Small- and mid-market buyout firms with dedicated operational teams are rare. Yet, counterintuitively, those same firms’ funds tend to outperform their larger peers despite their lack of resources. 

According to Fabien Chen, head of benchmarks at Preqin, smaller buyout funds in the US have outperformed their large-cap peers by a good margin in recent years. Over the past year, Preqin’s small index buyouts have had an average return in terms of quarterly NAVs and distributions of 11.6%, while its mega index buyouts have had one of 7.8%. Over the past five years, that gap jumps from 138% versus 105%. And finally, over the past 10 years, that gap jumps from 387% versus 286%.

There are many reasons for this stark difference in performance – first and foremost, exit opportunities are more robust in smaller markets. “Valuations are high and [large cap PE firms] cannot exit. There are very limited exit routes for them,” explained Chen’s colleague Victoria Chernykh, an assistant vice president of research insights at Preqin. “[Lack of exits] is significant in the mid-market and smaller markets, but it's less dramatic.”

PE exits were at a 10-year low in Q3 2023, according to our October 2023 report.

Chernykh added that one of the key differentiators is operational, though – because smaller companies rely less on the multiplier effect for capital to create scale and therefore value, small caps’ operational improvements are more pronounced and more important. 

"When you're a smaller company, things tend to be less efficient. So if you have help and if you scale up and grow and somebody is helping you with that, bringing capital in and expertise, you're going to become more efficient as a large or mid company,” she explained. “Larger companies tend to be very inert.”

This could be why private equity has been embracing smaller deals in recent months. As we previously reported, deal sizes are at all-time lows since the financial crisis while the amount of money raised for the mid market was reportedly half of all fundraising in Q1 2024.

And it’s not like industry players haven’t taken notice: Schroders Capital, for example, notes that large cap deals have grown at a much slower rate than large-cap fundraising over the past decade (a 1.6x rise in deals versus a 14.9x growth in fundraising) while small- to mid-sized deals (between $50 million to $2 billion) are growing more quickly than fundraising for the sector (a 2.7x rise in deals versus a 2.4x growth in fundraising). 

Meanwhile, PineBridge Investments thinks that middle market firms are “nimbler and better positioned to adapt swiftly to market changes, capitalize on niche opportunities, and drive value creation through operational enhancements.”

Given their limited resources to provide portfolio support, many of these smaller firms ask their investment teams to night shift as operating partners. Whether or not operations-driven alpha for smaller buyouts turns into dedicated operations teams becoming the norm, however, remains to be seen.