The old adage “markets don’t go up in a straight line and markets don’t go down in a straight line” captures the moment as accurately as ever.
After a bear market rally for the ages, the S&P 500’s valuation is back up to 19.8X the projected earnings for the next 12 months (assuming no recession over that time period). Despite the record pace of Fed tightening, and the highest forward-looking probability of a recession over the next 12 months since the early days of the global financial crisis (GFC)—excluding the pandemic, which was an unpredictable exogenous shock—we are only 1.4 multiple turns below where we ended 2021. Go figure.
So currently, if you are looking for growth with modest downside potential, your options are unfortunately fairly limited.
Unless, of course, you believe the economy can expand in perpetuity (despite multiple headwinds) and equity multiples can keep inflating “to infinity and beyond” (thank you, Buzz Lightyear), despite continued Fed balance sheet shrinkage, money supply contraction and a few more rate hikes to boot.
Sure, you can always chase the recent AI mania (who knew markets would so rapidly get back to paying exorbitant price-to-sales levels after the 2022 extremely overvalued corporate equity demolition), or you could go after the counter-trend/counter-trend/Jedi-mind-trick/super-reverse-China-stimulus play for the fifth time in the last six years.
OK, I just made up that last term. But it captures the fanciful mindset of the repeated attempts by investors to play China stimulus/reflation. News flash: China’s become a tough place to make money (well done, Chairman Xi), or to get jazzed about the next growth-with-no-cash-flow shiny penny that (re)emerges. But we’ve all seen how this movie ends—and not just over the last 30 years, but actually over the last three.
So, what’s an investor who needs some degree of growth to do?
Middle market private equity
One potential option to consider is middle market private equity.
In keeping with the tradition of democratizing alternatives, this sector/space is now no longer just for the uber wealthy and massive institutions. Now it’s become accessible to investors such as qualified clients and accredited investors.
It used to be that high investment minimums and illiquidity made this kind of access prohibitive, but lower investment minimums and limited liquidity are opening up middle market private equity to a new category of investor.
Let’s discuss the investment rationale for middle market private equity (PE) with a heavy emphasis on PE secondaries:
Fewer publicly listed companies
Over the past 30+ years, there has been a mega trend of companies either staying private or going private. There are a lot fewer publicly listed companies and the reasons for this are many. The trend was arguably accelerated by the Sarbanes-Oxley Act of 2022 (which put more onerous reporting burdens on public companies in response to shenanigans during the dot-com bubble) but the bottom line is that the latest data from the world bank and U.S. census bureau show approximately 35% fewer publicly listed companies in the U.S. compared to 1988 (~2,500 fewer listed companies) and approximately 43% more private companies consisting of over 100 employees in the U.S. compared to 1988 (~46,000 more private companies).
In other words, roughly 96% of all companies in the U.S. with over 100 employees are now private and only 4% are publicly listed.
Opportunity has shifted toward the private markets
Private markets have become an essential source of diversification and growth potential
- US Census Bureau; US-based private companies with more than 100 employees for years 1988–2019.
- World Bank; US-based listed companies for years 1988–2019.
Symbiotic relationships and substantial outperformance
Over the decades, a symbiotic relationship developed between private companies in need of capital to grow and flourish, and private investors/investment pools (aka private equity) with the ability to provide that capital. Fortunately for the uber rich and institutions, the ability to invest in private companies has led to substantial outperformance vs. the S&P 500 over 5-, 10-, 15- and 20-year time horizons.
Private equity has historically outperformed over the long-term
Private equity has delivered superior results over multiple time horizons
Source: Pitchbook North America PE benchmark as of 6/30/2022. To be included in pooled calculations, a fund must have: (i) at least one LP report within two years of the fund’s vintage, and (ii) LP reports in at least 45% of applicable reporting periods.
Note: Investors cannot directly invest in either of the indices presented above. Historical performance is not indicative of future results.
Middle market private equity advantages
There are many different types and stripes of private equity investing that can have both pros and cons. However, some of the advantages of middle market private equity (defined as companies with revenue between $5 million and $500 million) are the following:
- Less start-up fragility: You do not have the same degree of inherent fragility that comes with investing in start-up enterprises (that is the realm of venture capital).
- Breadth of opportunity: The breadth of the investment opportunity is staggering. There are over 140,000 middle market companies in the U.S. across various sectors with different growth profiles to pick and choose from.
- More actual transactions: Since 2015, over 90% of all PE buyouts have been in middle market companies.
- Cheaper pricing: Pricing is ~33% cheaper when compared to larger private companies.
- Corporate balance sheet leverage: Corporate balance sheet leverage tends to be lower by ~24%.
- Monetizing: Perhaps most importantly, monetizing (aka selling existing portfolio companies at a profit) is not as cyclically dependent on capital markets being open for business. Consider:
- Larger private companies are still somewhat dependent on public markets for IPOs for ultimate monetization by founders and private investors (and we all know how cyclical and fragile IPO appetite can be…just look at the last two years).
- However, smaller middle market companies have an additional monetization strategy: Selling to large PE firms that have over $338 billion in dry powder to invest.
Mid-market characteristics have driven outperformance
Comparison of mid-market vs. large-cap buyout transactions
- S&P Capital IQ: Mid Market (revenues from $5M to $500M); Large Cap (>$500M of revenue). Data may omit companies without revenue information, (3/15/2022).
- Pitchbook: Average entry price during the period of 2017-2022 for transactions above and below $500M of Total Enterprise Value “TEV”; purchase price multiple of 10.2x EBITDA for transactions below $500M TEV and 15.2x EBITDA for transactions above $500M TEV.
- Pitchbook: Average leverage at entry during the period of 2017-2022 for transactions above and below $500M of TEV; net leverage of 4.85x EBITDA for transactions below $500M TEV and net leverage of 6.37x EBITDA for transactions above $500M TEV.
- Pitchbook 2022 Annual US PE Breakdown: Private equity dry powder from funds with vintage year 2014-2022 and with a fund size of $5 billion or greater.
Steady supply of deals in U.S. mid-market
Since 2015, middle market transactions have made up over 90% of all buyouts
Source: Pitchbook 2022 U.S. Buyout Deal Breakdown.
What’s even better than middle market PE for growth? Over the next several years, the additional opportunity to go after middle market PE secondaries at a discount to net asset value!
But what the heck is a PE secondary? A PE secondary transaction is when an LP or GP interest in an equity fund is sold to another investor in—yes, you guessed it—a private transaction.
There are two types of PE secondary transactions:
- LP or limited partner led: Where a limited partner chooses, at their own discretion, to sell their interest in a private equity fund in order to raise liquidity. These transactions are typically done at a discount to net asset value of NAV.
- GP or general partner led: Where a general partner (the entity that manages the private equity fund) offers other limited partners the option to receive liquidity for their remaining private equity fund interests. Since there is typically positive selection at play where the GP wants to secure additional time and capital to maximize “winners,” these transactions can often be at a premium to NAV. In the current environment of excess private equity supply vs. demand or available capital, a greater percentage of GP led secondaries are transacting at (or below) NAV than above NAV.
The time for the right alts is still now
In a challenging market environment that continues to prove the old “no straight lines” adage I quoted in the beginning of this note, alternatives like middle market private equity may provide a much-needed growth solution.
I know this was a lot to digest, so the next strategy note will explain why the opportunity for middle market PE secondaries is compelling and how middle market PE, pursued through alternative structures, can potentially help investors achieve their financial goals.
And remember, the time for the right alts is still now!
Investing in alternatives is different than investing in traditional investments such as stocks and bonds. Alternatives tend to be illiquid and highly specialized. In the context of alternative investments, higher returns may be accompanied by increased risk and, like any investment, the possibility of an investment loss. Investments made in alternatives may be less liquid and harder to value than investments made in large, publicly traded corporations. When building a portfolio that includes alternative investments, financial professionals and their investors should first consider an individual’s financial objectives. Investment constraints such as risk tolerance, liquidity needs and investment time horizon should be determined.
This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.
Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.
All investing is subject to risk, including the possible loss of the money you invest.