The small market opportunity

Posted on: June 22, 2014

Small market private equity investing offers the potential for superior returns, due to a less competitive and relatively inefficient market environment. The rationale for a small market private equity premium is a simple one: historically, investors have been able to purchase smaller companies at a lower multiple of annual earnings. Later, after a company has undergone management, organizational, financial, and operational enhancements, and is readied for its eventual sale, investors can take advantage of higher purchase price multiples in the more competitive market for larger firms. The phenomenon of buying a relatively small company at a discount, improving it over time, then selling it at a premium in the larger and more competitive market, is sometimes referred to as “multiple arbitrage.” 

A sale to a private equity firm often signifies an inflection point in the growth cycle of a small company, representing a transition from entrepreneurial ownership to professional management and outside investors. These companies are often at a point in their life cycle when outside expertise is necessary to continue to grow the company. Further, transactions in the small market are often driven by fundamental life events experienced by the owners of small private companies (e.g. death, divorce and intergenerational transfers). These factors will likely continue to contribute to the ongoing robust opportunity set in the small market.

Further, the interests of the managers of small market private equity funds are well aligned with those of their investors. Large and “mega” private equity funds are able to amass a staggering windfall of profits from management fees alone, whether or not they produce strong performance. In contrast, managers of smaller funds are theoretically driven to produce strong performance to participate in performance incentive fees, as management fees alone are less significant.

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