Stockholm (HedgeNordic) – Small and mid-cap private equity, a segment which Flexstone broadly define as funds between USD 150 million and USD 1,5billion, and companies with enterprise values between USD 50 and 500 million, has outperformed large cap private equity over various cycles. Median net returns have shown an IRR 15% for small, against 12.2% for mid and 13.4% for large fund sizes, based on Preqin data as of Q2 2020.

The key return drivers for profitable investments are essentially the same for private equity of all sizes. Valuation multiple expansion as firms grow or move to public markets; leverage followed by deleveraging; and operational and revenue growth. However, the relative importance of the three drivers varies with the size of deals.

Valuation and Leverage

Valuation multiple expansion has made the biggest contribution in larger deals, which are now changing hands at 13x EBITDA versus 8-9x for medium sized deals, according to Pitchbook data.

Leverage has also been more important for larger private equity deals, since they can sustain higher leverage levels: an average of c.5.5 times EBITDA against c.5 times for mid and c.4.5 times for small, using S&P Global Market Intelligence data. However, these headline averages bely wide variations between industrial sectors. “More resilient, asset light sectors can support higher leverage levels whilst more cyclical businesses usually command 1 to 3 turns less leverage,” says David Arcauz (pictured left), Managing Partner at Flexstone Partners, who heads the European investment team and is a member of the Global Advisory Investment Committee. There are also substantial variations between funds: “leverage levels tend to be back to pre-crisis levels, but our portfolios on average have leverage levels of 3.5-4.0 times, one or two turns below the wider market average,” says Arcauz.

“More resilient, asset light sectors can support higher leverage levels whilst more cyclical businesses usually command 1 to 3 turns less leverage.”

Growth in the top and bottom lines has been more relevant for smaller funds and deals, partly because they are less leveraged. “Using less leverage means businesses have more capacity to reinvest in growth and weather difficult market conditions, helping them to be more flexible,” says Arcauz. “We think that operational value creation is a true repeatable skill, a real “savoir faire”. It is less market dependent than leverage, which has become more of a commodity with the emergence of private debt funds to complement traditional sources of debt like banks. Financial arbitrage works well when a rising tide lifts all boats but when the tide goes out you see who is not wearing swimming trunks. Market timing is also risky because very few people can call the top or bottom of the market,” says Eric Deram (pictured right), Managing Partner at Flexstone Partners in Geneva who serves on the Global Advisory Investment Committee.

“We think that operational value creation is a true repeatable skill, a real “savoir faire”.

Sector Specialists

Additional outperformance can come from sector specialists, which have outperformed generalist managers by 4.7% per year, according to data from Cambridge Associates and Pitchbook. “Sector specialists are a growing trend and the US market is 5-7 years ahead of Europe. Currently, a growing portion of the market is allocated to sector specialists, and we expect this trend to grow further over the coming years. Smaller firms with deep specialist expertise in sectors also develop more differentiated strategies, rather than relying on outsourced resources to define and implement their business plans,” says Arcauz.

Fees

Fees are also important for returns. Fees are generally higher on private equity than on liquid investments, but the weighted average fee that investors could pay is frequently lower than the headline figure, mainly because strategies like secondaries and co-investments have a lower fee intensity profile. The weighted average fee is also coming down as co-investments make up a growing share of the mix. co-investments represent 30 to 40% of primary volume, according to: “Investing outside the box: Evidence from alternative vehicles in private equity. Josh Lerner, et al – May 2019, Global Private Equity Barometer, Coller Research Institute, winter 2019 – 2020”

“You need a substantial primary investing program to access and select dealflow.”

The co-investment market has become deeper and more sophisticated, which allows for dedicated co-investment funds. Even after co-investment managers charge their fees, the overall cost ratio could be significantly lower and reduce the impact on net returns. “We run co-investment funds that have delivered attractive net returns to our investors. You need a substantial primary investing program to access and select dealflow. The majority of our clients have opted for a portfolio construction mixing primaries, secondaries and coinvestments,” says Arcauz.

Minimising Losses

The discussion around performance attribution drivers often seems to assume that all of the drivers are positive, but it is also important to minimize losses. Since 2008, Flexstone has only lost a handful of investments out of the 104 co-investment deals realised, generating a very low capital loss ratio. “Our realized loss ratio is much lower than industry averages of 12-15%. We have a very cautious selection approach and only work with fund managers that we know and trust. We are very selective in co-investing with first time funds as a result,” says Deram.

Return Outlook

Whether historical returns can be maintained is debatable. Some economists fear that the economy may be heading for a climate of stagflation: faster inflation with slow growth. Even under this scenario, Flexstone are confident that leading private equity managers should be able to keep generating a premium over public markets from active management and alpha generation. “Around 80-90% of small and mid-cap companies in Europe are still in private hands. In a more challenging economic environment, cash rich private equity firms may also be well positioned to consolidate through buy and build strategies as observed in Q1 2021 (70% of the deals closed in Europe were add-ons according to Preqin). Private equity can weather the storm, just as it did after the previous crisis like the GFC,” argues Arcauz.

This article featured in HedgeNordic’s “Private Markets” publication.