Micro PE will be big

Micro private equity (PE) will be bigger than people realise – and here is why:

1. The equity markets have headwinds of rising interest rates: global interest rates haven been on a secular downward trend since the early 1990s. Since then an easy investment has been equity market investing especially in index funds. But interest rates can’t go lower (other than negative!) and are more likely to increase. So in the future the equity markets are unlikely to benefit from the wind in its sails of falling interest rates.
2. Real estate ownership is out of reach for many people: the large rises in median house prices in recent years on Australia’s east coast means that home ownership is out of reach for many people – even professional people earning decent salaries. This will have two effects: i. people will need to look elsewhere than property to build wealth; and ii. people will be incentivised to create wealth in order to afford what was once the Australian dream – owning a home.
3. Business ownership is the primary wealth creation tool: the basic building block of wealth creation is a business – giving people more value than you charge creates wealth over time. This will become more obvious when the ‘easy wins’ of equity markets and real estate ownership appear more difficult.
4. Lower mid-market businesses trade on modest multiples: despite the impact of falling interest rates in equity markets, lower mid-market businesses have tended to trade on more consistent and modest multiples. Lower acquisition multiples mean more cash flow the business is generating – the lifeblood of private equity investing.
5. PE has been too successful and as a result can only target larger acquisitions: Australian private equity firms have been very successful at raising capital and achieving 20%+ returns over long periods. Which is a problem. The larger capital raised means they can only chase bigger deals. Any business with an enterprise value above $50m is very competitive – but not so smaller firms. Micro PE will benefit from less competition.
6. Yield is still being chased by investors: even as interest rates rise above historic lows, investors (including SMSFs) are chasing yield. Australia’s lower mid market selling on modest multiples can generate yield.
7. Established businesses will continue to benefit from technology, with potential for low hanging fruit for incoming owners: the wave of tech innovation has a long way to go – and many traditional SMEs haven’t necessarily kept pace with the potential for new tech in their business. Often outgoing owners prefer to stick with what they have always done rather than risk new and possibly costly tech implementations. And here is the opportunity for the incoming (often younger) owner. Micro PE will benefit from being able to increase business margins from technology that may have been under-employed in the business.
8. Alternatives to bank financing such as seller notes will mean individuals are more willing to take the risk of ownership: seller notes are mainstream in the US market and are becoming more common in Australia. They benefit both buyer and seller – the seller gets the benefit of a decent yield on their note that they may not be able to get elsewhere in the near-term. Buyers benefit from finance linked to the business and with the outgoing owner’s confidence. Wider adoption of seller notes will facilitate more micro PE deals.
9. The demographics of large numbers of business owners reaching retirement in coming years will mean more opportunities for micro PE acquisitions: opportunities for micro PE will only grow.