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.