Q&A: do not give up on the lower-mid-market, says Monument's Karl Adam

Greg Gille: A few years ago, small-cap and lower-mid-market funds were tipped as the most promising pocket of opportunity for LPs, given their attractive returns. But it would seem that in the very bifurcated market of the past couple of years, mega-buyout funds and big-name brands have been the clear magnet for capital. What is your take on this?

Karl Adam: The largest PE funds have indeed become even bigger over the past decade, consuming a greater share of overall capital raised. According to Preqin's 2020 Private Equity and Venture Capital report, the 20 largest funds accounted for approximately 40% of the total capital raised across the asset class in 2018 and 2019, representing a marked jump over the previous four years, when the 20 largest funds in each year accounted for less than a third of the total annual fundraising (which is still quite significant). And in many cases, the very largest managers are raising multi-billion-dollar funds rapidly.

They have also been successful in their efforts to add non-flagship funds. Data from Cobalt shows that among the top 10 GPs, more than 50% of their total fundraising is now being channeled to vehicles and strategies other than their flagship funds. Effectively, one GP can serve the needs of an investor across various asset classes, a trend that appears to be unchanged following the Covid-19 disruption, and may even be accentuated.

This fundraising success among the best-known GPs often comes at the expense of lower-mid-market firms, particularly those without strong brands.

GG: Does that call into question the intrinsic attractiveness of smaller funds?

KA: No, I would say that the lower-mid-market remains a fundamentally attractive environment for PE funds. For instance, the BVCA's latest PE & VC Performance Measurement Survey shows that "small PE" has outperformed all other sub-categories, including "large PE", over a 10-year time horizon. So from a performance perspective, the smaller end of the market should remain firmly on the radar for investors.

If you think of the current environment – with fierce competition for deals and high valuations in most sectors – the intrinsic qualities of funds in this bracket stand out even more. The lower-mid-market offers greater opportunity for a PE firm to acquire companies outside of a competitive process, which should result in more favorable entry valuations. And once invested, the GP's ability to make fundamental operational changes and dramatically grow EBITDA is often higher than in multi-billion-dollar companies.

Furthermore, the executives of the PE firm itself are primarily focused on generating outsized returns. Managers of large asset management firms often earn huge and stable management-fee incomes, so firms where carry is a bigger proportion of managers' overall compensation better align with the interests of investors.

GG: Are there any common strategies that stand out for lower-mid-market funds that have recently raised successfully?

KA: Technology- and healthcare-focused funds have been very much in vogue, including in the lower-mid-market. We are seeing an increasing number of sector-focused funds in Europe; they have been well established in the US for a long time. In theory, turnaround/distress should also be of interest in that segment, but equity markets recovered strongly in 2020, so many LPs feel they have missed the boat, unless they committed to this strategy already.

GPs that genuinely have off-market sourcing strategies (for example a focus on complex situations and/or companies not easily accessed via auctions) are popular with LPs, given the ongoing high-valuation environment.

The opportunity for investors to be a meaningful investor, perhaps with an advisory board seat, will appeal to a large segment of the institutional investor universe" – Karl Adam, Monument Group

GG: With that in mind, how would you advise lower-mid-market managers to position themselves in order to maximise their chance of success on the trail?

KA: Even in the current crowded fundraising environment, these managers can certainly be successful in fundraising. One of our main pieces of advice would be for them to emphasise the benefits that a relatively small fund can provide investors. The opportunity for investors to be a meaningful investor, perhaps with an advisory board seat, will appeal to a large segment of the institutional investor universe. Better access to co-investment opportunities, regular and direct dialogue with the most senior people at the GP, and other factors related to access can all be strong differentiators in the current market.

Another key is to focus the messages on the differentiation and high alignment that funds in that bracket can offer. Some features that may appeal to investors are a large GP commitment to the fund, as well as the absence of any distractions stemming from other complementary funds or conflicts of interest that other business lines may pose. Investors are also drawn to a constant focus over multiple fund series on a manager's "sweet spot" market opportunity.

GG: Beyond these strategic messaging recommendations, do you have any other practical tips on how lower-mid-market managers can best navigate a process?

KA: First of all, they should not ignore communications with investors until they commence pre-marketing. Investors take time to build relationships, so it makes sense to increase the number of high-quality touch points ahead of a fundraising. These can include update calls to keep investors apprised of developments, webinars, or invites to prospective investors to an upcoming AGM.

And I know this won't be surprising coming from a placement agent, but I truly feel GPs should not underestimate the value of an experienced guide. Proven placement agents with an extensive track record and network can create bespoke investor target lists, help fine-tune marketing materials, and add heft and bandwidth to distribution efforts. GPs should consider engaging these early in the fundraising process – typically, the earlier they start, the better the outcome.

GG: Looking ahead, what is your take on the fundraising environment over the coming months, and do you feel there are trends that could specifically benefit lower-mid-market funds?

KA: While 2021 is still young, many anticipate it could be a bumper year for fundraising. Pitchbook, for instance, predicts PE fund managers will raise more capital in 2021 than in any year in the history of the asset class, fueled by a "reverse denominator" effect attributable to the growth in public equities as well as pent-up demand for new commitments from investors. Its latest PE and VC report also documented a 100 basis point increase in the proportion of capital raised by funds outside of the top 50 in 2020, signaling demand from investors to broaden their relationships and access to smaller funds.

The conditions are there for lower-mid-market fund managers to break through; for most, it's just a matter of being able to find the right path to resonate with investors hungry for new relationships.

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