March 2019 Issue
While there seems to be a wall of money being invested in private equity (PE) funds at the moment – some attribute this to the relatively poor performance of hedge funds in recent years – and some PE houses are raising larger and larger funds as a result (Carlyle raised an $18.5bn fund in 2018), an interesting phenomenon in the market is the plethora of large cap and upper mid-market PE houses also raising small cap/tech funds, focused on smaller deals. Why is this happening and is this likely to continue? In the new PE world, is small beautiful?
A wall of money
Funds that have a proven track record found it easy to raise large funds in 2018. Private Equity International has reported that between them, the 300 top PE firms that made up their ranking had a five-year fundraising total of $1.5 trillion, with the top 10 alone accounting for almost $400bn. This is higher than ever before. There seem to be a number of reasons for this – ranging from the relative outperformance by top quartile PE funds, the relative underperformance of hedge funds and other alternative asset classes during the period and volatility in public markets. There are reports that several large cap PE funds are in the process of raising mega funds that should close in the first half of 2019. The ease of raising PE funds in the current environment seems to apply across not only the jumbo end of the market but also across the mid-market – Bowmark Capital raised its latest and largest fund of £600m in a mere 10 weeks.
The rise of smaller cap/tech focused funds
With this amount of money going into PE and the apparent ease of raising large funds, it is an interesting trend in this fundraising environment that large and upper mid-market PE funds are now looking to raise smaller cap/tech focused funds. For example, Carlyle, in addition to raising its latest $18.5bn fund, has also recently raised a smaller €1.35bn tech fund focused on European technology businesses (this fund was also raised at a record-breaking speed of three months). Permira has raised a growth fund recently and Apax raised a tech focused growth fund in 2017. In the upper mid-market, PE houses have also been raising funds focused on smaller deals, for example Silverfleet raised a fund focused on the lower mid-market.
Why are funds focusing on the lower mid-market/growth capital space?
The growth of the tech ecosystem in the UK and Europe now means that there are a large number of good quality growth companies in the tech space that are ripe for further investment to take them from the post Series A stage. These companies are looking for the next stage of growth capital investment to help them fund expansion (maybe oversees or into other product areas).
The percentage returns that are available at this small end of the market are much greater than at the mature large cap end of the market. It is fairly self-evident, but it is clearly easier to turn a £20m company into a £40m company than it is to turn a £1bn company into a £2bn company, particularly if the company involved is a high growth disruptor business, rather than a well-established mature business which is unlikely to have the same level of growth potential.
Growth capital investors such as the Business Growth Fund (BGF) have brought this area of the market into the spotlight and have made growth capital investing more mainstream – for example many investors who traditionally would only have taken majority stakes are now more prepared to take minority positions, which is typical of growth capital investment. Through investors such as BGF, growth capital terms are becoming more clearly defined – in a minority investment position there is always the friction between not being in control but having sufficient controls in place to protect your investment and having the ability to turn things around if the business gets into difficulties.
It is also clearly easier to exit a company at the mid-market level than at the jumbo end – the potential exit opportunities are so much greater in that you can sell on to larger PE funds, trade buyers or initial public offering (IPO). At the jumbo end where exits are for billions of pounds, dollars or euros, the options are narrower – there are fewer potential trade acquirers (and PE is less likely to be able to acquire and flip for a multiple) and so one is more dependent on an exit onto the public markets, which are susceptible to general economic conditions and sentiment, and go through phases of being closed to PE exits.
In terms of fund size, clearly being able to deploy a several billion pound, dollar or euro fund requires there to be large available target companies to acquire. The jumbo funds are still looking to invest in 10 to 15 companies – given team sizes and ability to deploy resource – in any given fund and, with an $18bn fund, this requires equity cheques of more than a billion in each deal on average. Adding leverage, this means targets with values of more than $4bn to $5bn, thus cutting down significantly the universe of target companies to invest in. If you are deploying a much smaller fund in smaller mid-market or lower mid-market size companies, this greatly increases the potential targets available for acquisition or investment. If you add to that the ability to take minority as well as majority positions, it significantly expands the flexibility available in deploying the fund.
Many of the tax structuring and financial engineering tools that had previously been available to PE have been curtailed by tax changes and regulation, meaning that increasingly returns need to be generated by an actual increase in value. This is easier to achieve at the growth capital level as the companies are often younger, higher-growth businesses, where PE can add value by helping professionalise the business, provide funding for bolt-on acquisitions and other strategies, such as expansion into other geographies and markets. It is a lot easier to add this value at the growth capital stage rather than in a mature professionalised business.
The macro outlook at present is uncertain, with the eurozone dealing with Brexit, growth slowing in China and trade wars between China and the US. In this environment, it would seem that taking smaller bets on higher-growth businesses may be a sensible hedge. For the reasons set out above, it may well be easier for the large cap PE investors to make higher percentage returns at the growth capital end of the market. For these reasons, the trend of large cap PE houses raising smaller cap, growth and tech funds is likely to continue – small (and perfectly or even imperfectly formed) is beautiful.
Malcolm MacDougall is a partner at Charles Russell Speechlys LLP. He can be contacted on +44 (0)20 7427 4544 or by email: email@example.com.
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