Generating Returns from Private Equity – Why Investors Must Look Towards the Lower Middle Market
Contributed by Marcus Evans
27 February, 2014
Amelia Island, FL, February 25, 2014
Â“Most bankers and private equity firms ignore small and medium sized businesses. However, financial returns can exceed the private equity returns of funds in the upper and middle markets,Â” according to Mac Gerlach, Managing Director, Cascade Partners. Â“Their lack of access to the public markets is a blessing to private equity investors,Â” he says.
Cascade Partners is a private investment firm attending the marcus evans Private Wealth Management Summit Spring 2014, in Amelia Island, Florida, June 1-3, 2014.
How should private equity be incorporated into a private wealth portfolio? What must family offices take into consideration?
Private equity can be incorporated into a private wealth portfolio to achieve both portfolio diversification and deliver above market returns on capital. In particular, it should be considered as one form of alternative investments and if used correctly, private equity investments can hedge against the volatility of the public debt and equity markets. If a family office is aiming to diversify its portfolio by investing in private equity, then it should invest in private equity firms that work with small and medium size companies, which operate at the most inefficient point of the capital and transaction markets.
Why should they consider lower middle market companies? How do they compare against larger companies?
Make no mistake, small and medium sized companies that compose the Â“lower middle marketÂ” are substantial enterprises. Many have compelling business models, generate substantial annual cash flow and are growing businesses. Their lack of access to the public markets is a blessing to private equity investors. The non-public markets at the lower end of the middle market are highly inefficient and a talented private equity firm can access those inefficiencies to benefit its investorsÂ’ returns. Frequently, these small and medium sized companies have been neglected from a management and resources perspectives, oftentimes for multiple years. The right private equity firm can generate significant alpha by establishing or upgrading basic infrastructure in an existing business (e.g. new management, sales teams, CRM systems, financial reporting and operational dashboards). These basic investments allow businesses to scale efficiently which frequently jumpstarts revenue growth, improves operating margins, and increases shareholder value.
What insights are required to invest in private equity successfully? What is unique about your investment approach?
There is no special sauce to investing in private equity. As with any worthy endeavor, success is dependent upon three things: preparation, timing and hard work. Although it would appear that preparation and hard work are the only two variables that are within oneÂ’s control, in reality, proper preparation includes picking the right opportunities for the right time period.
CascadeÂ’s investment approach is unique because we target companies that are frequently ignored by the rest of the private equity community. In particular, we target companies with USD 500,000 - 5,000,000 of annual cash flow. The general private equity community considers these companies to be too small and not worthy of their attention. However, our historical returns (3.5x cash of cash return and 43 percent IRR on 16 realized investments) prove that diamonds can be found in the rough. Additionally, our historic returns were not generated through financial engineering but through operational and management upgrades.
What risk management tips could you give to family offices? What helps deliver consistent returns?
As equity investors, we tend to focus on the upside of an investment, but take the steps necessary to backstop downside scenarios. In our experience, the best way investors can protect themselves is to work with high quality operators (i.e. CEOs, CFOs, COOs) - they can never do too much diligence on their operators - and work in-depth with them to develop and test an investment thesis. This entails checking every assumption and data point to ensure that macro trends are correct and that any risk is measured and quantified. Once this has been done and the operator has bought into the thesis, then they can protect against downside scenarios by searching for acquisitions that fit the investment thesis. Far too many other private equity investors start with a company that is available for sale and attempt to develop an investment thesis later. Even worse, the private equity investors may purchase an available company and then attempt to drop in a marginal CEO/CFO/COO who neither believes in the investment thesis nor the company. Those situations are typically destined for failure.
What trends do you project for this space?
As an industry, private equity is no different than other industries. There are expansions and contractions, innovations and fads, ups and downs. In the 1970s and 1980s, private equity was a relatively new concept and many private equity investors focused primarily on large companies. In the 1990s and 2000s, the large company market became moderately efficient, so private equity investors began to search for greater returns in the middle market. Those investors successfully found those returns, but in the process caused the middle market to become more efficient. Our speculative prediction is that the next wave of private equity professionals looking for greater returns will venture into the lower middle market or small and medium sized businesses. Approximately 94 percent of US companies have less than USD 50 million in annual revenue, yet most bankers and private equity firms ignore them. Our return results show that our approach to this end of the market can generate returns that exceed the private equity returns of funds in the upper and middle markets.
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