With an estimated $7.3 trillion in assets under management (AUM) spread out across roughly 4,500 firms, private equity is the largest alternative asset class in the United States. By acquiring controlling interests in target companies, private equity buyers gain the broad and unfettered discretion they need to make sweeping strategic changes within the businesses they own.
With an estimated $7.3 trillion in assets under management (AUM) spread out across roughly 4,500 firms, private equity is the largest alternative asset class in the United States.
Unlike its close cousin venture capital, private equity firms use a combination of debt and equity to purchase majority or full stakes in companies. By acquiring controlling interests in target companies, private equity buyers gain the broad and unfettered discretion they need to make sweeping strategic changes within the businesses they own.
For instance, a private equity firm may slim down a company’s administrative staff, sell off unprofitable divisions, replace its executive team, or implement loftier productivity metrics. The end goal is to improve a portfolio company’s profitability or grow its revenue so that the private equity firm and its limited partners (LPs) can lock in profits once the business is sold to another buyer.
In most cases, these operational transformations occur at a rapid clip—private equity firms (and their LPs) generally seek to offload their investments within three to seven years post-acquisition.
This peculiar attitude of impatience is no accident. General partners (GPs) heading private equity firms are, under traditional arrangements, evaluated according to the internal rate of return (IRR) they can earn for the fund.
GPs who can generate an IRR in excess of the fund’s hurdle rate (or the preferred return from the LPs’ perspective) are lavished with carried interest—substantial payouts that usually equal 20% of the fund’s profits. Make value-creating improvements with haste, and the IRR posted by a fund will rise, all else held equal. Let the process drag on for years, and a fund’s IRR will fall—sometimes even below the hurdle rate.
Why Do Traditional Private Equity Firms Buy Large Companies?
Speedy exits (or “business flipping”) aside, these incentives—coupled with the sheer size of many traditional private equity firms—also pressure GPs to eye large, stable, and well-established companies with substantial operating histories.
From a strategic standpoint, large deals are advantageous because they allow private equity firms to borrow on a non-recourse basis, which insulates a firm’s GPs from financial ruin in the event a target company performs poorly post-acquisition. Lenders may also be willing to present lower interest rates and flexible terms like interest-only periods, which can help relieve the strain on a target company’s cash flow in the first few years.
In a similar vein, traditional private equity firms seek large targets because debt must be serviced at regular intervals, most often monthly. Only a sizable enterprise with a history of consistent cash flow can withstand the effects of aggressive leverage without succumbing to missed payments.
More broadly speaking, debt enhances a fund’s (levered) IRR, since valuation improvements due to revenue growth, margin expansion, and efficiency gains accrue solely to equityholders (i.e. LPs and GPs). Thus, using as little LP equity as necessary to acquire as big of a business as possible is an easy way for GPs to juice a fund’s returns—provided again, of course, that the target company avoids insolvency and can cope with its debt burden.
On a practical level, mergers and acquisitions (M&A) transactions are expensive as well as time- and labor-intensive, so private equity firms would rather purchase several bigger companies than many smaller ones. Private equity “megafunds” with billions of dollars in capital to deploy will likewise have a proclivity for larger deals because they can invest more money into each deal.
It’s for these reasons that the average private equity deal size notched $964 million in 2022—and nearly $1.25 billion in 2021. White-shoe law firm Simpson Thatcher similarly notes that 389 buyouts conducted in 2022 around the world exceeded $1 billion in value.
On the other hand, “small” buyouts—those valued at under $100 million—are rarely performed by traditional private equity firms. Data from Bain & Company suggest that under 35% of buyouts in 2022 were worth less than $100 million. And in a blockbuster year like 2021, deals below the nine-figure threshold were even more scarce, clocking in at about 20% of all buyouts.
Micro Private Equity: Going Small, Really Small
If “the bigger the better” is the guiding principle for traditional private equity firms, perhaps the polar opposite is true for GPs heading micro private equity firms.
This emerging segment of private equity eschews large targets for microscopic “Main Street” businesses that are far too small to pique the interest of traditional private equity firms.
Though average deal sizes and limits will vary from firm to firm, buyout targets eyed by micro private equity firms—which include small businesses like mom-and-pop grocery stores, independently-owned car washes, single-store restaurants, owner-operated automobile repair shops, and local dental clinics—bear little resemblance to the corporate giants sought by traditional private equity firms.
These differences are similarly evident when it comes to valuation. Micro private equity firms seek to acquire targets at one to five times their annual earnings before interest, taxes, depreciation, and amortization (EBITDA), a steal in comparison to what their traditional counterparts typically cough up.
By contrast, global EBITDA multiples in 2022 stood at an average of 9.9x for companies worth between $100 million and $249 million, 11.1x for companies worth between $250 million and $999 million, and 12.9x for companies worth more than $1 billion.
Then again, there are compelling reasons why small businesses trade at lower multiples than large companies. A micro private equity firm buying a roofing contractor producing $500,000 in annual EBITDA is more often than not taking control of a company that lacks brand recognition, pricing power, and the ability to command economies of either scope or scale. In other words, small businesses have narrow competitive moats that leave them vulnerable to external threats.
A company that generates at least $5 million to $10 million in EBITDA—the minimum threshold a target must reach before it is of interest to traditional private equity firms—will trade at a far higher multiple than a small business because its revenue is diversified across hundreds or thousands of customers and it operates successfully at scale. Put another way, large companies usually have wide competitive moats that allow them to withstand outside threats, wield significant pricing power, and generate consistent demand.
How Do Micro Private Equity Firms Generate Returns?
Unlike their traditional counterparts, micro private equity firms cannot earn double-digit annual returns by taking a highly leveraged buy-and-hold approach. Instead, much like the “Main Street” businesses they invest in, micro private equity firms must make money by being scrappy and creative.
The best firms can earn outsized returns by exercising tactics to exploit deal terms and capital structures that are only available to small business buyers.
Asset sales
One prominent approach is to structure a buyout as an asset sale rather than a stock sale. In an asset sale, a micro private equity firm acquires some or all of the assets and liabilities of the target company. This results in better tax treatment for the acquirer because tangible assets can be depreciated and intangible assets can be amortized—in a stock sale, no such deductions are allowed.
Seller financing
Small business buyers can also ask a target company’s sellers to carry a second lien note on part of the business’ purchase price. These seller financing provisions are especially advantageous for micro private equity buyers given that lenders frequently impose low loan-to-value (LTV) caps when extending financing for small business buyouts. Combining third-party financing with seller financing allows a buyer to lever up further and put down less cash at close—factors that could enhance a fund’s levered IRR.
Earnouts
Micro private equity firms can even arrange for part of the negotiated purchase price to be paid as an earnout contingent upon the performance and continued success of the business post-acquisition.
Although earnouts are uncommon in transactions involving large businesses—appearing in just 1% of deals involving a publicly traded company and 21% of all M&A announcements—they are “more prevalent than ever in lower middle market transactions” and presumably even more common in the micro-business M&A space.
Multiple arbitrage
Additionally, micro private equity firms that acquire a target at low multiples can use this to their advantage if the acquired business experiences substantial growth during the firm’s holding period. Although generating enough organic growth by expanding operations to warrant multiple expansions is difficult to achieve in such a compressed schedule, producing inorganic growth via M&A is both possible and common.
For example, a micro private equity firm can acquire several small businesses at low multiples, consolidate them into one larger platform, and sell the combined (and now much larger) business for a higher multiple.
Off-market deals
Finally, micro private equity firms can negotiate more favorable terms with small business sellers by circumventing competition from other buyers. In traditional M&A transactions involving large companies, off-market opportunities are scarce. That’s because sellers will work with investment bankers to run a deal process, which will inevitably attract bids (and therefore competition) from other private equity firms.
As a case in point, the board of directors governing a publicly traded company whose shareholders are contemplating a sale is required to seek out competing bids from other buyers, since the board has a fiduciary duty to maximize the value of the buyout offer.
On the contrary, while conventional advice encourages small business sellers to find business brokers or M&A advisory firms to represent them during a sale, mom-and-pop sellers may be turned off by the high fees charged by sell-side brokers. Without representation, small business sellers may be tempted by unsolicited (read: lowball) offers from micro private equity firms specifically on the hunt for off-market opportunities.
Why Invest in Micro Private Equity?
Local landscapers, regional accounting firms, and hyper-niche software businesses—the targets of interest to micro private equity firms—won’t launch an IPO or make national headlines.
But for their proprietors and investors alike, these mom-and-pop shops hit all the important points—they’re abundant in number, simple to run, highly profitable, and have room to grow.
For instance, an average of 9,224 businesses sold per year between 2017 and 2022 on BizBuySell, the world’s largest small business marketplace. And as the Baby Boomer generation retires in earnest, “Main Street” businesses are expected to transition to new ownership at unprecedented rates. Score.org, an affiliate of the U.S. Small Business Administration, predicts that 5 million small businesses across the country will change hands over the next 10 to 15 years.
These statistics highlight a salient point: There are more small businesses worldwide than there are big ones, which means that micro private equity firms have a much larger universe of potential targets to choose from. Conversely, because micro private equity remains an obscure segment of the industry, funds targeting small businesses face less competition from rival firms than their traditional counterparts.
This reason, coupled with the fact that small business buyers are at liberty to propose creative (and return-enhancing) deal structures, means that micro private equity firms are able to target an internal rate of return (IRR) of 25% or more. Traditional private equity firms, meanwhile, target annual returns ranging between 15% and 20%.
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