Trends Watch: Lower Middle Market Private Equity

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Michael Trihy, Director/Portfolio Manager, Bow River Capital.

What is your outlook for lower middle market investing?

Long term we are quite positive on the lower middle market private equity investing landscape. We believe that the lower middle market segment of PE has the best outperformance potential – these are smaller, less sophisticated companies with a higher number of value creation levers that you can pull when compared to large cap businesses. There is also a lot more flexibility on exit options for small and mid-sized companies; a PE firm can sell to a broad set of strategic buyers as well as the ever-growing ecosystem of larger financial buyers. Large cap private equity has a much more limited set of exit options for a company, typically only a small number of large strategic buyers or an IPO. Performance in lower middle market private equity funds typically demonstrates a high level of dispersion so it’s crucial to be able to pick best-in-class managers with sector-specific expertise and the experience necessary to navigate a challenging macroeconomic backdrop.

Where do you see the greatest opportunities and why?

We think the most attractive managers to target for fund and co-investment opportunities are true specialists with deep expertise in narrow subsectors of the market that are less heavily competed (and hence tend to have more attractive entry pricing). From a transaction-type perspective, we also think that private equity and private credit secondary investments will continue to present attractive risk-adjusted returns due to the “denominator effect” impacting large pension funds and other institutional allocators. These large pools of capital are almost all over-allocated to private markets following the selloff in stocks and bands over the last 18+ months, and the result has been sustained selling of private limited partner (LP) interests and improved pricing across the entire secondary market.

What are the greatest challenges you face and why?

The most difficult aspect of investing today is the unpredictability of the forward-looking economic environment. Bond markets are pricing in an imminent recession in forward curves while central banks continue to message higher rates and stubborn inflationary pressures. There is a steady stream of private equity transactions getting done despite these issues, but the challenge is selecting from this broad pipeline those select companies that are likely to prove resilient in a recessionary environment while also having the ability to protect margins and maintain growth in the event inflation remains high and growth does not slow as projected. This is a delicate balancing act and results in a very high decline rate on new transactions.

What keeps you up at night?

My biggest concern is that growth slows but inflation remains stubbornly high. This could manifest in prolonged stagflation, or a scenario where a mild recession triggers a central bank overreaction and a spike of even higher inflation than we’ve seen in this cycle so far. Either of these would prove difficult for private equity, with margin pressure on the top and bottom line combined with higher debt costs across most businesses. This is not my base case, but I do think it is a risk that the market is underpricing.

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.