Han Dieperink: The advantages of small companies within private equity

November 14, 2023

By Han Dieperink, written in a personal capacity

Investors in private equity often prefer mega funds that have already established their reputation. However, in this economic climate, funds that focus on small companies offer many advantages that mega funds are currently missing out on.

In the IT world, the adagium 'nobody gets fired for hiring IBM' has held true for a long time. In the financial world, it is 'nobody gets fired for hiring BlackRock'. And in private equity, no one gets fired for selecting KKR. It is commercially savvy to market with established names, if only because unknown names may raise doubts for the end investor. After all, there is also a lot of chaff among the wheat within private equity.

Another, less positive reason for choosing the largest funds is that investors often try to save on due diligence. Sometimes the heavy operational due diligence is not even carried out at all. The reasoning is that if well-known institutional investors are involved, all will be good.

It is self-evident that selecting based on reputation risk, marketing strength and cost savings is not the way to select the best private equity funds. However, until recently this was much less of a problem than it is now. Large funds also conclude larger deals, partly because they can benefit from greater leverage. While small private equity funds do not go much further than 30% to 40% debt capital, simply based on an EBITDA multiple of 3 to 4 times, the large funds sometimes work with as much as 60% to 70% debt capital.

For a long time, working with debt capital was so cheap that this directly benefited returns. However, the vast majority of this financing is variable. That is why the interest costs for these companies have doubled in a short time. Large funds are therefore much more affected by rising interest rates than small funds.

The current market poses another problem for the large funds. For years they could rely on rising valuations. The model was simple. A company is taken off the stock exchange relatively cheaply and filled with debt capital, only to be sold for a higher price not much later.

The small funds focus much more on faster-growing small companies. Financiers often do not go much further than 3 to 4 times the EBITA for these smaller companies. That does not mean that with lower leverage they grow slower than the larger companies. On the contrary, on average an EBITDA growth of 30% per year is achievable.

With such strong growth in EBITDA, the increased interest rate has much less influence. Such companies increase in value even as the absolute valuation of the market falls. After all, the decline in value is more than compensated for by the underlying growth in EBITDA.

A disadvantage for the large private equity funds is that it is now less easy for them to list a company in turbulent times. Several IPOs have been postponed in the second half of this year. At the same time, money continues to flow to these large funds, while it is not easy to conclude new deals. Sellers also prefer to wait and see.

Still, the five-year investment period forces you to buy. After all, the mountain of 'dry powder' continues to grow. For small funds, these much larger funds now offer an attractive exit option due to their excess liquidity. This is also because these smaller funds focus much more on growth segments such as technology (software) and healthcare.

The funds that focus on small, fast-growing companies are so successful that it is questionable whether there is still a small-cap premium on the stock market. Anyone who looks a little further into the past will learn that small caps perform better than large caps in the long term. Since this premium was first described in 1981, on balance little of that outperformance remains.

Furthermore, there are far fewer small caps these days, because many young companies finance themselves through private equity. When a company comes to the stock exchange, it is usually no longer a small cap, but a billion-dollar company that tries to offer liquidity to existing shareholders. In other words: they try to cash in quickly. Usually that is not the time to get in.

Because more and more companies remain in the hands of private equity for longer, the small, strong growers in particular are disappearing from the stock exchange. It is possible that these strong growers are responsible for the historical, above-average performance of small-caps on the stock market. Future small-cap investors mainly look at private equity, but they should also opt for small companies there.

More columns by Han Dieperink