For years, certain limited partners have employed the barbell strategy, whereby they invest in small-cap and mega-cap buyout funds, but mostly ignore everything in between. The rationale has been threefold: First small-cap and mega-cap funds were considered the most likely to produce outsized returns, based on past performance data. Second, the middle-markets were saturated, which made it particularly difficult to pick winners. Third, that saturation resulted in purchase price inflation, as fewer and fewer firms had access to proprietary dealflow.
In today’s changed economy, however, many LPs are questioning the wisdom of a barbell strategy. Or, as one family office manager said to me the other day: “Those guys tried to be too cute by half… they’re going to lose their shirts.”
The barbell critique argues that middle-market funds are actually safer than small-cap or mega-cap funds, while acknowledging that all types of buyout firms overpaid during 2006 and early 2007. For example, today’s mega-funds are having a very difficult time securing leverage for new deals, which means that LPs will spend the next 12 months paying management fees on massive amounts of uncalled capital. On the small-cap side, critics suggest that these funds are particularly vulnerable to a recession, because their companies have the least margin for error. Middle-market funds, on the other hand, thread the needle – with less required leverage for new deals and more economic cushion for existing investments.
I floated this criticism by Erik Hirsch, chief investment officer for Hamilton Lane Advisors, a fund-of-funds and consultant that has championed the barbell strategy. He acknowledged having heard it before, but still doesn’t buy it.
“Most middle-market firms, and particularly the upper middle-market ones, were using similar debt ratios to the mega-funds, but weren’t getting the same terms, like covenant-light,” Hirsch argues. “What that means is that the lenders are more likely to come knocking on the doors of middle-market companies… I do put some stock in what is said about the small-market firms having a smaller margin for error, but you also have to realize that they rarely use leverage, so they’re the ones whose new deal business hasn’t been interrupted very much.”
As for me, I find merit in both arguments. So I need some tie-breaker ideas. For example, is it possible that middle-market saturation will actually work in its favor over the next years, as such firms will have a greater population of exit partners (via secondary buyouts)? I’ll keep pondering, and return to this topic in tomorrow’s email. Let me know your thoughts, either in the comments section or via email…