Smaller Businesses Aren't Even Blips on Private Equity's Radar — That's a Huge Mistake

James Moran  |

Image: iStock.com/Maxiphoto

In the fourth quarter of 2018, investment dollars flowed through private equity in quantities unseen since before the Great Recession — the PE industry saw a whopping $277 billion raised in the final quarter of the year. With $803 billion bankrolled throughout 2018, PE came close to the record $807 billion in deal value set back in 2007.

Despite this incredible growth, there’s still one area that PE consistently overlooks: small businesses. The majority of firms focus on middle market businesses (defined as companies producing revenues between $50 million and $500 million). This bias becomes evident based on survey data from the International Association of Business Brokers : In 2018, private equity groups accounted for only 25 percent of lower middle market transactions (businesses with $5 million to $50 million in revenue), and 1 percent of Main Street transactions ($0 to $5 million in revenue).

There are logical reasons for this discrepancy. First, deploying significant amounts of capital among smaller opportunities can be difficult. It's practically impossible to think small when you're working to raise hundreds of millions of dollars — a portfolio of 50 business would be impractical to manage, and transactional costs would eat up a disproportionate amount of the fund’s money. Second, smaller businesses tend to have smaller absolute upside potential. For larger firms that must line the pockets of numerous partners and investors, this is a real problem.

It might not be commonplace in the PE world, but there are significant advantages to investing resources in businesses still on the ground floor.

The Big Benefits of Thinking Small

Despite the aforementioned headwinds larger firms might face in entering this market, there are several reasons why small businesses present interesting opportunities for private equity. For starters, the sales multiple dynamic is much more attractive than in other PE segments. To illustrate that point, the same IBBA report referenced above claims that businesses with $500,000 to $2 million in earnings sold for up to 3.3 times earnings in 2018.

Relative to the middle market, where firms are paying highs of 10.3 times earnings, small businesses seem like a bargain — and these contracted multiples have a powerful effect on returns. A little back-of-the-napkin math tells us that if we buy a business producing $1 million in EBITDA for $3 million, our return will be about 33 percent on a cash-on-cash basis. Leverage would improve the return profile further. While these smaller multiples are indicative of the unique risks that smaller businesses face, the numbers suggest the rewards can be worthwhile for firms with the right sourcing strategies.

The second reason small businesses merit a look from PE firms relates to opportunities afforded by the opaque and hyperlocal nature of this end of the market. Investors who look for the right things are likely to come across mispricings and inefficiencies that would rarely occur in the middle market, where businesses tend to be more mature and more visible.

For instance, our firm recently considered a deal with a small business that would have yielded an 80 percent return on cash deployed annually until 2021 (without leverage), when the business would have reached its capacity and other expansion opportunities would have become available. It was a relatively simple rent-based business — the owner saw the long-term potential of the company, but he wanted to sell it for personal reasons. These types of opportunities do exist at this end of the market, and savvy investors can find them if they’re willing to be patient and do some digging.

Firms that do uncover unique opportunities typically benefit from another attractive aspect of the lower middle market: a much larger percentage of these businesses are closely held. Functionally, this means that investors can interact directly with the decision makers in a deal and establish personal relationships that matter. For values-driven firms, this provides a great situation. Investors always fare better with early feedback on how owners feel about their approaches, and this portion of the market allows for continuous feedback with fewer voices capable of derailing deals.

Lastly, firms operating in the lower middle market have a unique opportunity to scale local conversations and grow deeper connections in their communities. This is because many lower middle market businesses are regional or local players whose owners live in the communities they serve. This provides a wonderful long-term sourcing opportunity for firms willing to build enduring relationships, grow their networks, and share their knowledge and skills within the community.

The Future of Private Equity

The same handful of megafirms that currently receive the majority of the PE industry's attention will no doubt continue to dominate headlines. This is to be expected.

At the same time, the industry is beginning to wake up to the opportunities available in the lower middle market — and even on Main Street. Combined with secular tailwinds on the demographic front, this trend will set the scene for one of the more meaningful transfers of American business wealth in the 21st century.

Investors willing to roll up their sleeves and do the work required to invest in this portion of the market will be rewarded handsomely, and they will have a genuine opportunity to build lasting connections with business owners, intermediaries and their communities. At the end of the day, these are the things that make the work truly meaningful.


Jim Moran is the founder and managing partner of ValueStreet Equity Partners, a San Diego-based firm investing exclusively in small businesses. His entrepreneurial endeavors began in 2006 and culminated with the founding of a small business that grew to more than $30 million a year in sales. After exiting his business in 2016, Jim founded ValueStreet to pursue the work he loves on a larger scale. He holds a B.A. from Skidmore College in Saratoga Springs, New York. He lives in San Diego with his wife and son.




DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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