Markets

Why the best private equity deals come in smaller packages

Fri 31 Mar 23, 9:32am (AEST)
Hands holding a small package

Key Points

  • Private equity has become more accessible to retail investors and more companies are choosing non-public routes to raise capital
  • Schroder's Specialist Private Equity Fund focuses on small and mid-sized company buyouts in sectors with stable valuations and recurring revenues
  • Healthcare and technology are two sectors the fund invests in, with a focus on service-oriented healthcare companies and mature software companies in B2B, HR, and payroll markets. The fund also has exposure in China and India

As an asset class, private equity has become more accessible and of interest to the retail investor - especially in the last year as people looked for ways to diversify away from the traditional 60/40 portfolio. 

More companies are choosing the non-public route for raising capital - including delisting from an exchange due to its high ongoing costs. Sometimes, that process even involves private equity funds getting involved.

Famously, Blackstone Group bought a massive stake in the Hilton Hotels chain back in 2007. One massive debt restructuring and a re-listing later, the Group later sold its stake in the Hilton chain for an $18 billion profit. 

The Blackstone-Hilton deal is what is known in the industry as a buyout (specifically, a leveraged buyout). It also happens to be the kind of deal that Schroders' Head of Global Private Equity Portfolios Benjamin Alt and Investment Director David Bajada specialise in. 

As the portfolio managers behind the Schroder Specialist Private Equity Fund, they argue that the best deals are smaller in size and concentrated in sectors that perform throughout market cycles. 

In this wire, I'll share with you what those sectors are and some of their best ideas right now (both taking on new and exiting existing investments). 

The ten year opportunity runway for private equity in one table

Alt and Bajada say that private equity could have as many as ten more years in this boom cycle. Here are some of the top megatrends worth watching:

Screenshot 2023-03-27 at 11.45.16 am
Source: Schroders

Examining the process

This private equity fund differentiates from the competition by focusing on small and mid-sized company buyouts. In drawdown periods, smaller buyouts have tended to perform better since the Global Financial Crisis than their larger counterparts.

Alt says the team's favourite kinds of companies generally tend to be more mature and benefit from recurring revenues, as supposed to product-oriented growth. One of the other driving reasons behind the team's focus in the smaller end of the market is valuation stability. 

"We find that valuations for companies below a US$100 million enterprise value trade at between 7-8x EBITDA over the years," Alt notes.

He adds that leveraged buyouts are less employed as a strategy at the smaller end of town.

"Performance must be driven by company transformation. Leverage is used but not to the same extent as at the large end of the market," he adds.

Two favourite sectors

Healthcare is the fund's largest individual sector, with the team investing in companies right across the supply chain. 

We like to invest in companies that are service-oriented (eg roll-ups) but we also invest in other areas of the supply chain including companies that support the broader healthcare supply chain, such as medical device manufacturers or laboratory/pharmaceutical products.

The fund has holdings across a range of early-stage biotech companies as well as a range of crown jewel GP-led transactions.

“Crown Jewel" transactions involve the transfer of an existing asset or several assets into a new structure in order to provide some liquidity but more importantly retain ownership of trophy asset for longer term to truly maximise value. Bajada explains that these types of transactions provide downside protection while opening the fund up to 'trophy' assets.

The Schroders team also look for market leaders which have strong management teams, strong pricing power, but are under-capitalised. That's because they will most likely trade at massive discounts, which allows the fund to swoop in. 

In the Technology space, the team have a heavy bias towards mature software companies - particularly in entities that work in the B2B, HR, and payroll markets.

"Most of them were able to increase prices last year by 10-15%, and the customer churn rate was in the range of 1%. So it's all highly valuable," Alt adds. 

For its growth-oriented investments, the team have 10% of its portfolio (soon to be 30%) in Asia. Most of the fund's exposure in this hemisphere is in China and India, with a special interest in the Chinese healthcare, technology, and consumer sectors. 

"They really cater to that domestic demand and to the growing middle class that now wants better healthcare products," Alt says. 

A recent co-investment

One of the team's more recent deals involves an American fast food chain. Apart from trading at an attractive valuation, Bajada argues this investment gives downside protection as consumers opt for lower-cost food products and experiences. 

"There is a lot of low-hanging fruit in their growth thesis given their previous owners really had to hold back given the COVID-19 pandemic," Bajada says. 

It also appeals to the technological revolution mega-theme as the company moves away from physical stores and paper coupons towards delivery apps and digital marketing.

The $55 million deal was closed in Q2 2022 and is a co-investment with a long-time business partner stateside. 

A "crown jewel" trade

Earlier, this wire touched on "crown jewel" GP-led transactions as a key attraction for the fund's managers. This case study is an example of that transaction. The fund in question has two "trophy" assets, both in the software and IT integration services area. 

The deal, closed in Q4 2022, is a classic small-to-mid-sized market buyout situation made at an attractive valuation in a hot industry.

"They both play into that trend of increased spending on digital transformation, ERP adoption into the cloud, and also seeing a lot more outsourcing for more customised software development. These are two businesses that play off a lot of those trends," Bajada says.

Exiting at the right time

While it's one thing to enter at a good price, you've also got to know when to exit. One of the fund's latest exits generated 2.4x return on invested capital.

The company is a value-added distributor of engineered industrial fluid power and automation solutions (think the actuators used in valves or planes). Bajada noted the fund manager had been tracking the company for over a decade before it finally invested in the company at a 7x multiple. 

Three add-on acquisitions, an extra US$6 million in EBITDA and three years later, Schroders sold its stake to a large strategic firm at a premium valuation.

Not bad for an industrials company.

This article was first published for Livewire Markets on Thursday, 30 March 2022.

 

Written By

Hans Lee

Senior Editor

Hans is one of the Senior Editors at Livewire Markets and Market Index. He created Signal or Noise and leads the team's coverage of the global economy and fixed income markets.

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