UK small-cap GPs look to build on growth amid Covid-19 turmoil

Small-cap investment activity in the UK & Ireland saw an upward trend over the five years prior to the coronavirus crisis. The volume of deals worth less than €50m in the region grew from 85 in 2015 to 132 in 2019, according to Unquote Data. The segment's share of total buyout volume for the region also grew from 45.5% to 57% during the same period.

Claire Madden, CEO of Connection Capital, thinks the coronavirus crisis will further increase the number of opportunities available in the small-cap sector: "Many businesses will need the short-term fix of debt to get through, but many may then require a reset of their equity base to move forward once the immediate crisis has eased.

"This creates an opportunity for investors like PE firms that take a longer-term view in backing usually strong businesses. In addition, all assets have been or will be repriced, which again, will stimulate the market."

The UK & Ireland's small-cap market has also seen a spate of recent fund closes in 2020. To date, YFM has closed its Buyout Fund II on £80m, August Equity Partners V closed on £300m, Active Partners III closed on £100m and Vespa III closed on £150m, among others. The sector is likely to see more investment in the future, with 12 SME-dedicated funds currently raising, according to Unquote Data. Open funds include Harwood Private Equity V, which was registered in July 2019; Dunedin Buyout Fund IV which was registered in July 2018; and Kester Capital II, which held a first close on £50m in June 2019.

Madden says: "Many private equity firms, including Connection Capital, will be concentrating on portfolios in the short term, while those with a small portfolio and a lot of dry powder will see lots of opportunity."

Attractive drivers
Several factors could explain the growth in the small-cap sector prior to the coronavirus crisis. Across Europe, average entry multiples for the segment were consistently lower than their larger counterparts. In 2019, the average entry multiple for assets under €50m was 10x EBITDA, and assets valued at €50-100m had an average entry multiple of 9.3x, according to Clearwater International's Multiples Heatmap. In contrast, the average entry multiple for assets valued at more than €1bn was 12.8x.

As such, small-cap deal volume increased by 55% from 2014 to 2019, while deal value increased by just 40%. Furthermore, the number of targets in the size bracket is far larger than investment opportunities available to mid-market and large-cap firms.

A briefing paper from the House of Commons reported that in 2019, 99% of businesses in the UK had fewer than 50 employees. The number of companies in the UK has also grown by an annual average of 2.9% since 2001, with many naturally being in the small-cap segment.

Says Adam Maidment of Kester Capital: "Because the UK lower-mid-market is such a big universe of deals, you do not see the same competitors on every deal and you get many more truly off-market deals. Everyone's got their own individual, strong adviser relationships and there are so many in the lower-mid-market that no private equity house can effectively cover them all."

Meanwhile, in contrast to the abundant small-cap segment, a shortage of quality assets in the upper-mid-market was driving frothy pricing prior to the Covid-19 outbreak. While prices for these deals are expected to cool off, investors are also now facing a drought of affordable financing options, in addition to vendors being minded to postpone processes where possible to avoid unfavourable multiple arbitrage.

How pricing in the smaller segment will be affected by the coronavirus crisis is not yet clear, though. Madden says: "I think there will be a flurry of post-crisis restructuring deals, but you need to be able to forecast accurately in order to price those deals, which will require normalised trading conditions for that particular business."

Madden also draws a distinction between companies that have financially benefited from the crisis and those that have seen their revenues drop to zero. "Those that have been unaffected or benefited from the crisis will be attractive targets, although I think they will still be caught up in the downward pricing pressure across the market, which had become quite overheated prior to the crisis," she says. "It always takes some time for sellers' price expectations to adjust to the new world order."

Minority rule
Another driver behind the gradual increase in small-cap activity in recent years was investors' willingness to adopt more varied investment strategies – another trait that could pay off in the post-Covid-19 landscape. "Private equity, and in particular the small buyout market, has become more accepting of minority investments, and we are certainly happy to look at those smaller deals, which might open further market opportunities," says Mark Ligertwood from Dunedin. "It may be that the mid-market is slightly less enthusiastic about these opportunities in the minority space and in creative equity solutions."

Investors such as ESO Capital and Rockpool take hybrid strategies, where they can both invest and lend to SMEs. In addition, minority investments are generally more common in smaller transactions, with mid-market firms only recently taking minority stakes on a regular basis, as previously reported by Unquote.

Founded in 2011, BGF offers growth equity to SMEs in exchange for minority stakes. Grant Paul-Florence, an investor at the firm, says: "Established mid-market funds tend to have clearly defined strategies, and to move away from those might be difficult. More recently established small-cap players have emerged to address the market need and may be able to take a fresh look at what they do."

Madden thinks this advantage will stand small-cap investors in good stead in the current situation. "Flexibility in structuring and target returns is key," she says. "For example, we don't run a fund, so we can look at private equity, private debt and hybrid solutions without any restriction, and each opportunity can be assessed and structured accordingly."

With larger firms such as Bridgepoint and Livingbridge now raising SME-dedicated vehicles, the small-cap market could be gearing up for even more activity in the long term, especially considering new market dynamics that have developed amid the coronavirus crisis.

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• Topics
• UK / Ireland
• GPs
• Investments
• Fundraising
• Connection Capital
• BGF (Business Growth Fund)