Structural advantages in small and middle-market opportunities

The smaller end of the U.S. buyout market—companies with annual revenues of $10 million to $300 million—has several structural advantages.

• Bigger opportunity set: Roughly 147,000 companies—96% of all privately held companies—are small and middle-market, which is 25 times larger than the opportunity set available to large cap PE firms (Exhibit 1).

• Lower purchase multiples: This universe of small companies is large and fragmented, making it the least efficient segment of the buyout market and resulting in lower purchase multiples relative to the heavily intermediated and smaller pool of large cap opportunities. Since 2010, the median acquisition multiple for companies valued at less than $1 billion has been 15% lower than companies valued between $1 billion and $2.5 billion, and 22% lower than companies valued at more than $2.5 billion.
• Less leverage: Lower purchase multiples also mean that small and middle-market buyouts require less leverage to achieve their target returns. On average, companies that are valued under $1 billion have 20% less acquisition leverage than larger companies. This reduces risk and interest payments, freeing up cash to invest back into the business or return to shareholders. 

• Operating improvement opportunities: Small and middle-market firms are seeking to create value through growth and operational improvements, rather than relying on financial engineering to produce returns. These companies seek to raise their professional standards and can benefit from the resources that high quality PE firms offer; access to well-established networks of experienced managers, operating advisors and board members with specific sector or functional expertise can meaningfully improve technology, marketing and distribution functions. Layering in strategic add-on acquisitions can add scale, diversification, geographic reach and a broader set of products or services.

Current market conditions could favor smaller deals

In addition to structural advantages, small and mid-sized investments may be better positioned in the current private equity environment. Rising interest rates over the past two years have significantly slowed the private equity deployment and distribution cycle. The global value of PE exits in 2023 was down 71% from the peak in 2021 and 24% below the prior year. Global buyout deal volume dropped 60% from 2021 to 2023 while the distribution rate (the ratio of annual aggregate distributions to net asset values) declined from a highwater mark of 34% in 2021 to 15% in 2023 (Exhibit 3).

Large buyout funds are more reliant on IPOs as exit strategies because the companies have often become too large for most strategic investors or other financial sponsors to easily acquire. The 80% decline in IPO exits in 2023 relative to the trailing five-year average has been a particular headwind for this end of the market.

In contrast, over 90% of exits in the small and middle-market have historically been sales to strategic buyers or financial sponsors. Strategic acquirers are typically drawn to these companies as they are large enough to make an impact, but not too large to digest or clear antitrust scrutiny. These buyers are also typically looking to add specific capabilities or enter new markets, objectives that are less dictated by the macro environment.

Large financial sponsors are also longstanding buyers of small and middle-market PE-owned companies, either as new investments or as add-on acquisitions to existing platforms. Slower deployment combined with growth in assets raised by large buyout funds has created increasing stockpiles of dry powder (Exhibit 4). Over half of what is estimated to be more than $1.6 trillion in dry powder held by PE firms globally resides in funds that raised $3 billion or more. This capital must be deployed within an investment period of typically four to five years and PE firms are economically incentivized to invest the funds.

Companies currently owned by small and middle-market general partners (GPs) are a major source of potential investments for large GPs as these businesses have been thoughtfully constructed by their current owners to fit the characteristics that large cap buyers value, such as scale and diversification, along with high quality systems, processes and management teams.

Historically resilient returns for investors

The returns on small and mid-cap private equity investments have been compelling for investors with a long time horizon. The IRR of top quartile buyout funds less than $3 billion in size has been consistently higher than their larger peers (Exhibit 5).

However, there is a wider dispersion of returns across a larger group of managers at the smaller end of the market (Exhibit 6), highlighting the importance of having sufficient resources and a well-established process to make prudent manager and asset selection decisions. 

Manager selection will be especially important for individual investors, who will have an increasing choice of investments as alternative asset managers offer new products targeted to them, such as evergreen private market funds.

J.P. Morgan Asset Management’s Private Equity Group (PEG) is led by a seasoned team of senior portfolio managers that have worked together for an average of 24 years, during which time we have developed the systems, processes and pattern recognition to evaluate opportunities across a broad cross-section of sectors, strategies and geographies generated from an expansive network of over 250 GP relationships.