The last frontier of private equity

Access to private markets is available to investors like it never has been before, thanks to a cycle of product innovation that’s created pathways to open-ended structures (sometimes referred to as ‘evergreen’ funds), and the ability to offer some avenues to liquidity.

In particular, several well-renowned managers, such as Hamilton Lane, Partners Group, HarbourVest have all brought funds to the Australian market that provide exposure to well-diversified global private equity, across mid-market and large-cap companies. These funds are well-rated by researchers and are no doubt an excellent place to start when building private equity exposure into portfolios.

Many wholesale investors are probably already familiar with these funds but may be less familiar with ways to get exposure to lower mid-market companies right here in Australia. This is the segment of the market on which Fortitude Investment Partners focuses exclusively.

When we talk about the lower mid-market, we are really talking about companies that have an enterprise value (or EV, meaning the total cost to buy the company outright, including both equity and debt: it’s the sum of a company’s market value, including debts, minus its cash and cash equivalents) of less than $200 million.

These companies, if listed on the Australian Securities Exchange (ASX), would be considered ‘micro-caps’ (in fact, any listed company under $300 million in EV is typically considered a ‘micro-cap’).  There are currently around 1,470 microcap companies listed on the ASX, out of a total of 2,059 companies.

Now, in the private market the opportunity set is much, much larger. According to the Australian Bureau of Statistics (ABS), in the private market there are more than 68,000 companies in the lower mid-market. This compares to an opportunity set in the ‘mid-market’ (an EV of between $200 million and $500 million) of 2,208, and the ‘large cap’ market (EVs of more than $500 million) of 1,725 companies.

Moreover, while many private equity firms begin their life in the lower mid-market, over time many will gravitate towards the mid-market and large-cap market as they attract capital, and need to deploy into ever-larger transactions. This means that competition for deals is fierce, as is the pressure to deploy. Ultimately, this means that the ratio of five-year transaction value to PE ‘dry powder’ (that is, capital reserves held by PE funds, ready for deployment into investments) in the mid-market is 25:1 versus 218:1 in the lower mid-market.

This means a few things. First, it means that with less competition for deals, the price multiples paid for companies (typically an EBITA, or earnings before interest, tax and amortisation multiple) is going to be lower in the lower mid-market. In fact, at Fortitude we typically pay an average EBITA discount of 30 per cent–50 per cent, versus the mid-market and large-cap market.

Second, as investee companies mature and move out of the lower-mid market and into the mid-market, the average price multiple will increase because of the increased competition for deals at this tier of the market. This is called ‘multiple expansion’ and is one of the (many) levers that Fortitude uses to generate returns for investors.

Third, quality companies at this stage of their lifecycle are easier to scale. This is because they have typically carved out a market niche that provides a meaningful pathway for expansion through both organic and inorganic growth. This means the potential to add value over time can be significant.

Finally, when the time comes to exit a company, there is typically a broad range of buyers available. This might include other private equity firms, who focus on mid-market or large cap or it may be companies, which typically have more discretion to make strategic acquisitions at the $200 million–$500 million EV range.

The lower mid-market offers an expansive opportunity set, the ability to add value, expand multiples and ultimately, find buyers. This is exactly why Fortitude Investment Partners exclusively focuses its time on finding great companies in this segment.

Chris Brookman is chief commercial officer at Fortitude Investment Partners.