Why This LP Hunts in the Lower Middle Market

It’s not very often that you find limited partners who are interested in backing companies and private equity firms in the lower middle market. The lower middle market is more complex than the larger or middle market and it’s harder for limited partners to put meaningful amounts of cash to work at a time. For global asset manager Aberdeen Standard Investments, however, the lower middle market is the sweet spot. MMR had the opportunity to chat with Whit Matthews, a senior investment director in their private equity group.

MMR: Why are you interested in the lower middle market?

We are always looking for pockets of inefficiency. The lower middle market is an area where there are inefficiencies. We are looking to build portfolios of underlying companies generally sized sub-$100 million of enterprise value and sub $10 million in EBITDA at the entry point. We want to take these relatively small businesses and sell them up the food chain to larger private equity firms and strategic acquirers.

In today’s low yield, low return environment, identifying areas for potential outsized returns is critical. The lower middle market has the potential to do that. First of all, private equity as an asset class has consistently outperformed other asset classes on a long-term basis. That’s well documented. Within private equity itself the smaller end of the market outperforms the larger end, if you can identify top quartile performers. We believe that in order to do so you need to take a consistent approach to this end of the market. You can’t jump in and out of the space. It takes time and knowledge to pick the right managers.   

MMR: How would you characterize the lower middle market today?

The lower middle market continues to present opportunities that trade at a discount to larger ends of the market. Today’s pricing is certainly higher than it was three or four years ago, however the smaller end of the market still trades at a relative discount. It’s still relatively inefficient even though things are frothy.

MMR: What do you look for in the private equity firms you invest in?

Teams or firms have to have a real reason to exist. They need something that makes them unique, whether that’s sector expertise, a strategy expertise, or a differentiated way to source deal flow. Often, it’s some combination of these things. The market is certainly full of excellent firms and there’s a lot out there to choose from. Finding folks who can outperform other managers has always been more of an art than a science, but we have been in the lower middle market for a handful of cycles so we feel we have a bit of pattern recognition to help identify managers we believe will have success in the future.

MMR: Why does your strategy make sense today?

If you are going to play down in this part of market you need a perspective on the broader landscape. There are independent sponsors, family offices, and others out there in this market. You have a lot more deals and firms to choose from. At the larger end of the market there are fewer deals and fewer firms to invest in so your options are more narrow. The variety is good, but there is a lot to choose from.  

MMR: What role are emerging managers playing in today’s market?

Emerging managers are growing into a more meaningful part of the private equity landscape everyday. If you think about how private equity has grown it’s easy to assume that there are thousands of professionals who have grown up in well-established private equity firms. We are seeing more and more of those individuals and teams hanging their own shingles. We have seen over time that many of the best performing funds have been first-time funds. There are a lot of opportunities to capture outperformance if you select the right managers. There are more and more emerging managers to pick from which is great, but it’s not without risk either. LPs have to know what they are doing.

MMR: How do independent sponsors and family offices going direct impact market dynamics?

It’s adding to the competition at the lower end of the market. But it’s also changed things for sellers. Traditional private equity is not the only option to sell to anymore. In a market where the elusive proprietary deal is hard to come by, family offices and independent sponsors may be amongst the unique few managers who can continue to do so. While they provide another avenue for investors to access the lower middle market, one needs to tread carefully. If you are investing directly with independent sponsors you can have a binary result versus the benefit of the cross-collateralization you get when you invest in a private equity fund that is investing in multiple portfolio companies, not just one.

MMR: What do you expect for the PE industry for the next six months?

We think there will continue to be growth in the number of first time funds and we are still in the relatively early innings of the independent sponsor model’s evolution. It will continue to grow and become more institutionalized. From a market perspective the lower middle market will continue to outperform for the best managers. As far as market conditions, we continue to be optimistic and don’t see any near-term correction on the horizon. We are just doing what have always done: staying the course and investing consistently in a part of the market we know well and believe in.