Things are looking brighter in the smaller side of PE

In a way, the 'exit' challenge gives emerging firms, smaller buyout shops and even first-timers an advantage over more established GPs.

So much focus this year among LPs has been on the lack of exit activity and the slowdown in distributions from their private equity programs.

In a way, the ‘exit’ challenge gives emerging firms, smaller buyout shops and even first-timers an advantage over more established GPs. These firms likely don’t have portfolio issues taking up their time and attention, and they are well positioned to exit investments to larger firms that are still well-stocked with dry powder. It sets up for a positive outlook over the next few years for the smaller side of the PE world.

“The lower mid-market opportunity set is as good as it’s ever been,” Scott Reed , partner with HighVista Strategies , told me. “There’s over a trillion dollars of dry powder across private equity right now, most of it sitting in the hands of upper mid-market and large-cap managers. That capital will start burning a hole in those GPs’ pockets. The easiest way for them to deploy that capital is to look downstream to the portfolios of smaller managers.”

We explore these dynamics in the June issue of Buyouts, along with our always popular list of “the most interesting” emerging managers raising capital in the market this year. We base this subjective judgment off of recommendations we get from market sources, including LPs.

It’s interesting that the market is set up for what could be an inversion of demand – traditionally, LPs have avoided newer firms (or smaller shops) in favor of more established managers in times of market uncertainty.

But in today’s higher rate environment, established firms are having trouble finding exits for older investments. This is being driven by a few factors – for assets acquired around the 2019 to 2022 era, GPs were able to use cheap debt to buy companies at valuations likely higher than they would get today.

Now, those GPs need to sell the assets in an era of more expensive debt in a lower-valuation environment. The math just doesn’t work. And that’s just in the scenario of sponsor-to-sponsor exits (usually the dominant form of exit in PE).

Another exit path, the public listing, has been mostly shut, and while seeming to have more activity recently, IPOs have never been the GPs’ favorite choice. An IPO exit takes several years to fully complete and the ultimate return depends on how the stock performs.

Finally, there is always the possibility that a large strategic buyer swoops in and snaps up an asset. But strategics aren’t as active, and there are only so many larger corporations looking for M&A opportunities.

With this in mind, many established firms are looking to alternative forms of exit – continuation funds, NAV loans, etc … it’s a tough time for many firms right now. And this has leaked into the fundraising market, where LPs are demanding to see more robust DPI activity as one of the prerequisites to opening their wallets for new funds.

Read the full column here on Buyouts. As always, hit me up with your thoughts, or just good ol' tips n' gossip at [email protected] or find me on LinkedIn - Chris Witkowsky .