When Kevin Kester was running a US$4 billion private equity and real estate portfolio for the big Colorado Public Employees Retirement Fund a few years ago, he became aware of how difficult it was to invest in smaller companies. This was a bit frustrating because he was also aware that the small end of the private equity market seemed to be less efficient than the large end, and exhibited different characteristics. For instance, unlike the public markets, smaller private companies tend to trade at lower price:earnings ratios than their larger counterparts. This allows potential purchasers the ability to buy cashflows for less money. With less money at stake, there is also less pressure to leverage the businesses in order to get target returns of 20 per cent or more.
The problem for Kester and the US$30 billion Colorado fund was that he was investing tranches of US$200-odd million into the bigger funds and the managers who worked the smaller end of the market would have entire funds of less than this – typically US$150- 200 million. So, he set up his own program which attracted the attention of one of the biggest private equity managers in the US, Siguler Guff. Principles George Siguler and Drew Guff recruited Kester from the Colorado fund in 2004 and helped him create a similar small-cap private equity fund for the general institutional investment community.
From a fund-of-funds manager perspective, Kester says, underlying PE managers operating at the small end tend not to generate the same excess profits on management and transaction fees as they do at the large end. The primary share of wealth for the small-cap managers is their carried interest in the investments and their own direct investments. From the manager’s own business perspective, the small end of the market also presents different challenges. For instance – and this gets back to Kester’s original problem at Colorado – the average manager handles about 10 investments in any single fund, no matter how big. So, at the small end, the manager may do 10 deals at $10-15 million each. Raising a total of $100-150 million for a fund would usually require bypassing the institutional market, at least in the US, and going straight to family offices and high-net-worth individuals.
That market is much more difficult to access than the pension fund market. An interesting aspect of the market is that a lot of private equity managers, if not all, have tended to begin their careers at the small end. Many firms which launched in the 1980s, either in the US or Australia, necessarily did very small deals to cut their teeth. At the time, mega-buyouts were unheard of. Those firms have grown in time and, because of the economics of the industry, have moved way up the food chain in terms of deal size. But according to George Siguler, an old hand in the US market, some of those managers get sick of the bureaucracies that their old firms become and hanker for the days when they were able to do deal themselves. It is these types of managers which Siguler Guff seeks out, as well as those willing to specialise in the less-glamorous small end of the market.