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Scott Reed is co-head of private equity USA at Aberdeen, based in the Boston office. He joined Aberdeen in 2015 from FLAG Capital Management. Reed spoke with Buyouts about his firm’s focus on smaller funds and lower-middle-market opportunities in PE.
Many GPs are having success raising larger funds. Why are you interested in the smaller end of the PE spectrum and on lower-middle-market buyouts?
We believe there are fundamental inefficiencies that exist at the small end of the private equity spectrum that the vast majority of investors either don’t fully understand or appreciate, or they are ill-equipped to take advantage of those opportunities on their own.
We’ve really honed our investment strategy over the last decade to focus quite distinctly on the smaller end of the private equity ecosystem. Our sweet spot, if you will, is funds below $1 billion in size, really going all the way down to the least efficient part of the private equity continuum, to managers with funds as low as $100 million. There is more opportunity to buy businesses at lower purchase-price multiples away from the herd of large private equity funds that are trying to put capital to work.
Is your attention to the lower-middle market more tactical and opportunistic, a response to consolidation and competition at the top of the PE market, or more of a long-term, strategic focus?
We think the opportunity in lower-middle-market private equity is more structural in nature than opportunistic at this part of the cycle. There are fundamental structural imbalances in the U.S. private equity market that lend themselves to the small buyout opportunity. And that has to do with relative amounts of capital in different parts of the private equity spectrum, and it has to do with the large number of companies that exist at the small end of the business ecosystem that would be relevant for private equity.
It’s a much greater universe of opportunities and it’s fundamentally inefficient, in that those companies are bought and sold outside of competitive auction processes. There’s a real opportunity for private equity managers to source differentiated and noncompetitive deal flow [that] ultimately translates into lower purchase-price multiples and greater opportunity to generate returns. So it all links together.
What are some of the challenges that prevent investors from fully taking advantage of the lower-middle-market space?
To do it well, you have to have the resources on your team to go out and meet with the smaller managers. You have to really work that much harder, but the reward is the potential for outsize returns.
While there is greater return opportunity at the small end of the market, there is also much greater dispersion of potential returns, so it’s not sufficient to simply invest capital with any small buyout manager and expect to generate that type of outperformance. You have to pick the right managers. Often times, that is a challenge because those managers are hard to find, or they’re hard to diligence, or they’re hard to access, and therefore they’re difficult for most investors to actually invest in.
History shows that you have a far greater likelihood of generating outsized returns from smaller funds than you do with larger funds. But the challenge is there’s a very large haystack that you need to pick through to find those compelling opportunities.
What about first-time funds? Do you actively seek them out or shy away from them?
We are very comfortable investing in first-time funds. We seek them out because we want to see everything in our marketplace.
First-time funds gained a reputation for being riskier and inconsistent in quality. And that was well deserved because back in the early-mid 2000s, many of the first-time funds that were forming consisted of individuals who hadn’t necessarily worked together at a prior firm; [people] who didn’t necessarily have principal investing backgrounds. It might have been a former investment banker getting together with a consultant that he had gone to business school with, and maybe a friend who was an operator, and trying their hand at private equity investing. Unsurprisingly, a lot of those firms didn’t perform all that well, so the entire category of emerging managers deservedly gained a bit of a taint around it.
In contrast, today a lot of the first-time funds we’re seeing in the marketplace are of much higher institutional quality. They’re full teams in many cases that have spun out or split away from their predecessor firms, where they had been well-trained over a period of years and where they developed real track records of working together. Those firms and and those strategies are often of much higher quality than the first-time fund profile that existed 15, 20 years ago.
Aside from the potential for outsized returns, are there other advantages to be found in the lower-middle-market space?
At the smaller end of the private equity continuum, a lot of the activity is about company building. It’s not about over-leveraging a company and squeezing every last drop out of the lemon. It is about buying a family-owned business that has grown well over the last 10, 15 years but needs help getting to the next level.
Edited for clarity by Dietrich Knauth