The Shifting Middle Market

Middle market private equity funds generally target a sweet spot deal / check size which is too large for individuals / retail yet too small for institutional competition. The investment thesis is to find a gap in the market where a reasonable amount of capital can be deployed at more attractive returns than institutional allocations. Finding this gap or alpha can be achieved a few different ways. Targeting smaller checks allows funds to avoid competition. Targeting less experienced sponsors who have less access to capital is another way to structure more favorable deals for JV equity. Lastly, funds can target less consensus or desirable investments such as lower quality assets, alternative asset classes, less attractive / smaller markets.

All these strategies are essentially forms of risk which are prudently taken in hopes of achieving above average returns. Let’s first focus on check size. Historically, middle market private equity deal sizes have been $5M to $15M checks. Funds entice sponsors with a single check solution to their capital raising challenges.

However, due to the 2012 JOBS act, technology, and social media marketing, sponsors have been able to raise more and more retail capital through syndications. Top syndicators can even raise $25M to $50M of retail equity for a deal, which comes at more attractive terms than partnering with a JV equity partner for the same amount of equity.

As prices have risen, larger funds have been raised, and sponsors have grown their ability to raise more retail capital, the definition of middle market private equity has moved higher. Now it seems that most seasoned sponsors can raise $10M of retail equity so JV equity providers are being pushed to $10M to $25M checks to be a compelling single check option.

Through competition and the rise of lower cost passive investment options such as ETFs, there has been fee compression in alternative asset classes such as hedge funds, real estate, and private equity. On the other hand, sponsors can disintermediate the capital formation process by raising equity directly from individuals, thus avoiding a double promote (LPs invest in a fund which charges a promote and invests in a sponsor’s deal which also charges a promote) in some circumstances. Because of this disintermediation, sponsors can earn higher fees from retail investors while still providing similar or better returns. This dichotomous reality of institutional fee compression and growing retail investor capital formation is making it harder for fund managers to find strong partners for smaller middle market transactions.

One way fund managers are combating this trend and finding alpha is through partnering with less experienced sponsors. Emerging sponsors are generally riskier for JV equity to invest with but can be a successful way to access smaller, good deals at more favorable terms. Additionally, emerging sponsors with fewer deals in their portfolio and on their track record are likely to work very hard to make one of their first deals a success because their reputation is on the line. Conversely, a tenured sponsor who has done over 50 deals can afford the reputational hit of having a deal go south and therefore may be less likely to do everything in their power to ensure a deal’s success.