Should I invest in middle-market private equity?

For over a year now, the industry has been abuzz about the increased allocation to private equity by ultra-high net worth (UHNW) families. This is unsurprising, given that they have the ability to be patient investors. Additionally, domestic market equity returns continue to be uninspiring, while hedge funds suffer through a prolonged period of underperformance, versus low-cost ETFs and other alternatives. Given this context of low interest rates, fully valued equity markets and disappointing hedge fund returns, there is little wonder as to the increased appetite for private equity.

Historically, private equity has out-performed comparable public markets; Cambridge Associates’ pooled net IRR data (as of December 31, 2015) for the trailing one-, three-, five- and ten-year periods for U.S. large and mega-buyout funds showed returns of 10.5, 16.8, 15.1 and 11.4 percent, respectively. Large and mega buyout funds are those larger than $1 billion and $5 billion, respectively. By contrast, the S&P 500 (including dividend reinvestment) produced 1.4, 15.1, 12.5 and 7.3 percent annualized returns over the same time frame. Data intelligence firm Preqin also noted that private equity now manages $2.4 trillion in assets, with 689 funds closed in 2015, raising $288 billion.

Increasingly, UHNW families have been seeking direct investments in privately held companies. And while some have the operational history and in-house expertise to source direct private-equity investments, this is not the case for most multifamily offices (MFOs) and registered investment advisors (RIAs).

Building a full portfolio of direct investments, however, requires substantial due diligence and operational expertise.

So, this scenario presents an interesting opportunity for investors in middle-market private equity, defined as those funds targeting transactions with enterprise values between $25 million and $1 billion.

Pitchbook’s Q1 2016 U.S. Middle Market Report showed that in 2015 there were 2,023 private-equity middle-market deals, with an aggregate value of $374 billion.

And in a May 2016 BloombergGadfly column, “Private Equity is Seeing Diminishing Returns,” Nir Kaissar postulated that, given the increasing size of private equity, industry returns could be expected to decline.

Data sources CohnReznick, Preqin and Pitchbook have all noted that deals have gotten more competitive and valuations have increased. The potential for high returns on capital brings more investors and dollars, which tends to compress returns. Despite this backdrop, the longer-term outlook for middle-market private equity seems positive.

Even if returns are subject to compression, U.S. middle-market buyout (inclusive of small-market buyout) returned 9.9, 14.0, 13.5 and 12.7 percent over the previously mentioned period, providing excess returns over public markets.

Additionally, as reported in CohnReznick’s Momentum 2016 Middle Market Private Equity Outlook, “Far beyond financial engineering and balance sheet optimization, it is increasingly imperative for middle market PE firms to explore and implement digital strategies that can dramatically improve business.”

Patient investors may be rewarded over time by allocating to a diversified portfolio of middle-market PE funds.

Indeed, digital marketing platforms like Facebook, Twitter, LinkedIn and search-engine optimization often require upgrading. It goes beyond this, though: Private equity firms can add substantial value through numerous operational improvements, including CRM software implementation and upgrades, customer-success functions, transportation and logistics, strategic partnerships and long-term vision creation for smaller and middle-market companies.

Given the available alternatives, patient investors may be rewarded over time if they allocate to a diversified portfolio of middle-market private equity funds.

With smaller fund sizes and higher returns, direct manager access is challenging and beyond the reach of most RIAs. We believe, therefore, that an investor allocation to a top-tier middle-market secondaries manager complements a portfolio and rounds out existing private equity allocations.

Geller Family Office Services is an SEC registered investment advisor. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by GFOS), or any non-investment related services, will be profitable, equal any historical performance level(s), or prove successful. GFOS is not a law firm, and no portion of its services should be construed as legal advice. A copy of our written disclosure statement discussing our advisory services and fees is available on request. The scope of the services to be provided depends upon the terms of the engagement.

This article was originally published in the August/September 2016 issue of Worth.