Can Nurturing the Overlooked Lead to Better Risk-adjusted Returns?
The New Lower Middle-Market
According to Bain & Company, in the decade from 2013 through 2023, total global AUM allocated to private investments grew at a 14% CAGR. Within that broad category, Venture Capital commitments outgrew all other categories with a 23% CAGR. Over that period roughly 55,000 startups received seed funding in the US alone, up from 16,000 in the prior decade (source: Pitchbook). Even if the above AUM growth differential is set to moderate over the next decade, Venture Capital remains a significant engine of early stage business creation, contributing to economic development and innovation globally.
Many lower middle-market businesses emerge from this ecosystem with no IPO or “venture scale” prospects. These overlooked companies may not be headline-grabbing success stories, but they contribute critical new innovations and products, serve customers, and consistently generate billions of dollars in revenue in aggregate. Yet, they are often operationally miscalibrated long after it has become clear that a venture-scale outcome is out of reach.
A Value Creation Approach
A recalibration requires a redirected focus on operational efficiency as the foundation for the resumption of growth. In other words, you need to walk before you run again. From an investment perspective, this requires an altogether different approach than early-stage investing, which focuses almost entirely on pre-transaction origination and underwriting. In a value- or operations-focused approach, investors have higher ownership in the outcome, so their initial goal should be to devise and implement a value creation plan that can deliver on a specific investment thesis.
The drivers of return to such a value strategy can be broadly classified into three main categories: underwriting an effective path to breakeven and gradual margin expansion, generating moderate organic growth, and financial structuring.
🕵🏼 Margin Expansion: A focus on margins may represent a shift in mindset from high burn to focusing on efficiency as the cost of capital has risen. Margin enhancement is likely to rely on optimizing processes and rationalizing the workforce. Investors should question everything, from sales and marketing budgets or feature development to service delivery, in order to understand the most efficient ways to drive growth, customer acquisition costs and unit economics.
📈 Organic Growth: Organic growth may be accomplished by tweaking business models to reduce cyclicality, gaining market share in existing areas through better products, services or customer experiences; expanding into new markets by launching new products, entering new geographies, and targeting new client segments; and/or having a more analytical, data-driven pricing strategy to optimize revenues from each transaction.
🛠 Financial Structuring: Whether through majority recaps, higher liquidation preferences or conditional funding, investors can structure transactions and investor rights to ensure a high level of capital protection and fiduciary oversight. Structuring is a fair tradeoff that re-aligns stakeholders in a business, and recognizes the higher degree of investor involvement in the value creation process.
In short: A value creation approach is crucial to reducing investment risks and improving return profiles. It has been shown to generate superior returns with lower dispersion in private equity, relative to real estate, where financial engineering and leverage dominate, or venture capital, which emphasizes riskier growth.
