Man jumping from one side of a broken bridge to the other side

As the private equity cycle unfolds, it was only natural to expect small and middle market participants to outperform after years of sluggish capital raising and performance.  But frankly, it’s happened with even greater speed than we had imagined.  According to Pitchbook, middle market PE funds have outperformed their larger peers by more than 900 basis points in the last year.  This is the widest gap since 2016, and while part of the divergence is about access to capital for deals of various sizes, valuation is making the biggest difference.  While we often talk about growth and value being in or out of favor in public markets, some version of this happens in private markets as well.  At the end of the first quarter, middle market buyout multiples were 10.8x EV/EBITDA.  Smaller buyouts were even cheaper at 6.4x, while mega-deals (those over $5B) were valued at 16.9x.  This is no small gap and with increases in interest rates, value, or in this case smaller deals were more attractive and took significant market share as overall deals were down materially.  

In thinking about why this would be, part of it is about the success of larger companies in a world of free money and the reflexive activity as upside became difficult to see.  But the other part is about access to capital for the companies themselves.  In a downturn, small and midsize businesses have fewer options for financing, and as such, less availability of capital.  So, if they need capital, small and midsize business owners have little choice but to take a deal from PE that might be at a lower valuation than they had previously imagined.  It’s expensive capital for the companies, but it’s a huge win for investors.  That is, as long as they’re invested in the right part of the risk curve.  For the same reason that bigger and more expensive funds are less attractive in this market, venture capital suffers from many of the same issues of valuation but without the likely cash generation.  

The best part about this?  We’re early in this part of the cycle.  As time goes by, more companies are going to need capital.  Many will have put off raises for some time and will be more willing to offer lower valuations later in the cycle and we’ll be here to capitalize. 

Sources: Pitchbook, Pitchbook


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