The 440,000 businesses most investors never look at

“That's a factor of 22. At the small end of the market, this is a far bigger pond to fish from,” says Alt.

It’s a part of the market that most investors never reach, but represents a “sweet spot” for Schroders Capital. Focusing on entrepreneur and family-led businesses ranging from $100 to $500 million enterprise value creates opportunities for transformation and the returns don’t necessarily come from financial leverage or multiple expansion but from the gap between what a business is when it’s acquired and what it becomes.

“In private equity investments, you almost hope for inefficiencies to enter companies, transform them and then hopefully successfully sell them,” Alt adds.

Untapped potential

This is in contrast to the image that forms in many investors’ minds when they think about private equity: massive deals that see companies streamlined aggressively to pump up the value or stripping them for parts.

Around 67% of the deal flow in Schroders Capital's target segment comes from that entrepreneur and family-led segment. According to Alt, these businesses are typically excellent at their core product or service, trusted by their customers and deeply embedded in their industries, but they carry a particular set of operational inefficiencies that a skilled buyer can address systematically.

"Many times there is huge potential to strengthen management, to professionalise them, to implement new or better systems, to make those companies greener, better, more readable, more transparent," Alt says.

“Then if you go into an exit process five years later when you want to sell the company to a strategic corporate buyer or a larger private equity firm, they can go into the process and understand the company very quickly, which is clearly an advantage.”

The list of improvements is consistent across deals: management depth that has not kept pace with revenue growth, financial reporting that is adequate for a founder-led business but insufficient for a buyer's due diligence process, geographic concentration that limits the addressable market, and an absence of the systems and governance that allow a business to scale without the founder in the room.

When a family-owned business is ready for a transition, the conversation looks very different to a competitive auction. An industry specialist who understands the sector, has relationships with comparable companies and can articulate a vision for where the business goes next has a material advantage over a generalist fund simply running a process.

“Imagine you run a family-owned company. Someone comes in who really knows the industry, sits down and gives you a great idea of what else is possible or what might have been missed,” Alt says.

“That’s a totally different discussion than when someone comes in and just asks you about your company for an hour or two.”

Doubling EBITDA, not loading up debt

At the smaller end of the market, the financial architecture of a deal is constrained by design. Banks and private debt funds typically provide 30 to 40% debt against 60 to 70% equity, translating to three to four times net debt to EBITDA. There is no room to manufacture returns through leverage.

Instead, Schroders Capital underwrites to doubling EBITDA. Based on the firm's exit analysis, doubling EBITDA while holding the entry multiple and leverage level constant should double the equity value. Any multiple expansion on exit is upside, not the base case.

“Our goal and our idea of that segment is to buy low, transform, grow our market, and then sell, hopefully with a multiple arbitrage. But it’s never our goal, and the underwriting doesn’t include any of that multiple arbitrage gain.”

Alt adds that “markets are recovering a bit unevenly”, with the near-term outlook for exits much better in the small-mid segment.

“Why? Because there's more exit optionality. Logically, if you have a company at $500 million - $1 billion, then you have potentially more buyers than you have for a company at $5-$10 billion,” he says.

“Smaller businesses offer great value creation potential. I always say it is easier to navigate a speedboat than a tanker. With smaller companies, little changes like implementing consistent management can make a huge difference.”