Insight Article Desktop Banner
 
 
Insight Article
  •  
February 01, 2024

The Founder Advantage: Finding Alpha in Middle-Market Private Equity

Insight Video Mobile Banner
 
February 01, 2024

The Founder Advantage: Finding Alpha in Middle-Market Private Equity


Insight Article

The Founder Advantage: Finding Alpha in Middle-Market Private Equity

Share Icon

February 01, 2024

 
KEY TAKEAWAYS
1

Mid-sized private equity investments have generated outsized relative revenue and EBITDA growth.

2

Sponsors need a unique strategy and approach to succeed in the dynamic middle-market landscape.

3

Focusing on founder-owned or founder-involved companies can be a source of repeatable alpha.

4

Founder deals often have a unique and diversified set of value creation opportunities.

5

Succeeding with founder investments requires the right culture, approach and incentives.

 
 

The middle market: Where outsized value creation has flourished1

In the past two decades, private equity (PE) has grown from a relatively niche asset class to one that has become increasingly competitive, with a plethora of new offerings. Dedicated strategies are now offered for large-cap, mid-sized, and small-cap companies—and everything in between, with more PE managers emerging every year.

In this increasingly crowded asset class, we believe that the middle market can be a differentiated source of alpha—especially for companies with founder involvement. But we believe that generating alpha in the middle market requires a manager with specialized capabilities, a rigorous due diligence approach, and a proven playbook for creating value in the sector. Such expertise becomes even more crucial when partnering with entrepreneurs and business founders. In this paper, we outline why we see significant potential in this approach to the middle market, and begin with a review of the middle market’s competitive track record thus far.

While PE as an asset class has consistently generated strong asset-level returns, the middle market has emerged as a particularly attractive place to invest, given the immense supply of privately owned targets and the greater potential for outsized value creation. At the end of 2022, there were approximately 660,000 firms in the U.S. with 20-1,000 employees, representing a fertile hunting ground for sponsors focused on the middle market (Display 1).

 
 
DISPLAY 1
 
Small and mid-sized private companies are a rich target landscape for PE
 

Source: U.S. Census Statistics of Small Businesses (2020 SUSB Annual Data Tables by Establishment Industry (census.gov))

 
 

At the same time, Morgan Stanley’s proprietary data on market-level PE returns indicates that sponsors may drive significantly greater relative revenue and EBITDA growth in U.S. middle-market investments, compared with large-cap deals (Display 2).

 
 
DISPLAY 2
 
Middle-market PE investments have driven greater revenue and EBITDA growth than large cap
 

Source: MSIM database of transaction level information, including only U.S. deals and excluding Morgan Stanley transactions. Represents a sample of portfolio companies that report on EV, Revenue, EBITDA, Net Debt, Public/Private Company, with data as of June 30, 2023; MSIM analysis as of September 2023. Given the sample universe and size, there is potential for selection bias. Middle market is defined as a transaction value (TEV) of $500M or less. Sample includes 166 total transactions—37 large cap and 129 middle market. Analysis excludes outliers.

 
 

Why middle-market PE has outperformed

What explains the competitive track record of PE investments in small to mid-sized companies? We have identified several structural features that we believe enhance the potential for sustained alpha generation.

First, by definition, middle-market investments usually have a small market share, creating significant headroom for organic growth through new customers, new products, new markets, or a combination of all three. In contrast, mature market leaders typically have limited potential for future growth.

Second, middle-market companies often have significant opportunities to expand margins by scaling up to reduce vendor costs and driving corporate efficiency as the business grows.

Finally, middle-market companies often operate in fragmented industries, and are of a sufficiently small scale that add-on acquisitions can drive meaningful equity value creation. In contrast, M&A in more consolidated, mature markets often does not move the needle as meaningfully.

In our view, these advantages have attracted growing interest among investors. Since 2010, the annual capital raised for middle-market investing has increased from $34 billion to $179 billion, and the share of total PE exits made up by middle-market transactions has increased from 82% to 90% (Display 3).

 
 
DISPLAY 3
 
Since 2010, middle-market capital raised has increased from $34 billion to $179 billion.
 

Note: Middle market exits calculated based on share of exits with TEV < $500M

Source: Pitchbook Q2 2023 Annual U.S. Private Equity Report

 
 

With so much attention and capital flowing into the middle market, the average PE auction process has become more competitive and the margin of error has compressed.

The appeal of founder-involved deals

As a result, we believe that sponsors are under increasing pressure to identify and specialize in sub-segments of the market where the equity value creation opportunity is greatest. Sponsors will need an additional edge that can help drive top-quartile performance. We believe that edge can be found by partnering directly with company founders, whose companies can be a source of sustainable alpha in the middle market. This is illustrated in Display 4, which shows how over a broad market sample of 129 U.S. middle-market PE exits between 2007 and 2023, founder-involved investments drove significantly greater relative revenue and EBITDA growth compared to non-founder investments.

 
 
DISPLAY 4
 
Middle market deals with founders involved have outperformed those without founders.
 

Source: MSIM database of transaction level information, including only U.S. deals and excluding Morgan Stanley transactions. Represents a sample of portfolio companies that report on EV, Revenue, EBITDA, Net Debt, Public/Private Company, with data as of June 30, 2023; MSIM analysis as of September 2023. Given the sample universe and size, there is potential for selection bias. Middle Market is defined as a transaction value (TEV) of $500M or less. Founder involvement defined based on MS asset-level research at the time of transaction. Sample includes 129 middle market transactions—62 with founder involvement and 67 with no or unknown founder involvement. Analysis excludes outliers.

 
 

We see a number of benefits to founder-involved investments that are more pronounced than in a standard middle-market PE investment.

Partnering with founders often goes hand-in-hand with providing the first institutional capital to a family-owned business. Thus, important groundwork begins pre-investment—founder recapitalizations often entail bilateral negotiations or limited sale processes. This means competition for each asset can be lower, and sponsors often have more time to assess the business and develop strong relationships with management.

After closing, founder-involved transactions present greater opportunities to execute quick wins and professionalize the business, in our view. Unlike companies that have been owned by institutional investors for multiple chapters, founder-owned businesses often have a greater opportunity to grow revenue, expand margins, and build teams in the early days of an investment.

Finally, we believe that founders usually feel a very strong sense of loyalty to their companies and are typically highly motivated to solidify their legacy and reputation. Founder enthusiasm and support are assets that can help drive growth in many ways, both tangible and intangible. These include building strong customer relationships, identifying and nurturing add-on acquisition targets, and serving as an ambassador for future investors.

A specialized approach and toolkit

To fully unlock the alpha embedded in many founder-owned businesses, we believe that sponsors need a specialized skill set relative to a standard PE transaction and a collaborative working style—one that can maximize results and mitigate risks.

To start, we believe that sponsors must be prepared to deliver comprehensive support. Because many founder-involved transactions are not marketed broadly by sophisticated intermediaries, sponsors may need to manage the full end-to-end diligence process internally and work with a flexible timeline that many founders require.

In the early days of a new founder-involved investment, sponsors may need to dedicate real time and effort to developing genuine relationships with management. Such relationships, in our view, are crucial to help drive the significant change that frequently comes with a PE investment, given the outsized influence founders often have on the operations and culture of their business. To facilitate this cooperation, we believe that incentives need to be aligned to keep the founder fully engaged. A good incentive model balances the founders’ requirements for near-term liquidity while maintaining sufficient financial “skin in the game” for them to stay engaged for the next chapter of the investment.

As the investment moves into the value creation planning and execution stage, it is critical for the sponsor to appraise—and complement—the founder’s management strengths. For example, the archetypal founder-owned business has a strong product, value proposition and customer relationships.

But often, the founder has not sought out external perspectives and best practices from their industry or others. At this crucial stage, we believe that effective sponsors will have an established toolkit to provide tangible support. Whether through strategies and tactics that can drive organic growth, price optimization, cost reduction, system/process centralization or team building, we believe that this is where the sponsor/founder partnership can take the business to the next level—both in financial performance and ultimately equity value creation.

The role of founder-owned PE investments going forward

We believe middle-market PE will continue to be a dynamic investment landscape as sponsor competition and new fundraising remain robust, transaction volumes continue to normalize after the 2022-2023 disruption, and the macroeconomic environment continues to have pockets of uncertainty and volatility. In our view, to generate sustainable alpha, PE sponsors need a differentiated strategy and hands-on operational toolkit.

We believe that founder-owned and involved businesses create an opportunity for sponsors to drive sustainable outperformance. The supply of founder-owned companies that will be potential PE acquisition targets is expected to keep growing, as the U.S. Baby Boom generation continues to move into retirement age. By 2030, 73 million Americans are projected to be 65 years of age or older, and many of these founders and family owners will be looking for a business transition and a personal liquidity event (Display 5).

 
 
DISPLAY 5
 
A wave of founder and family exits is expected as Baby Boomers retire.
 

Figures shown in bar chart represent number of people in millions.

Source: “Demographic Turning Points for the United States: Population Projections for 2020 to 2060,” U.S. Census.

 
 

We believe that founder-owned assets create differentiated opportunities for value creation and serve as an effective complement to standard middle-market transactions within a PE portfolio. In our view, they offer distinct benefits that come from partnering and aligning with owners to drive the next chapter of their business. We believe that succeeding with founder-owned companies requires a specialized strategy and approach that focus on building genuine relationships, aligning incentives, and deploying a tested operational toolkit to drive on-the-ground business building and value creation.

 
 

1 IMPORTANT: This material is a general communication, which is not intended to be impartial, and reflects the beliefs of Morgan Stanley about certain market factors for which others may have different views. All information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. See other important disclaimers at the end of this material.

 
aaron.sack
Head of Capital Partners
Morgan Stanley Capital Partners
 
patrick.whitehead
Executive Director
Morgan Stanley Capital Partners
 
 
 
 

IMPORTANT INFORMATION

The views and opinions and/or analysis expressed are those of the authors as of the date of preparation of this material and are subject to change at any time without notice due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment personnel at Morgan Stanley Investment Management (MSIM) and its subsidiaries and affiliates (collectively “the Firm”), and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific strategy or product the Firm offers. Future results may differ significantly depending on factors such as changes in securities or financial markets or general economic conditions.

This material has been prepared on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information and the Firm has not sought to independently verify information taken from public and third-party sources.

Alternative investments are speculative and include a high degree of risk. Investors could lose all or a substantial amount of their investment. Alternative investments are suitable only for long-term investors willing to forego liquidity and put capital at risk for an indefinite period of time. Alternative investments are typically highly illiquid – there is no secondary market for private funds, and there may be restrictions on redemptions or assigning or otherwise transferring investments into private funds. Alternative investment funds often engage in leverage and other speculative practices that may increase volatility and risk of loss. Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

The whole or any part of this material may not be directly or indirectly reproduced, copied, modified, used to create a derivative work, performed, displayed, published, posted, licensed, framed, distributed or transmitted or any of its contents disclosed to third parties without the Firm’s express written consent. This material may not be linked to unless such hyperlink is for personal and non-commercial use. All information contained herein is proprietary and is protected under copyright and other applicable law.

DISTRIBUTION

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

EMEA: This communication was issued and approved in the United Kingdom by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authority’s rules).

Financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. Morgan Stanley Investment Management shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary. If such a person considers an investment she/he should always ensure that she/he has satisfied herself/himself that she/he has been properly advised by that financial intermediary about the suitability of an investment.

This material is for Professional Clients/Accredited Investors only.

In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at 24-26 City Quay, Dublin 2, DO2 NY19, Ireland.

Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.

Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority. Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 11096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain.

MIDDLE EAST

Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). In addition, real estate investments are subject to a variety of risks, including those related to, among other things, the economic climate, both nationally and locally, the financial condition of tenants and environmental regulations. Saudi Arabia. This document is not and does not purport to be any of the following: (a) a marketing communication, (b) a securities advertisement, (c) a financial promotion. Material contained herein has not been based on a consideration of any individual client circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, recipients or viewers of this document should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision. This document may not be distributed in the Kingdom of Saudi Arabia except to such persons as are permitted under the Rules of Offering Securities and Continuing Obligations and the Securities Business Regulations issued by the Capital Market Authority. The disclosure of this presentation is restricted to sophisticated investors.

The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. Prospective purchasers should conduct their own due diligence on the accuracy of the information in this presentation. If you do not understand the contents of this document you should consult an authorized financial adviser. Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore. Australia: This material is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act. Calvert Research and Management, ARBN 635 157 434 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Calvert Research and Management is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia. Japan: This material may not be circulated or distributed, whether directly or indirectly, to persons in Japan other than to (i) a professional investor as defined in Article 2 of the Financial Instruments and Exchange Act (“FIEA”) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other allocable provision of the FIEA. This material is disseminated in Japan by Morgan Stanley Investment Management (Japan) Co., Ltd., Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association. 

 

This is a Marketing Communication.

Check the background of our firm and registered representatives on FINRA's BrokerCheck

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Subscriptions    •    Privacy & Cookies    •    Your Privacy Choices Your Privacy Choices Icon    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.