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Delivering liquidity: Small and mid-sized co-investment deals shine in the absence of IPOs

October 16, 2024 | 6 min read

Many LPs are feeling an extended liquidity squeeze, trying to fund (re)investments while stuck between infrequent distributions and slowed IPO activity. Despite the IPO market showing some signs of recovery, the backdrop remains lukewarm, and the outlook is uncertain at best. But, finding liquidity and opportunities for value creation in today’s market is far from singularly hinged on the IPO window reopening. In fact, several pockets of the private equity market have shown resilience throughout 2023 and 2024.

Private equity’s small and middle-market segments tend to be less beholden to public markets, creating more optionality with respect to finding liquidity. We believe this is particularly the case for small and middle-market opportunities within direct co-investing strategies, which tend to be more diversified than typical private equity funds and often have several assets primed for exit transactions regardless of the cycle. Understanding the nuances of the small and middle-market co-investment landscape is crucial to uncovering liquidity and optimizing risk-adjusted returns during more challenging business conditions.

Making sense of the IPO debate in 2024

After a two-year lull in the IPO market, unsurprisingly, those with a vested interest in its recovery (e.g., large investment banks) have been shouting the loudest in forecasting a resurgence. Predictably, these commentators also advocate that larger listings (which often come with higher fees for the investment bank) are likely to be the most executable and beneficial for stakeholders in the current environment.1

This argument, however, hinges on two distinct factors: Higher valuations in public markets and lower volatility. The chart below illustrates a clear link between higher IPO counts when price to earnings ratios are elevated and volatility is lower, but few commentators feel there is sufficient data today to decisively support a forecast one way or the other. We would tend to agree that the timing and reopening of the IPO window to historic levels remains uncertain.

Quarterly IPO count by select IPO window metrics (2019-2023)

Source: Pitchbook, data is based on European IPOs and Euro Stoxx 50 Volatility Index as of December 31, 2023. Bubble size is scaled based on IPO count for the quarterly period noted.

Liquidity beyond IPOs: Think small and middle-market

With IPO uncertainty facing ongoing macro and geopolitical risks, and a growing dissatisfaction among LPs given the lack of urgency GPs are placing on liquidity and distributions,2 what other routes besides IPOs are available to GPs to return capital and realize meaningful value for investors? And what private equity strategies are best placed to exploit these other exit pathways?

First, while IPOs are an important exit avenue, they have never been the leading path to providing distributions to LPs. In fact, since the Great Financial Crisis, IPOs have consistently accounted for ~14% of exit activity by average volume and only 15 by average exit count.3 Moreover, acquisitions, including sales to strategic buyers and financial sponsors, have played a significant role in returning cash back to LPs, particularly during 2022 and 2023,4 and these exit opportunities have grown in importance over the last several years given the state of the IPO landscape.

US private equity middle-market exit count by type

No Data Found

Source: PitchBook, US exit count data as of March 31, 2024.

Clearly, several viable alternative paths to liquidity remain active outside of the IPO route, particularly for small and middle-market companies. We believe these smaller companies by their nature tend to be less operationally and financially developed than their larger-cap counterparts, which can inherently create more potential for value creation. Further, value creation can come in a number of forms for small and mid-sized companies including, but not limited to: geographic or product expansion executed organically or through M&A, technology adoption, professionalization of the management team, or adoption of more competitive pricing structures and go-to-market strategies. These companies also have lower total enterprise values which we believe results in smaller acquisition check sizes. In the current environment, this positions small and middle-market businesses as more viable acquisition targets driving up exit activity, and as a result, potential distributions.

As base rates ease and spreads tighten, the middle-market buyout environment stands to be a key beneficiary. Not only can platform acquisitions become viable targets — an important investment strategy in the middle-market space — they can also increase the ability for add-on investments. A large majority of add-ons are sourced in the middle-market segment. Add-on acquisitions account for three out of every four buyouts in the US private equity deal market today, and they drive 54.7% of all deal value in the middle market.5 Portfolios with operating companies exhibiting low leverage, high growth, and steadily improving margins will likely become key targets. This in turn has the potential to drive valuation marks and ultimately distribution activity in middle-market portfolios that have companies with these characteristics.

While the opportunity for value creation in the small and middle-market is potentially significant, this segment of the market typically exhibits a greater dispersion of returns relative to the larger end of the market. That higher dispersion means that the opportunity for alpha generation is greater, but the risk of choosing the wrong manager (or transaction, in the case of co-investing) is larger too. For those choosing to invest in the small and mid-cap market, manager/deal selection and data-driven due diligence is critical.

Understanding the co-investment angle in today’s shifting landscape

As GPs search for new investors to continue their fundraising in a more challenging environment, co-investors are becoming increasingly crucial to unlocking a particularly attractive deal that might otherwise remain out of reach to the GP given their current LPs’ concentration limits or fundraising timelines. From an LP’s perspective, a co-investment approach offers: access to top tier GP deal-flow through a solutions-orientated approach, diversification by multiple metrics (GP, EV, industry, geography, value creation approach etc.), and a lower fee burden compared to many other forms of private markets investing.

Co-investment portfolios, especially those that focus on small and middle-market companies, can provide investors with a level of diversification that offers resilience and the potential for liquidity through various business and market environments. Understanding how the co-invest market intersects the small and middle-market private equity landscape is crucial to unlocking the potential liquidity and performance benefits.

Over the past 10-15 years, the private equity industry has evolved into a highly specialized asset class. The number of specialist firms swelled by over 25% from 22.9% in the decade from 2000-2010 to 30.1% during the period from 2010-2020 — with the count of generalists falling more than 6% over the two-decade period.6 This has led to an ecosystem where many GPs have developed focused teams in a select number of industry segments. While this has created GPs with strong track records in their focus markets, it can also create concentration risk for LPs allocating to only a limited subset of sector-focused GPs. Co-investment funds have established themselves as a place where investors can now access the sector expertise of underlying private equity managers while mitigating risk through a broadly diversified co-investment portfolio.

GP specialization rises over the decade changing the co-invest landscape

No Data Found

Source: PitchBook, data as of December 31, 2020. Data represents US GPs that qualified for all three vintage cohorts. The style classification for each cohort is based on the previous 10-year deal history.

As investors approach the shifting co-investment ecosystem, it is important to understand that in today’s backdrop GPs are increasingly searching for co-investment partners that can offer more than simply writing an equity check to aid in funding transactions. GPs are seeking out friendly co-investor partners providing a solutions-based approach rather than another private equity firm that can potentially disrupt the governance structure of a business and cause a distraction to management teams that are actively executing on a business plan.

While syndicated deals continue to have relevance, in today’s more constrained credit and exit environment, GPs are seeking partners that can also co-underwrite, warehouse, lead and price new rounds of capital, and/or provide bespoke liquidity solutions. A solutions-based approach is increasingly separating the winners from the losers in today’s co-investment allocation process, particularly in the small and middle-market where there is often significantly greater potential for outsized returns.

Key takeaways

With an uncertain outlook for IPO activity going forward, the market backdrop is creating new dynamics outside of the traditional large and mega deals of just a few years ago. A spotlight on the small and middle-market segments, particularly in the context of direct co-investment strategies, is showing notable resilience and potential for value creation. At the same time, structural nuances and a greater number of liquidity levers at the disposal of small and middle-market GPs are providing LPs the potential for more meaningful distributions. Coupling these current dynamics with an evolving co-investment landscape, allocators should remember:

  • Small and mid-sized companies by nature are nimbler with numerous paths for creating value and a range of exit pathways that are more insulated from changing macroeconomic conditions and volatile public markets.
  • In today’s market backdrop, the structural features of small and middle-market companies is offering the potential for greater LP distribution activity.
  • Today’s current co-investment environment is offering allocators access to top-tier GPs with attractive deal economics that they may not have had access to in previous market cycles.
  • In a more difficult fundraising environment where GPs are increasingly searching for bespoke solutions-based approaches to solve a myriad of financing and business needs, a co-investment strategy in the small and middle-market is offering access to potentially meaningful liquidity.

Would you like to discuss Direct co-investments?

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Footnotes
  1. Reuters, Europe sees a two-speed IPO recovery as smaller deals lag, May 10, 2024.
  2. Bain & Company, “Searching for Momentum: Private Equity Midyear Report 2024” and ILPA survey of limited partners poll (n=148).
  3. Pitchbook, 2023 Annual US PE Middle Market Report and Q2 2024 US PE Middle Market Report.
  4. PitchBook, 2023 Annual US PE Middle Market Report.
  5. PitchBook, Q2 US PE Middle Market Report.
  6. PitchBook, data as of December 31, 2020, based on US GP style classification between 2000-2020.
Disclosure

HarbourVest Partners, LLC (“HarbourVest”) is a registered investment adviser under the Investment Advisers Act of 1940. This material is solely for informational purposes; the information should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. In addition, the information contained in this document (i) may not be relied upon by any current or prospective investor and (ii) has not been prepared for marketing purposes. In all cases, interested parties should conduct their own investigation and analysis of the any information set forth herein and consult with their own advisors. HarbourVest has not acted in any investment advisory, brokerage or similar capacity by virtue of supplying this information. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication, are not definitive investment advice, and should not be relied upon as such. This material has been developed internally and/or obtained from sources believed to be reliable; however, HarbourVest does not guarantee the accuracy, adequacy, or completeness of such information. The information is subject to change without notice and HarbourVest has no obligation to update you. There is no assurance that any events or projections will occur, and outcomes may be significantly different than the opinions shown here. This information, including any projections concerning financial market performance, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. The information contained herein must be kept strictly confidential and may not be reproduced or redistributed in any format without the express written approval of HarbourVest.

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Professional Investor Definition

“Professional Investor” under the Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) (the “SFO”) and its subsidiary legislation) means:

(a) any recognised exchange company, recognised clearing house, recognised exchange controller or recognised investor compensation company, or any person authorised to provide automated trading services under section 95(2) of the SFO;

(b) any intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong;

(c) any authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(d) any insurer authorized under the Insurance Ordinance (Cap. 41 of the Laws of Hong Kong), or any other person carrying on insurance business and regulated under the law of any place outside Hong Kong;

(e) any scheme which-

(i) is a collective investment scheme authorised under section 104 of the SFO; or

(ii) is similarly constituted under the law of any place outside Hong Kong and, if it is regulated under the law of such place, is permitted to be operated under the law of such place,

or any person by whom any such scheme is operated;

(f) any registered scheme as defined in section 2(1) of the Mandatory Provident Fund Schemes Ordinance (Cap. 485 of the Laws of Hong Kong), or its constituent fund as defined in section 2 of the Mandatory Provident Fund Schemes (General) Regulation (Cap. 485A of the Laws of Hong Kong), or any person who, in relation to any such registered scheme, is an approved trustee or service provider as defined in section 2(1) of that Ordinance or who is an investment manager of any such registered scheme or constituent fund;

(g) any scheme which-

(i) is a registered scheme as defined in section 2(1) of the Occupational Retirement Schemes Ordinance (Cap. 426 of the Laws of Hong Kong); or

(ii) is an offshore scheme as defined in section 2(1) of that Ordinance and, if it is regulated under the law of the place in which it is domiciled, is permitted to be operated under the law of such place,

or any person who, in relation to any such scheme, is an administrator as defined in section 2(1) of that Ordinance;

(h) any government (other than a municipal government authority), any institution which performs the functions of a central bank, or any multilateral agency;

(i) except for the purposes of Schedule 5 to the SFO, any corporation which is-

(i) a wholly owned subsidiary of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong;

(ii) a holding company which holds all the issued share capital of-

(A) an intermediary, or any other person carrying on the business of the provision of investment services and regulated under the law of any place outside Hong Kong; or

(B) an authorized financial institution, or any bank which is not an authorised financial institution but is regulated under the law of any place outside Hong Kong; or

(iii) any other wholly owned subsidiary of a holding company referred to in subparagraph (ii); or

(j) any person of a class which is prescribed by rules made under section 397 of the SFO for the purposes of this paragraph as within the meaning of this definition for the purposes of the provisions of the SFO, or to the extent that it is prescribed by rules so made as within the meaning of this definition for the purposes of any provision of the SFO.

The first of such classes of additional “professional investor”, under the Securities and Futures (Professional Investor) Rules (Cap. 571D of the Laws of Hong Kong), are:

(k) any trust corporation (registered under Part VIII of the Trustee Ordinance (Cap. 29 of the Laws of Hong Kong) or the equivalent overseas) having been entrusted under the trust or trusts of which it acts as a trustee with total assets of not less than HK$40 million or its equivalent in any foreign currency at the relevant date (see below) or-

(i) as stated in the most recent audited financial statement prepared-

(A) in respect of the trust corporation; and

(B) within 16 months before the relevant date;

(ii) as ascertained by referring to one or more audited financial statements, each being the most recent audited financial statement, prepared-

(A) in respect of the trust or any of the trust; and

(B) within 16 months before the relevant date; or

(iii) as ascertained by referring to one or more custodian (see below) statements issued to the trust corporation-

(A) in respect of the trust or any of the trusts; and

(B) within 12 months before the relevant date;

(l) any individual, either alone or with any of his associates (the spouse or any child) on a joint account, having a portfolio (see below) of not less than HK$8 million or its equivalent in any foreign currency at the relevant date or-

(i) as stated in a certificate issued by an auditor or a certified public accountant of the individual within 12 months before the relevant date; or

(ii)  as ascertained by referring to one or more custodian statements issued to the individual (either alone or with the associate) within 12 months before the relevant date;

(m) any corporation or partnership having-

(i) a portfolio of not less than HK$8 million or its equivalent in any foreign currency; or

(ii) total assets of not less than HK$40 million or its equivalent in any foreign currency, at the relevant date, or as ascertained by referring to-

(iii) the most recent audited financial statement prepared-

(A) in respect of the corporation or partnership (as the case may be); and

(B) within 16 months before the relevant date; or

(iv) one or more custodian statements issued to the corporation or partnership (as the case may be) within 12 months before the relevant date; and

(n) any corporation the sole business of which is to hold investments and which at the relevant date is wholly owned by any one or more of the following persons-

(i) a trust corporation that falls within the description in paragraph (k);

(ii) an individual who, either alone or with any of his or her associates on a joint account, falls within the description in paragraph (k);

(iii) a corporation that falls within the description in paragraph (m);

(iv) a partnership that falls within the description in paragraph (m).

For the purposes of paragraphs (k) to (n) above:

  • “relevant date” means the date on which the advertisement, invitation or document (made in respect of securities or structured products or interests in any collective investment scheme, which is intended to be disposed of only to professional investors), is issued, or possessed for the purposes of issue;
  • “custodian” means (i) a corporation whose principal business is to act as a securities custodian, or (ii) an authorised financial institution under the Banking Ordinance (Cap. 155 of the Laws of Hong Kong); an overseas bank; a corporation licensed under the SFO; or an overseas financial intermediary, whose business includes acting as a custodian; and
  • “portfolio” means a portfolio comprising any of the following (i) securities; (ii) certificates of deposit issued by an authorised financial institution under the Banking Ordinance (Cap, 155 of the Laws of Hong Kong) or an overseas bank; and (iii) except for trust corporations, cash held by a custodian.

Institutional Investor / Accredited Investor Definition

An institutional investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(a) the Singapore Government;

(b) a statutory board as may be prescribed by regulations made under section 341 of the SFA, as prescribed in the Second Schedule of the Securities and Futures (Classes of Investors) Regulations 2018;

(c) an entity that is wholly and beneficially owned, whether directly or indirectly, by a central government of a country and whose principal activity is —

(i) to manage its own funds;

(ii) to manage the funds of the central government of that country (which may include the reserves of that central government and any pension or provident fund of that country); or

(iii) to manage the funds (which may include the reserves of that central government and any pension or provident fund of that country) of another entity that is wholly and beneficially owned, whether directly or indirectly, by the central government of that country;

(d) any entity —

(i) that is wholly and beneficially owned, whether directly or indirectly, by the central government of a country; and

(ii) whose funds are managed by an entity mentioned in sub‑paragraph (c);

(e) a bank that is licensed under the Banking Act 1970;

(f) a merchant bank that is licensed under the Banking Act 1970;

(g) a finance company that is licensed under the Finance Companies Act 1967;

(h) a company or co‑operative society that is licensed under the Insurance Act 1966 to carry on insurance business in Singapore;

(i) a company licensed under the Trust Companies Act 2005;

(j) a holder of a capital markets services licence;

(k) an approved exchange;

(l) a recognised market operator;

(m) an approved clearing house;

(n) a recognised clearing house;

(o) a licensed trade repository;

(p) a licensed foreign trade repository;

(q) an approved holding company;

(r) a Depository as defined in section 81SF of the SFA;

(s) a pension fund, or collective investment scheme, whether constituted in Singapore or elsewhere;

(t) a person (other than an individual) who carries on the business of dealing in bonds with accredited investors or expert investors;

(u) a designated market‑maker as defined in paragraph 1 of the Second Schedule to the Securities and Futures (Licensing and Conduct of Business) Regulations;

(v) a headquarters company or Finance and Treasury Centre which carries on a class of business involving fund management, where such business has been approved as a qualifying service in relation to that headquarters company or Finance and Treasury Centre under section 43D(2)(a) or 43E(2)(a) of the Income Tax Act 1947;

(w) a person who undertakes fund management activity (whether in Singapore or elsewhere) on behalf of not more than 30 qualified investors;

(x) a Service Company (as defined in regulation 2 of the Insurance (Lloyd’s Asia Scheme) Regulations) which carries on business as an agent of a member of Lloyd’s;

(y) a corporation the entire share capital of which is owned by an institutional investor or by persons all of whom are institutional investors;

(z) a partnership (other than a limited liability partnership within the meaning of the Limited Liability Partnerships Act 2005) in which each partner is an institutional investor.

An accredited investor as defined in Section 4A of the SFA and Securities and Futures (Classes of Investors) Regulations 2018 is:

(i)  an individual —

(A) whose net personal assets exceed in value $2 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(B) whose financial assets (net of any related liabilities) exceed in value $1 million (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount, where “financial asset” means —

(BA) a deposit as defined in section 4B of the Banking Act 1970;

(BB) an investment product as defined in section 2(1) of the Financial Advisers Act 2001; or

(BC) any other asset as may be prescribed by regulations made under section 341; or

(C) whose income in the preceding 12 months is not less than $300,000 (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe in place of the first amount;

(ii)  a corporation with net assets exceeding $10 million in value (or its equivalent in a foreign currency) or such other amount as the Authority may prescribe, in place of the first amount, as determined by —

(A) the most recent audited balance sheet of the corporation; or

(B) where the corporation is not required to prepare audited accounts regularly, a balance sheet of the corporation certified by the corporation as giving a true and fair view of the state of affairs of the corporation as of the date of the balance sheet, which date must be within the preceding 12 months;

(iii) A trustee of a trust which all the beneficiaries are accredited investors; or

(iv) A trustee of a trust which the subject matter exceeds S$10 million; or

(v) An entity (other than a corporation) with net assets exceeding S$10 million (or its equivalent in a foreign currency) in value. “Entity” includes an unincorporated association, a partnership and the government of any state, but does not include a trust; or

(vi) A partnership (other than a limited liability partnership) in which every partner is an accredited investor; or

(vii) A corporation which the entire share capital is owned by one or more persons, all of whom are accredited investors.

Continuation solutions encompass a host of transaction types in which a GP secures interim liquidity and/or additional primary capital for their LPs in a strongly performing asset, or set of assets, that the GP will continue to own and control. Specifically, they include continuation funds, new funds created by GPs for the purpose of acquiring the asset(s) that continue to be managed by the same GP and capitalized by one or several secondary buyers, or equity recapitalizations involving a direct equity or structured equity investment into a portfolio company. These transactions can also include a parallel investment from the GP’s latest fund into that same pool of assets (a “cross-fund trade”).