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How Coronavirus Is Impacting Lower Middle Market M&A Activity
Last week, Axial convened a virtual roundtable of members to review the impact of the coronavirus pandemic on lower middle…
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“If all you have is a hammer, everything looks like a nail.” – Maslow’s hammer
Partly through the prevalence of top-down asset allocation, the institutional investment world tends to promote a highly specialized investment mandate at a fund level. While it is important to stay within what Warren Buffett would call a “circle of competence,” specialization in private markets, taken too far, is sub-optimal for all stakeholders and creates a plethora of misaligned incentives.
A business or business owner seeking capital does so because they are looking for a solution. The sensitivities, desires, and expectations of those seeking capital vary widely from situation to situation. As such, an investment firm that can be flexible on the structure of its investment can give stakeholders more of what each values most highly.
Take the case of a company seeking growth capital with an owner or CEO that is most interested in the future upside from business growth. In such an instance, the CEO would be more likely to provide downside protection, via a senior security or preferential waterfall, and forgo cash to maximize upside, via rollover equity or some contingent consideration. Investors who can provide that one-stop solution, compared to ones who can only do plain vanilla equity or senior debt, should bring better risk adjusted investment returns and a better working relationship with the owner. Meanwhile, the owner can benefit from this flexible structure because he or she would get capital which might be more patient, less demanding, and less restrictive.
Assets and businesses that are new or unfamiliar are non-investable for many funds. As a result of the lack of competition, these assets and businesses are more likely to generate a better risk adjusted investment return for investors than those that can be easily classified and which are well understood. Blackstone’s Tactical Opportunities Fund is a notable example of a large alternative asset manager realizing that having an entire toolbox, as opposed to just a hammer, is a sensible and attractive approach to investing. Owners of unconventional assets also benefit from the emergence of these flexible funds because they can find capital which cannot easily be raised via conventional or traditional approach such as debt or plain vanilla equity.
The broader its mandate, the less likely an investment firm is to be an expert in a particular area. That said, a mandate that is too focused can also be dangerous, especially for investors. There are very few examples of focused strategies returning capital to investors when, admittedly in hindsight, their focus is broadly unattractive. Structured credit funds in 2007/2008? Energy funds in 2014/2015? High yield funds in 2014/2015? Maybe those funds missed the forest for the trees. More nefariously, maybe those funds knew what was coming but realized that acknowledging such would put them out of a job. Either way, investors ended up being the losers.