April 2024 | 
6 min read
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 in Australia, versus Coles and Woolworths.
There are also SMEs who are innovators who introduce game-changing products and services. Think about companies like Facebook and AirBnB, 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 the sector has helped 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.
Our private equity portfolios, for instance, look for firms globally of around A$200 million – A$2 billion in size in sectors like technology, healthcare, and business-to-business industrial services. We make investments in profitable, cashflow generative companies with have proven records of revenue and cashflow growth and forecast to continue or accelerate on such trends.
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, there are nearly 200,000 middle-market businesses employing around 48 million people — almost one-third of America’s workforce.2
Many of these businesses are facing succession issues with baby-boomer founders considering retirement and weighing up selling the business to private equity, or alternatively passing over the reins to a relative or someone they know to run the business.
We see this as a substantial catalyst for more private equity transactions in the mid-market sector over the coming two decades. Even today, 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 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 less dependent on debt 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 the investment sweet spot
Mid-sized companies are in the investment sweet spot as they are less financially vulnerable than small companies and have greater growth potential than large companies.
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 technology and health sectors are experiencing transformational changes which are reshaping business, and society more generally, and are beneficiaries of long-term structural tailwinds. As a result, we believe they have the potential to enhance private equity portfolio outcomes over time.
In our view, some of the best opportunities lie in technology businesses that have reliable cash flow and provide mission-critical products and services to their customers, 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.
Such businesses tend to have pricing power in the market, and cross-sell other adjacent services to customers, who truly value the product and service the business is providing. The cost base is typically small relative to revenue, and we see strong gross margins and profitability in these types of businesses.
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. Our managers are also incorporating artificial intelligence (AI) into their products and services, where applicable.
Healthcare is also 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, specialist healthcare private equity mangers outperform generalist managers in the sector, due to the discrete nuances of managing these investments and the various risks involved including retaining specialist labour workforces, managing insurance and government funded payors, and regulation. There remain strong opportunities in the sector, particularly in healthcare businesses of scale.
Risks
Of course, any investment comes with risk. For PE investments, a major risk is the timescale for returns. A typical investment might take 4-5 years or even longer to be sold, and investors typically demand a premium to compensate for this.
Worth a look
In a challenging economic environment, it is worthwhile looking at specialist private managers who are actively improving the businesses they are investing in, while accessing broad diversification.
References
1 What is middle market private equity? Katy Hancock, 8 March 2023, https://pitchbook.com/blog/what-is-middle-market-private-equity
2 Ibid
3 Ibid
4 Ibid
5 Why the mid market matters in private equity. Sean Lightbown, 28 April 2023, https://www.moonfare.com/blog/why-mid-market-pe-matters
Important information
The financial products or strategies described in this article are available for investment by Australian residents only (and some New Zealand residents), and any financial product advice is intended for Australian residents only and not for residents of any other jurisdiction.
This information has been prepared by MLC Asset Management Pty Limited (MLCAM) (ABN 44 106 427 472, AFSL 308953) (ABN 30 002 641 661, AFSL 230705). MLCAM is part of the Insignia Financial Group of companies comprising Insignia Financial Ltd ABN 49 100 103 722 and its related bodies corporate. No member of the Insignia Financial Group guarantees or otherwise accepts any liability in respect of the Fund or the services provided by MLCAM. The information contained in this communication is general in nature and does not take into account your objectives, financial situation or needs. Because of that, before acting on this information we recommend you obtain financial advice tailored to your own personal circumstances.
The information in this communication is prepared for information purposes only and does not purport to contain all matters relevant to any particular investment. Any opinions expressed in this communication constitute our judgement at the time of issue. We believe that the information contained in this communication is correct and that any estimates, opinions, conclusions or recommendations are reasonably held or made at the time of compilation. However, no warranty is made as to their accuracy or reliability.
