Part II: Accessing Superior Returns in Small Tech Buyout
- While we see small-cap tech buyout returns as attractive, the dispersion of returns means manager selection is critical to capturing outsized return potential
- Small-cap companies often have unique diligence challenges and require additional support post-close, requiring GPs to possess specific skillsets
- A dedicated tech sector “river guide”, like Industry Ventures, can provide thoughtful, risk-adjusted exposure to the segment through differentiated diligence and deliberate portfolio construction
Recap of Part I: Why Small Tech Buyout May Be the Most Attractive Opportunity in Private Equity
As highlighted in our previous article “Part I: Why Small Tech Buyout May Be the Most Attractive Opportunity in Private Equity,” we believe that small tech buyout funds are the best-kept secret in private equity and have the potential to produce outsized returns for investors. This outperformance is driven by several key dynamics, including 1) lower entry valuations, 2) attractive organic and inorganic growth potential during the hold period, 3) lower reliance on leverage relative to upstream investors, and 4) efficient and well-capitalized exit markets. However, just being in small-cap tech buyout is not enough – selecting the right managers in the small-cap ecosystem is critical to accessing outsized returns. In Part II, we will highlight the importance of not only the small buyout manager selection process but also the importance of portfolio construction to access top quartile performance in small tech buyouts.
Growing Ecosystem of Small Tech Buyout Funds
The vast majority of software and services companies in the U.S. are small, with less than $50M of revenue. However, the total capital raised in 2022 by small buyout funds (<$1B in committed capital) that are targeting these small companies was only 17%1. This mismatch provides ample hunting ground for these small managers. As the leading software buyout specialists have continued to scale, we have seen a number of managers leaving these larger platforms to launch small-cap funds to capitalize on this growing opportunity set.
*Fund I or first Fund raised post-2000.
Not a comprehensive list of managers. The managers were selected for illustrative purposes only. Full list available upon request.
1. Target fund size.
2. Charlesbank Technology Opportunities Fund.
3. Accel-KKR Emerging Buyout Partners.
While the small-cap market represents a minimal amount of the total capital raised in buyout, this end of the market actually has more funds than any other segment within the buyout ecosystem, with over 3001 US PE funds less than $1B in size raised in 2022 alone, or 82%1 of all funds raised. With new emerging managers launching all the time, it creates significant noise and makes it difficult to discern who is differentiated.
Highs and Lows: Dispersion of Returns
As we explored in depth in Part I, tech-focused buyout funds have outperformed broader private equity over the past decade, generating IRRs that are 440 basis points higher than the overall private equity market3. Within technology, outsized returns are actually most acute within the small-cap segment. As a result, top quartile managers in the small end of the market have generated deal IRRs of nearly 50%4, exceeding those of their larger top quartile peers, which range from 30%4 to just shy of 40%4 gross IRR. Furthermore, small-cap technology-focused firms outperformed all other size segments within tech buyout.
However, selecting the right managers is essential to gaining access to the attractive returns that top quartile funds in the small-cap segment strive for. As highlighted in the chart below the disparity between top quartile and bottom quartile performance is also most acutely felt in the small-cap segment – so the highs are higher but the lows are lower, highlighting the need to identify the right GP in the small end of the tech buyout ecosystem.
No Free Lunch: Outperformance of Small-Cap Segment is Not Without Risks
The small-cap tech buyout market presents unique risks for companies and investors operating in that space, making it imperative to select managers that are experienced in navigating these complexities.
The companies that small-cap managers are targeting are small, often with less than $50M of revenue. As a result, these businesses are typically subscale at entry and can often face a range of growth-related hurdles. These may include incomplete C-suites, insufficient back-office infrastructure and internal controls, high levels of customer concentration, underinvested product development, and immature sales functions – all of which can hinder scalability and growth. Of course, this is part of the opportunity when investing in these companies and therefore, it is crucial for buyout managers that are active in the small-cap tech market to be able to provide the operational oversight and know-how, mentorship, and networks needed to bring to bear the right processes and the right people at the right time to create value and be a beneficial partner.
Tech Sector Expertise
Technology-focused buyout managers with deep sector expertise are better suited than their generalist counterparts to navigating the growth-related challenges that smaller software and software-enabled services companies face. Not only will tech specialist investors be better positioned to find an edge in diligence, but they will also be able to more swiftly and more effectively drive value creation through market awareness, functional area expertise, add-on opportunities, and exit planning. While having a deep understanding of technology is a major competitive advantage, determining that level of sector expertise among emerging managers can be challenging and often requires significant diligence by investors.
Emerging small tech buyout managers not only need to invest in great deals, but also need to scale their firms and demonstrate to the market and potential LPs that they are credible partners. In addition to just assembling the investment team and crafting a firm culture, firm building often includes expanding back-office capabilities, formalizing operational processes and value creation playbooks, developing repeatable sourcing practices, and implementing standardized reporting. We often witness emerging managers initially focus on building their investment resources, while keeping their back-office infrastructure lean. Eventually, as the portfolio grows, the needs of the manager evolve such that the marginal benefit of adding an operations / value creation focused resource outweighs that of adding more investment personnel.
As small-cap GPs lay the foundations of their firms, they must also navigate their investment processes, with often significantly smaller budgets and teams than their prior upmarket predecessor firms. Given their limited resources, small-cap GPs must be more prudent than their larger peers about how they allocate resources towards diligence. This can contribute to increased difficulty in winning deals, especially when these firms are still developing their brand. To be a successful firm in the small-cap buyout market, GPs must thoughtfully allocate time and resources, fill their team with the right talent, and bolster their brand, all while making investment decisions – not an easy feat.
Finding the Best Managers
In contrast to their upmarket, well-tenured, blue-chip brethren, small-cap tech buyout managers can be difficult to diligence for the reasons highlighted above. In addition, their track records are often relatively unproven, with attribution from prior firms not necessarily guaranteed. Track record relevance is also not guaranteed, as deals done by senior investors at prior firms may be in different sectors and/or size ranges than the ones these investors are targeting at their new firms. Finally, while larger firms tend to have mature back-office functions and reporting, small tech buyout managers are often engaged in firm building, with such elements being under development.
Benefits of Access
In this current macro environment, the performance gap between top and bottom quartile funds are magnified. We are seeing that the top quartile fund managers are typically not only skilled in discovering great investment opportunities, but are also adept at improving a portfolio company’s profile during its investment hold period. Increased competition and a recession on the horizon have made it more difficult to select high quality managers. Identifying managers with the experience to navigate all market conditions is key.
Private equity manager selection has also become more complex over time, increasing the importance of a disciplined process. From 2011 to 2021, 70.9%6 of capital went to experienced managers. Through Q3 2022, private capital fundraising totaled $926.4B6, but $785.9B6 (or 84.8%6) went to 9596 experienced managers, while the remaining $140.6B6 went to 8886 emerging firms6. Despite that, in the chart below, we see that emerging managers actually represent over 50%7 of the top 10 best-performing PE funds within any given vintage. While identifying these funds is challenging, if done correctly it can generate best-in-class returns.
Angle = Alpha
Identifying, accessing, and supporting top quartile managers within the small-cap ecosystem is the key to unlocking potential outsized returns in this end of the market. However, successfully navigating towards these top-tier managers requires a nuanced understanding of the relevant sectors/segments, a strong network, and creative capital solutions – all of which are foundational to our Industry Ventures Tech Buyout funds.
Within the small-cap tech buyout market specifically, high-quality manager selection comes from tenured pattern recognition of technology trends and analysis of technology business models. Such an understanding not only aids in sourcing, but also facilitates a more pointed diligence process where the most impactful return drivers/detractors are thoroughly inspected.
Additionally, long-lasting relationships with entrepreneurs, fund managers, service providers, and limited partners are key to developing relevant and timely information flow, developing new manager relationships, and sourcing transaction opportunities. A networked investor is certainly one that will benefit from broader market awareness and risk-mitigated decision making.
Finally, small-cap managers – particularly those investing deal-by-deal or raising their first fund – often find themselves juggling the challenges of capital formation, firm formation, and deal formation all at once. Often, these managers could benefit from partnership capital solutions, whether it be warehoused deal constructs, GP partnership capital, or other alternative solutions. Exploring these solutions require flexibility, candor, and creativity.
Building Thoughtful Exposure to Small Cap Tech
The small-cap tech ecosystem is multifaceted and prudent investors must approach portfolio construction carefully. We view diversification, co-investments, and secondaries as essential gears that work in tandem to deliver attractive, risk-adjusted returns to this end of the market.
Diversifying Across Managers
The universe of small-cap tech buyout managers today consists of a range of investment philosophies and strategies, each of which are themselves products of prior deals, lessons learned, and varying world views. As an example, some managers will not hesitate to roll up their sleeves for special situations investing whereas other managers are focused on growth buyouts with select M&A to further accelerate growth. In addition, managers can vary by their focus areas (geographic and/or industry). Furthermore, in light of the recent bank run involving Silicon Valley Bank, the importance of diversification is self-evident as it also serves to mitigate idiosyncratic risks at both the fund and portfolio company levels.
Co-Investing: Concentrating Exposure to Leading Companies
As we explored in depth in an earlier article, “White Paper: Small Tech Buyout – The Fourth Exit Option,” LPs have been co-investing alongside GPs with increasing regularity, with more than half of all LPs actively or opportunistically doing so. In fact, more than a fifth of all buyouts involve LP co-investment8. LPs are increasingly interested in concentrating their exposure in top-performing portfolio companies, and by doing so through co-investments with favorable economics can potentially generate even greater returns. For LPs and emerging managers in particular, co-investments tend to be mutually beneficial; LPs can develop deeper relationships with GPs, while GPs can capitalize on deal flow that they might not otherwise have access to due to investment sizing constraints. The possibility of being able to co-invest alongside these emerging managers as they raise capital provides a compelling opportunity for LPs to generate attractive returns.
However, in order to generate outperformance relative to a portfolio of 100% primary commitments, LPs must have a differentiated angle on their co-invest program in order to achieve long-term success and mitigate adverse selection. At Industry Ventures, this angle takes the form of unique information access and relationships within the technology sector, all of which manifest in helpful insights gained during (often) compressed transaction timelines. Our broad relationships across the private technology lifecycle, combined with our targeted focus on the small-cap tech buyout universe, ensures that we can focus on the most impactful qualities of any deal and the GP leading it.
J-Curve Mitigation Through Secondaries Creating Accelerated Liquidity
Over the last two decades, the secondary market has gradually expanded and matured to become a standard through which investors can gain access to more seasoned investments. Secondaries can also provide diversification by sub-sector, geography, vintage, and investment concentration, as well as offer capital efficiency from earlier distributions, making them more appealing to investors. The mixture of portfolio diversification through secondaries and co-investments can help put capital to work quickly and generate a return on capital in a shorter timeframe than traditional funds. Our 20+ years of experience in secondaries allow us to efficiently and discreetly diligence and execute on opportunities with structuring creativity that drives attractive outcomes.
Over the next decade, we expect there will continue to be a growing number of tech buyout fund spinouts from larger established firms, capitalizing on opportunities down-market. This expanding set of small, specialist tech investors with fresh dry powder at their disposal can play a key part in a LP’s portfolio by providing complementary return drivers and portfolio diversification benefits. In order to obtain top quartile returns, one needs to overcome the challenges associated with diligencing and accessing this segment of the market. A deep understanding of the sector, broad awareness of small-cap segment participants, and a differentiated diligence angle will all serve to maximize the potential of achieving outsized returns. Additionally, careful portfolio construction across primary fund commitments, secondaries, and direct co-investments is necessary to optimize the risk profile associated with such returns.
Historically, top quartile managers in the small end of the market have generated the highest gross MOICs of nearly 4x4 on transactions compared to their larger peers, ranging from 2x4 to 3x4 MOIC. The challenge of course is understanding the important nuances of finding these newer managers who have the requisite skill and experience to fall in the top quartile ranking in the future. We believe that LPs who have the risk tolerance to back new managers, and the ability to skillfully diligence the market and selectively co-invest alongside them will be rewarded.