Greg_bright09When 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.

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