Welcome back and thanks for joining me (John Bailey, Co-Founder at OneFund) for another week of Capital Call. The newsletter from LPs for LPs.

The mission with Capital Call remains: delivering concise, top-notch insights and updates from the private markets tailored to what matters for LPs.

If you are a new subscriber, make sure to check out our most recent newsletter in which I share some insights on Founder-Owned Targets Dominating the M&A Buyout Landscape

This week I’ll dive into a few data points from Pitchbook’s Q1 2023 US PE Middle Market Report and some of its implications for LPs.

Subscribe now and stay ahead of the curve with OneFund. 

Industry Insights

Today, let’s talk about middle-market managers and how they’ve done in the current environment (hint, they’ve done well). But before we get started, what is a middle-market fund and how do they differ from the megafunds that many of us are more familiar with (e.g., KKR, Apollo, Carlyle, etc.)? Here are a few characteristics of middle-market funds.

1. Smaller fund sizes: Middle-market firms are generally “smaller” when compared to megafunds, with fund sizes in the hundreds of millions of dollars or low billions

2. Smaller deal sizes: They focus on investing in companies with relatively lower enterprise values which may have annual revenues ranging from tens of millions to a few hundred million dollars

3. Investment Strategy: Middle-market funds typically target companies with growth potential, seeking to add value through operational improvements, strategic initiatives, and organic or inorganic growth

Pitchbook’s Q1 2023 US PE Middle Market report, released last week, showed that middle-market share of all buyout deals was 76.5% in Q4 2022 and 75.6% in Q1 2023 - a number that has never been over 72% for a full year.

MM PE also represented 88% of buyout fundraising in Q1 2023, a significant increase from 45.4% in 2022, and has seen investment returns outperforming megafunds as a whole for the past three continuous quarters. It remains to be seen however how solidly these trends will continue into 2023/2024 and investors should exercise caution, especially as an influx in fundraising to a particular strategy can have multiple and return implications down the line.

In this week’s newsletter, I’ll dive further into the middle-market PE landscape and highlight the trends that matter most to LPs.

1. Mid-Market Take-Private Deals on the Rise

Take-private deals have historically been all but reserved for megafunds, however, many recent transactions are now considered mid-market. Q1 2023 saw 7 out of 18 take-private transactions at the sub-billion threshold. 

Looking at the below deals, almost all were trading at significant discounts to their 52-week highs and were forced to privatize as a result. Many of these targets are known as “boomerang” stocks, where companies that recently went public saw massive valuation drops and ended up going private again. Falling below the $1b market cap threshold is very difficult for a public company since there’s not enough volume activity to attract market makers and research coverage, and fund managers cannot acquire sizeable positions without becoming owners. Pitchbook expects many of the public listings from 2020 and 2021 to fall in this space, allowing middle market PE sponsors to capitalize on the trend. 

Take privates are an interesting strategy that gives these middle-market funds more options to drive returns for LPs and also gives their LPs increased diversification in strategy. Diversification is something I nearly always consider to be a good thing.

When looking at funds, LPs should increasingly consider mid-market buyout firms with the capabilities to conduct take-privates as they become a more viable option. Keep in mind that these transactions are typically more complex than private market M&A, requiring sponsors to navigate strict regulatory reviews, widespread ownership structures, and sensitive timing considerations. This expertise is historically left to megafunds, and LPs should diligence a MM PE funds capabilities and history here before investing.

2. Middle Market Valuations Becoming Increasingly Attractive 

Mid-market EV/EBITDA multiples have always featured a discount to the overall PE market for several reasons including risk, competition, and access to resources. However, this gap has continued to widen. Q1 2023 MM EV/EBITDA multiples further compressed in the twelve trailing months to 10.8x, a steep discount compared to the 16.9x figure for deals worth $5b+. This is even more pronounced in the lower middle-market, where deals below $100m feature median EV/EBITDA multiples of 6.4x.

While recently, MM Buyout PE has outperformed megafunds by 9.17% over the past year, representing the widest gap since 2016, it does not mean however that middle-market PE is a silver bullet. First, because entry multiples are lower, exit multiples also typically lag behind unless the portfolio companies can grow considerably. Second, it highlights the importance of diversification across fund strategies. LPs who have traditionally relied on the “tried and true” method of committing to reputable megafund strategies or purely committed to middle-market managers, would have had more variable returns in the long run than an LP investing across strategies.

3. Carve-Out Decline Set to Reverse

Corporate carve-outs have steadily declined as a portion of MM PE deals over the past decade, but this trend may finally be reversing. In Q1 2023, carveouts comprised 7.9% of deals, representing a slight increase from the 7.7% 2022 figure. 

This uptick isn’t significant, but current market conditions may drive carve-out growth further.  Economic headwinds are forcing companies to re-evaluate their asset bases which will result in spin-offs of non-core or distressed assets to strengthen balance sheets with additional cash. Carve-outs tend to be small in deal value, giving middle-market buyout firms another venue to search for deals. 

Since carve-out deals are typically acquired for a discount and feature compelling organic growth potential they have the potential to drive outsized returns for LPs. Sponsors can also restore distressed or underperforming businesses back to health through strategic investments or integrations.

If you enjoyed this read and would like to discuss further, feel free to schedule a call with us - we’re happy to chat.

Updates from Across the Ecosystem

Fundraising

📈 As Hellman & Friedman roars to $20bn, it explores liquidity options for LPs

📈 Wellington Management Closes Fourth Late-Stage Private Fund, Exceeding $2.5 Billion Target

📈 Ex-L Catterton dealmaker’s shop Newcastle targets $200m for Fund I

Reports

🔬Macquarie: Three reasons private equity dealmaking will rebound in 2023

🔬Pitchbook: Quantifying the Success of YC and the Largest Accelerators - Takeaways for VCs, LPs, and Startups

🔬KKR’s latest analysis on the crisis in market confidence

GP Perspectives

Orlando Bravo (Founder, Thoma Bravo)

In Bravo’s recent interview with Bloomberg, Bravo expects a rebound of deal activity for the remainder of 2023 supplemented by a strong pipeline of take-private transactions. He also explains that the current environment has motivated sponsors to focus on profitability measures over revenue growth and that VCs failing to boost profitability will cause further demise in the industry. Bravo is also very bullish on the implementation of generative AI in Thoma Bravo portfolio companies, predicting 10%+ margin increases as a result. 

Chris Perriello (Head of Secondaries, Carlyle)

Perriello explains that Carlyle has recently focused on MM and LMM strategies that have optionality on exits, whether it’s sponsor-to-sponsor trading, strategic exits, or buy-and-builds. Carlyle has been avoiding opportunities that rely heavily on public market exits due to constrained pricing and the IPO environment, shifting their average cheque sizes lower than what they previously targeted.

About OneFund

OneFund is democratizing access to Private Equity and Venture Capital for everyday investors. We partner with the world's top PE & VC funds to offer investment options without the million-dollar minimums. 

If you would like to follow what we are doing, get more regular updates directly from the team, or access to the platform, you can join our waitlist below!