valuations (the denominator) can lead a portfolio to be over/under-allocated to private markets.