Mid-sized companies are a go-to for PE investing

Kristian Zimmermann, Co-Head of MLC Private Equity
Rachael Lockyer, Portfolio Manager MLC Private Equity

Small-to-medium enterprises (SMEs) tend to stir positive emotions. They conjure up images of the underdog or fledgling taking on big players in established industries. Think about IGA, even Aldi, in Australia, versus Coles and Woolworths.

There are also SMEs who are innovators who introduce game-changing products and services. Think about companies like McDonald’s and Amazon, to name some. They are giants now but started life as ideas in the heads of their founders. 

Big companies don’t start out big. They usually start small. Some progress all the way to become large established companies. Some, sadly, go out of business altogether.

Our private equity (PE) team has been active in the mid-size part of the SME space for many years and we’re enthusiasts about the potential benefits of PE investing in this sector because they have helped to deliver strong long-term returns for our clients.

But before going on to explaining why we think well-chosen mid-sized companies are attractive for PE investing, an explanation of private equity is in order.

In short, private equity involves owning or investing in private companies not listed on stock exchanges.

Like any investment, there are risks involved with PE and it’s important for investors to consider them before participating in PE investing and that’s why we touch on PE-related risks later in this commentary.

Our private equity portfolios, for instance, look for firms globally of around A$500 million – A$2 billion in size in sectors like healthcare, technology, and non-discretionary consumer products.

The mid-sized market opportunity

There are multiple reasons why we think mid-size companies are attractive, from our perspective as private equity investors. For starters, it’s the sheer size of the opportunity set.

In the United States, mid-size companies are “the major driving force of the US economy, supporting one-third of the total Gross Domestic Product (GDP).¹ Additionally, in the United States, there are nearly 200,000 middle-market businesses employing around 48 million people — almost one-third of America’s US workforce.² All up, the mid-size company market represents around two-thirds of total US private equity deal value.³

We also believe they are an investment sweet-spot (see chart). In our view, they’re not as financially vulnerable as small companies, and have already proven themselves to some extent, having successfully matured from start-ups and or small companies to financially and operationally more mature mid-sized ones.⁴

In other words, they are more grown-up and big enough to generate real cash flows, but not so big that future growth becomes harder to achieve or to quickly adapt to technological changes and
new business dynamics. Moreover, mid-size companies typically have more business growth and business process improvement potential than larger, more mature companies.

In our view, they are ideally suited for the ‘active management’ approach of specialised private equity managers who work closely with company management teams to drive growth, enter new markets, professionalise operations and increase margins.

The best mid-cap companies are those with clear market leadership in a specialist sector, dependable revenues and unique or ‘mission critical’ technologies or products.

Less dependent on debt

Mid-market companies are also less dependent on debt /borrowings to fund their operations and to drive growth. That is an important consideration, at a time like now, when interest rates have been higher than they have been for years.

Mid-market companies with less than US$50 million of EBITDA (which stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation, an important measure of the profitability of a company’s business operations), were found to have consistently lower levels of borrowings, relative to the size of the business, than larger businesses.⁵

Mid-sized companies are arguably in the investment sweet spot

Source: The Journal of Private Equity, Vol. 2, No. 3  

Mid-cap companies are also not as risky as small-cap businesses. In an economic downturn, they are less likely to struggle than small-cap companies, from our experience.

Mid-cap sectors that can enhance PE portfolios

The health and technology sectors are experiencing transformational changes which are reshaping business, and society more generally. As a result, they have the potential to enhance private equity portfolio outcomes over time.

This links well with PE funds, which are about creating long term value. PE managers can cut investee company costs faster and take advantage of market consolidation opportunities when peers may be struggling, while still benefiting from longer term market growth potential.

Healthcare is currently experiencing growth on the back of greater health spending related to longevity, ageing populations, and the rising cost of ever-more advanced treatment technologies and methods.

In our view, some of the best opportunities also lie in tech firms that have reliable cash flow and provide mission-critical products and services, rather than simply revenue growth potential. They are targeting real needs and improving the “plumbing” of an industry or have a core business that is essential for consumers.   

Specialist technology expertise can help to fast track the improvements of companies in times where it is critical to accelerate technology uptakes, such as the COVID period.

A patient approach to providing capital and working with partners to build up mid-size businesses is a great match for private equity.

Risks to be considered

Of course, any investment comes with risk. For PE investments, a major risk is the timescale for returns.

It can sometimes take several years for PE managers to identify appropriate investments, then formulate and execute on an investment thesis, before proceeding to sale (‘exit’) to generate potential profits. Until the successful selling of underlying investments, investors’ capital in PE funds doesn’t generate a cash return.

PE funds may invest in companies that are still at relatively early stages of development where the business model has not been fully tested, which involves higher risk than buying an established company on a public equity market. PE managers will often use a substantial proportion of debt to finance their acquisitions, increasing their exposure to potentially higher interest rates, in the process.

Unlike share market investments — whether directly held or via managed funds and Exchange Traded Funds — where investors can regularly buy or sell their holdings, investments in PE funds are typically ‘locked up’ for set periods to allow the manager time to work through their investment strategy.

Investors’ money can be locked in a PE fund for 5-10 years, so investors need to be comfortable with their money being inaccessible.

Another consideration is that PE funds may charge higher fees than some other types of investments where the fund managers are less actively involved in driving results.

Then there is operational risk, which is the risk of loss resulting from inadequate processes and systems supporting the private equity manager or the underlying companies in PE funds.

Unlike in public markets where prices fluctuate constantly, private equity investments and co-investments are subject to infrequent valuations and are typically valued quarterly and with some element of subjectivity inherent in the assessment. 

Finally, there are general market risks such as foreign exchange fluctuations, and changes in interest rates, just to name some. 

Worth a look

In a challenging economic environment, it may be worthwhile taking a look at specialist private managers actively improving the businesses they are investing in.