Mid-Market Private Equity: 2.0

We hear from Eric Deram, Managing Partner at Flexstone Partners, on solving the challenge of geographical diversification in the middle market

Mid-market private equity has grown in popularity as investors seek to invest in the high-growth companies that drive economies.  

The relatively small scale of deals compared with the large buyout funds means the focus of mid-market private equity is local. That is, the segment is dominated by domestic private equity funds investing primarily in domestic companies. Investing in single countries or regions can make sense – the closer you can get to investee companies, the more likely you are to select the ones with the greatest potential. However, the model lacks diversification; investors are potentially exposed to countries and regions that have structurally slow growth or suffer from geopolitical problems.  

Exposure to companies in a larger number of countries, across geographic regions, strengthens diversification, potentially providing protection against underperforming national economies and benefiting from faster-growing ones.  

But is it possible to both invest locally and, at the same time, have a global focus?

Why Invest in the Mid-Market?
The small- and mid-market private equity sector has historically provided outperformance across most phases of the economic cycle. Investors also like the fact that they usually pay lower entry multiples than for larger deals. In addition, it is a highly active segment with strong deal flow. In fact, 83% of the deals closed since 2014 were classified as mid-market.  

The strategy is good at adapting to changing market conditions compared to larger deals because smaller companies tend to be more agile and give the breadth of investment opportunities, allowing investors to nudge their investment strategy more easily. In addition, the mid-market reduces risk by relying less on leverage to generate returns. Whereas large-cap deal leverage is 5.4x a company’s profits, leverage is just 5.0x profits for smaller deals.

There is a wider array of exit opportunities in the mid-market too, including selling a portfolio company to a larger fund or peer-group competitor.  

Mid-Market Is Well Placed to Withstand Headwinds
Of course, there are currently potential headwinds amid the pandemic shock to the global economy. But the long-term perspective may be some consolation to private equity investors. Put simply, no buyout vintage has ever failed to produce positive returns on capital, no matter how severe the downturn. Even vintages launched in the years immediately before the Global Financial Crisis (GFC) produced positive IRRs; however, there is no guarantee that future vintages will produce similar returns.  

Mid-market funds are particularly resilient to downturns, given their relatively low leverage and greater potential to refocus companies. To protect value, we think it is also vital to transact only deals that are within the ‘sweet spot’ of the lead private equity investor. That is, the GP has demonstrable skills and knowledge of the deal type and is not transacting opportunistically.  

When a buyout fund makes a sweet spot investment, average returns are 2.2x the price paid. When the fund strays from the sweet spot, returns are just 1.3x the price paid. We cannot stress this point too strongly and have developed a systematic sweet spot framework to address it. This framework helps avoid style drift, conserve resources, and produce more accurate decision-making. It is an important defense against the kind of crisis we have seen in 2020.  

The Challenges of Geographic Diversification
Even if the mid-market has great potential to create superior value, geographical diversification is key to secure this value creation while mitigating the downside risk.  

There are challenges to achieving geographic diversification, not least because of the diversity of the private equity environments in different countries and regions. In Europe, for instance, the bulk of the private equity markets are driven by smaller deals, while in the US, average fund sizes tend to be larger. Meanwhile, in Europe debt levels for mid-market deals have fallen markedly since 2016, while in the US they have remained more or less stable.  

From a regional and cultural standpoint only the US is homogenous. Europe and Asia are both fragmented so you need a local partner. Each country in Asia and Europe has different codes, cultures, structures, and laws. It is possible to take a blanket approach and target only larger, highly visible companies that operate across Europe or across Asia, but this risks missing the value created by fast-growing, lesser-known enterprises in niche sectors.  

Global Presence, Local Focus
To unearth the most promising mid-market companies worldwide requires a global team with local expertise in the world’s major regions: Europe, US, and Asia. Accessing a global opportunity set necessitates feet on the ground, and proximity to companies and deal networks. With subscriptions to the best-performing mid-market funds in high demand, access to managers is critical. None of this can be achieved by operating remotely.  

Flexstone Partners was conceived expressly to bring a global perspective to the private equity mid-market. Constructed by the combination of three existing Natixis affiliates present in the three largest private equity markets in the world, its management team has decades of experience in the mid-cap buyout and growth segments.

A la Carte Investing
Investors have told us they want globally diversified portfolios that are tailored to their particular needs. Some want certain geographical exposures to dovetail with existing exposures in their portfolios. For others, the priority may be to take more risk, perhaps by investing in first-time funds or by loading up on emerging markets. We think it is important to respond to this and provide an a la carte menu for investment strategy, research and selection, structuring, tax, accountancy, and reporting.  

This approach allows investors to diversify by region, but also by manager type, sector, and size of deal. The resulting portfolios respond to the objectives of clients, with assets matching these objectives.  

Some institutional investors have the resources and experience in private equity investing to make their own global allocations. Many others, however, would like to tap the historically high returns from the private equity mid-market, but seek a partner to steer them through the complexities.

This is where a global private equity advisor, with a local presence on the ground in all the major regions of the world and 20+ years’ experience of investing the mid-markets, can prove its worth.  

About Flexstone
Flexstone Partners is a global private investments firm delivering customized solutions across small- and mid-cap private equity, real estate, private debt, and infrastructure. The firm seeks to actively capture responsible growth opportunities in compelling, hard-to-access markets across North America, Europe, and Asia. With more than 27 years of private market average experience, Flexstone Partners has over 40 institutional clients with more than $7.8bn under management across primary, secondary, and co-investment funds in North America, Europe, and Asia-Pacific. - www.im.natixis.com/flexstone-partners