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Private equity has been a powerful source of alpha generation and growth, and many portfolios diversify into the asset class. Middle market private equity (“MMPE”), in particular, has historically been under-analyzed and underexplored regarding its opportunity set, leading to mispricing and undervaluation on investable companies. This is especially true in comparison to the large-cap positions found within the more familiar funds from the big-brand PE managers.
MMPE also offers several key advantages related to large-cap private equity, such as price discovery, alpha generation, and the ability to capture growth in niche markets. Additionally, MMPE faces fewer operational challenges, such as slower exit cycles, giving it a distinct advantage.
The number of midmarket companies is vast compared to large-cap companies, with around 200,000 midmarket businesses in the United States, and another 230,000 in the European Union. That massive midmarket represents about one-third of U.S. private sector GDP. With such a large range of companies, industries, and niche opportunity sets that wouldn’t be actionable for large-cap investors, MMPE is able to generate enhanced returns through valuation discounts, value add, and more versatility with regard to entry and exit.
The size of the deals in private equity is extremely important for investment returns. In fact, there is an inverse relationship between deal size and returns in private equity. Typically, managers find it easier to create value within these small companies compared to larger, more established ones. Invested capital in smaller companies results in more significant changes to the company, as opposed to investing in a larger business with a limited growth ceiling where the investment enacts less meaningful changes. That said, while small deals can have the highest average returns, they also have the potential to carry significantly more risk and volatility.
For example, in top quartile funds from 1992-2022, the internal rate of return (IRR), a key measure of the fund’s profitability, was 7.9% and 9.5% for mega- and large-funds, but 14.6% and 24.8% for mid- and small-size funds respectively.1 Further, the average spread, or difference between quartile 1 and quartile 3, is only 10.3% and 16.2% for mega- and large-funds, while the spread of mid- and small-size funds are 16.7% and 21.6% respectively. This data, displayed in the graphs below, highlights how smaller funds have greater return potential, but larger funds have more consistent and predictable spreads and volatility.2 (PPB calculations based on raw data pulled from Preqin Pro.)
Consequently, the midmarket has served as that “middle ground” between returns and volatility. Through utilizing the middle market, firms can react more nimbly to market changes and take advantage of niche investment opportunities that wouldn’t typically present themselves to large-cap investors. These niche businesses and opportunities offer attractive growth potential to the investors and an opportunity to finance substantial positive changes to the business that catalyzes alpha generation.
The far greater growth potential in the midmarket is highlighted through upper quartile MMPE funds that closed between 2013 and 2021, which reported net IRRs that were over 700 basis points higher than the upper-quartile large-cap funds.3
More for less in middle markets
Middle market private equity managers can exert greater influence on their investments, sparking better returns. In 2021, there was a 24% valuation discount between the middle market and large-cap private businesses.4 But the real opportunity can be seen in data that indicates middle market fund managers make a greater positive impact on revenue and profitability than managers focused on large-cap businesses.
To wit: Data suggests that MMPE generates, on average, 75% revenue growth from entry to exit of an investment. That is just 26% for large-cap companies. Additionally, midcap businesses saw average EBITDA increases of 93% from entry to exit of an investment, but that metric stood at only 35% for large-cap companies.5
The other benefit MMPE offers investors is quicker investment exit cycles and better entry points compared to large-cap private equity. MMPE funds typically have quicker exits, resulting from the flexibility typical of the middle market’s smaller deal size and the amount of value-add they can provide over a shorter period of time. A shorter timeline, or exit cycle, for selling or exiting an investment—often through a sale, IPO or other liquidity event – can be advantageous, because it allows for faster returns for the investor and gives the company the ability to reinvest capital in new opportunities.6
However, holding periods for North American private equity funds have increased from an average of three years in 2008 to a little over seven years in 2023.7 This reflects a much greater sentiment within large-cap private equity, given there are far fewer investors who can purchase a large-cap company’s equity after a private equity enhancement, and given the unwillingness to sell the portfolio company due to a longer investment horizon and diminished value-add influence. Conversely, mid-market company investors are more willing to take their payouts with greater regularity, leading to easy entry opportunities and more attractive exit points.
Of course, MMPE deals’ exit cycles can vary depending on industry and market conditions and company-specific factors. Advisors investing in MMPE should be aware that there may also be lock-up periods or contractual restrictions in place for certain deals. However, these tend to be shorter than those found in large-cap private equity deals.
MMPE: More deals, more diversity
MMPE also serves as a stronger diversifier than large-cap companies due to the deal process and the sheer number of deals available in the middle market. In fact, the middle market comprised 53% of total U.S. private equity deal flow in 2023, up from 45% in 2021. There are only so many companies that have total equity value above $10 billion, but there are hundreds of thousands that fall into this midmarket space.
MMPE’s diversification benefits are derived from the opportunity to invest in far more companies and industries, providing exposure to a greater volume and diversity of deals than are available in the large-cap market. The value added through middle market investments can provide the portfolio company with further improvements and aid growth, which enhances MMPE’s overall ability to be a quality diversifier and hedge against broader public equity markets.
Navigating the middle market
As more advisors look to private equity as an effective means of diversifying their clients’ portfolios and providing a fertile source of uncorrelated alpha, the middle market merits a closer look. But before jumping in, partnering with the right MMPE manager is key to navigating this space. Through these allocations, advisors can create better portfolios for their clients.
Notwithstanding the volatility and risk, the benefits of investing in MMPE are well documented, from the fund managers’ ability to drive more fundamental EBITDA/revenue growth within their portfolio companies, to the potential for shorter exit cycles with more natural buyers of these businesses. In addition, from a pure numbers perspective, there are just more of these quality MMPE companies out there to further diversify a client’s portfolio compared to larger PE funds, which tend to be more concentrated in bigger companies.
Frank Burke is Chief Investment Officer and Jack Gray is an Investment Analyst with PPB Capital Partners.
The statements herein are based upon PPB Capital Partners opinions and the data available in publication. They are subject to change at any time without notice. This communication does not constitute investment advice and is for informational purposes only. An investor should assess his/her investment needs based on his/her financial circumstances and investment objectives. Neither the information nor any opinions expressed herein should be construed as a solicitation or a recommendation by PPB or its affiliates to buy or sell securities or investments or hire any specific manager.
Endnotes
1 Preqin Pro data
2 Preqin Pro data
3 Source: Costabile, Steven, Cora Chen, and Justin Pollack. "Why We Think the Middle Market Can Beat Out Large-Caps in Private Equity Investing" (2024).
4 Source: “The Potential of Middle-Market Businesses for Private Equity Firms,” PineBridge Investments
5 Source: The Founder Advantage: Finding Alpha in Middle Market Private Equity, Morgan Stanley Capital Partners
6 Source: Fenancio, Giorgio. "Private Equity Investment Holding Period Explained: How Long Do Private Equity Firms Keep Companies?" (2024).
7 Source: Fenancio, Giorgio. "Private Equity Investment Holding Period Explained: How Long Do Private Equity Firms Keep Companies?" (2024).
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
