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Small Deals, Big Returns

Danielle Fugazy | August 15, 2019

Big versus small has been a lingering question in the private equity space for decades. Of course in the 1980s big buyout deals were all the rage and that trend continued into the 1990s. During the last decade the middle market became the darling of the private equity industry and now the lower middle market garners plenty of attention as well. Still the question remains: What size buyout firm generates the best returns? 

In May, Cambridge Associates published an article discussing the returns of private equity mega funds, which it defines as any fund that has raised $10 billion or more. Big funds means big resources. These funds usually have easy access to leverage, the ability to engage with top tier advisors, and a deep network to recruit the best talent for their portfolio companies. Based on these advantages, it would seem an obvious conclusion that these mega funds should produce above-market returns. 

However, according to the article, mega-fund returns are more akin to those of the public markets than they are to private equity funds of other sizes. On a three, five, ten, and 12.75-year basis (through September 30, 2018), Cambridge’s analysis shows that global mega funds returned 15.6%, 14.9%, 13.5%, and 10.5%, respectively. This puts them more or less equal to the Russell 3000®’s  performance on an mPME basis. In addition, mega-fund returns are more than 60% correlated with public indexes, nearly twice the correlation of funds of less than $1 billion in size, which typically produce larger returns. 

According to new research from McKinsey & Company, mid-sized M&A deals actually deliver the best returns for large corporations. “We crunched the numbers, and the answer was clear: pursue many small deals that accrue to a meaningful amount of market capitalization over multiple years instead of relying on episodic, ‘big-bang’ transactions,” according to the McKinsey report, “How lots of small M&A deals add up to big value.”

Between 2007 and 2017, programmatic acquirers in McKinsey’s data set of 1,000 global companies achieved higher excess total shareholder returns than did industry peers using other M&A strategies like large deals, selective acquisitions, or organic growth.What’s more, the alternative approaches seem to have under-delivered. Companies making selective acquisitions or relying on organic growth, on average, showed losses in excess total shareholder returns relative to peers. 

Programmatic acquirers that pursue small deals with steady approach have a few things in common. 

They bring their strategic goals into deal sourcing discussions and put together an M&A blueprint that helps them identify whether or not they may be the best owner of company. The blueprint also helps the company assess how realistic it is to expect success from the deal. 

They often tackle due diligence and integration planning simultaneously—holding discussions far ahead of closing about how to redefine roles, combining processes, or adopt new technology. 

“Having the right resources ready seems to be a key tenet for these companies,” says the report. 

Corporate culture and organizational health— both their own and that of the target companies— also seem to be important concerns for these successful acquirers. According to the research, programmatic acquirers are more likely than peers to pay close attention to cultural factors during both diligence and integration processes.

“For instance, the integration team at one technology company closely tracked the balance of employees who would be selected for the combined entity from across both the parent company and the target. If any area of the business was not achieving a balance that matched the relative scale of the merger, team leaders intervened. Additionally, employee selections could not be approved without ratification from the integration team. If two candidates were deemed equally suitable for a role, the team tilted its selection to the target-company candidate, recognizing that managers in the acquiring company likely already had a built-in unconscious bias in favor of the homegrown employee. If neither candidate was considered suitable, the team moved quickly to recruit externally,” according to the report. 

Lastly, programmatic acquirers often focus on building end-to-end M&A operating models with clear performance measures, incentives, and governance processes.

According to the report, “By building a dedicated M&A function, codifying learnings from past deals, and taking an end-to-end perspective on transactions, businesses can emulate the success of programmatic acquirers—becoming as capable in M&A as they are in sales, R&D, and other disciplines that create outperformance relative to competitors.”

Axial is the deal network for the middle market.

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