E333: Why a $19B Allocator Is Betting on Lower Middle Market Buyouts

0:00So Alex, you're at RCP Advisors, which has 19 billion AUM. And last time we were chatting, you mentioned how LPs are still spending most of their allocation in private equity in the large funds. Why is that wrong? The simplest reason is that the smaller part of the market has provided the most consistent outperforming returns over 20 and even probably 30 years. Not only is it higher returns, they generally have in our sort of lower middle market or small buyout market, shorter duration. So usually quicker to distributions. Exits are generally either to larger private equity firms or companies that are owned by larger private equity firms or sometimes the independent companies.

0:36And really less than 2%, at least for RCP, our exits have been to public markets or IPO. So that significantly reduces hold times. And the reality is that the vast majority of capital, as you mentioned, has still been raised in funds, what we'll say is over a billion dollars in fund size. We'll use a billion dollars as sort of a demarcation line. And while the vast, vast majority of the capital is being raised in those larger funds, it It only makes up probably less than 10 % of the actual target opportunities and companies that exist out there. And so that mismatch of capital really leads to some structural advantages for the managers that are operating in the smaller part of the market.

1:07How would you explain that LPs are very sophisticated investors if lower middle market has been so good for so long? Why are people allocating more to buy out versus lower middle market? Because it's hard. That's the main reason, right? So this part of the market has over 1 ,200 managers. So it's a very large market to cover. And within those managers, the returns are on average better and sort of the top quartile returns are better. But there's also a left tail, right? So there are the risk of having sort of, let's say, a larger potential distribution of outcomes. And so manager selection, right, becomes, you know, really key and important.

1:42And the characteristics of the managers in our part of the market is that they act in some ways very similar to what we see in the best venture capital managers, in that if you're raising a$500 or$600 million fund and you have a very good track record and you have a good team and you're fought after by limited partners, you are probably oversubscribed by two or three times, if not more. So access is a huge issue. Being able to cover the market is very difficult because you're talking about lots and lots of managers. And the other real issue for a lot of the bigger institutional investors is that it's very difficult for them to put to work the amount of capital that they need on a per line item basis, right?

2:15So if they're looking to invest in private equity funds and buyout funds, then let's say their minimum might be$100 million. Well, if you're investing in the best$500 million manager, you can't get$100 million, right? It's very difficult to do. And that's actually, frankly, why a lot of institutions use a fund of funds like us or others as a way of getting that allocation to the smaller part of the market that is extremely difficult for even relatively sizable teams to do on their own. Another word for manager risk and manager selection risk is career risk. It goes back to the old adage as you don't get fired for firing IBM.

2:45And what's interesting, a lot of people, there's a bias to this as well. That's quite interesting, which is if you invest into IBM and IBM goes down, well, IBM went down. But if you invest into a small company and it went down, you made the mistake. So there's this fundamental attribution bias where if you invest in a lower mill market manager and they do bad, the person who made the investment to a lower mill managers is seen as making the mistake versus if it's in a buyout, it's blamed on the market and other external forces. That's absolutely true. And I would say that for a lot of folks that might even be pretty active investors in private equity, but don't know our part of the market, they could look at our names in our portfolio and maybe not even recognize any of them.

3:21And that's not unusual. And sometimes the best managers are the ones that stay under the radar screen. Unlike big market private equity, the majority of managers that we back actually aren't in the major cities. They're not in New York, they're not in Chicago, they're not in LA. They're in secondary and tertiary cities, right? Because that's where, frankly, a lot of the smaller companies are, right? And when we're talking about small, we're talking about companies that are generally under 100 million of enterprise value, right? And so those managers tend to be more local. They tend to be not in New York, although there are obviously a lot of managers that we do back in New York as well, but they tend to try to use that fact to ingratiate themselves within our part of the market.

3:57Most sellers are actually family-owned businesses, right? So our data does about 75 % of the deals that are done in this part of the market are from businesses that are owned by a family or an entrepreneur owner. And that is just a very different type of transaction than, let's say, a private equity firm to private equity firm transaction where a large bank is involved in holding a big auction, right? And so the sort of intricacies of winning that deal, of creating value in those companies is a very different type of skill set and, frankly, a different type of opportunity to actually create value.

4:25And that's one of the reasons why we see these returns in this part of the market be so robust. Expert calls have always been one of the most powerful ways to build conviction. But today, investors are asked to cover more companies, move faster, and do it with leaner teams. With AlphaSense AI-led expert calls, their Tejas call service team sources experts based on your research criteria and lets the AI interviewer get to work. The magic is in the AI interviewer, purpose-built and knowledgeable-based information to conduct high-quality context-rich conversations on your behalf, acting as a trusted extension of your team.

4:58Then they take it one step further. Your call transcripts flow natively into your AlphaSense experience and become querible, searchable, and comparable. So your primary insights plug directly into earnings prep, digital work streams, and pitch books with zero tool switching. And with AlphaSense expert call services, the AI-led expert calls are just one option because we know the importance of a hybrid expert research approach. AI for coverage and efficiency. Humans for complexity and conviction. It's the institutional edge that scales research without scaling headcount. For hedge funds, that means validating thesis assumptions across dozens of experts before earnings instead of a handful.

5:35For private equity, it means faster pre-IOI scans and deeper commercial diligence. For investment banks and asset managers, it means pulling real operator perspectives straight into models and sector positioning without disconnected tools or manual handoffs. All of it lives inside the AlphaSense platform, trusted by 75 % of the world's top hedge funds, alongside filings, broker research, news, and more than 240 ,000 expert call transcripts, turning raw conversations into comparable, auditable insight. Take advantage of AlphaSense AI-led expert calls now. The first to see wins. The rest follow.

6:11Learn more at alpha-sense.com slash how I invest. When you look at large buyouts, they're oftentimes using a lot of financial leverage. You mentioned in lower middle market, oftentimes providing real value to the company. Is there an argument to say that lower middle market is actually safer than large buyouts, or is it just higher returning, higher risk? Safer in some ways, riskier in others. So we'll take leverage as an example, right? So in most of the managers in our part of the market and in our data that we show, let's say in companies under 100 million of enterprise value, just to give some numbers, the median multiple, right, on cash flow that we often see the debt being is around three turns cash flow, right?

6:46We usually see capital structures in the deals about 50-50 equity and debt. Compare that to the upper part of the market where that multiple might be six turns of cash flow, might be 30-70, right, equity to debt. So in that way, financial leverage is less of a risk, but there's also a reason why the companies in this part of the market are using less leverage, or I should say the managers when they do these transactions use less leverage. There's other things about these small companies that makes them inherently risky, right? There are risks involved that bigger companies don't have. So, for example, if you're a family-owned business that's been run by the same person for 20 years, you may not have the best operations in place, maybe not best practices.

7:22Your CFO might be really a controller, right? It might be the cousin of the owner, right? And so there's opportunities to improve these companies, right? So the flip side of that is they are a little bit less, more risky on entry. They may have customer concentration in a way that a$5 billion company doesn't have. But these are also things that are big opportunities, right? So the managers that we back in this part of the market are groups that have very activist ownership structures, right? And strategies, right? They are using operational resources. They are improving what is, let's say, a less polished asset, right?

7:51One that has a need for a more professional management team, a real CFO. Maybe they have customer concentrations, so they might use M &A or other means to sort of diversify their customer base. They may have geographic concentration, right? These are all big risks. But if you can have a manager that attacks these risks, right, and can grow that company and scale it, right, and do it organically, but also through M &A, which is a big part of not just a bigger part of the market, but our part of the market, there's a lot of fragmented industries. And you can create that value with scale. Then you're selling that asset, which is a much more polished asset, into a much frothier part of the market, right, where most of the capital is, where they use double the leverage, where their cost of capital is different, frankly.

8:31And that leads to what we call multiple expansion, right? So valuations are lower in our part of the market, and there's structural reasons for that, right? Because these companies are a little less polished, they don't earn the same amount of dollars per cash flow. But once you fix that, right, and you grow these companies and you scale them, they become really attractive assets. And for every dollar of cash flow you've grown, you get the returns on the growth, but you're usually getting a higher valuation multiple on those dollars of EBITDA as well. And in our data, what we see is that the median sort of what we call multiple expansion between when you bought the company to when you sold it in our part of the market is around two terms.

9:02So if you bought it for six times, you might be able to sell for eight times or more. Top quartile is like four terms. So that is what leads to sort of these outsized outcomes in our part of the market. And that also sort of counteracts the fact that you are dealing with companies by their very nature that can be more risky in their operations at the time that you buy. So brass tacks, when you compare large buyouts versus lower middle market, how have they done over the last couple of decades? If you think about it as a vintage year basis, right? The top quartile returns in the smaller funds have beaten the top quartile returns in the larger funds, again, using$1 billion fund size as a demarcation line, 13 of the 16 vintages in that time period.

9:38And they've beaten them by over 600 basis points on average. So significant outperformance in IRR. And then on the other side, the other three years, how have large buyouts done and what has been their outperformance? So when large buyouts beat small buyouts in those three vintage years, the outperformance was only 250 basis points or so. So again, when large buyouts is beating small biots. It's a little bit less magnitude, and we see much higher magnitudes in the vast majority of the vintage years historically. And those tend to be almost like interest rate trades. The interest rates goes down, and then the leverage, basically the company adds value to that.

10:12Is that an oversimplification? It is a little bit of an oversimplification, but it's not completely wrong either, right? So there's no doubt that in times of interest rates reducing, the amount of leverage that's used in the bigger part of the market, that interest rate reduction, and really the sort of healthy functioning of the debt markets in the bigger part of the market are key to having M &A performed, key to getting exits. And of course, another big part of that for the bigger part of the market is a very functioning IPO market, right? Because in some cases, those companies are so large, that's the only place you can exit them.

10:38In our part of the market, because we use such a significant amount less debt in our transactions, over the time period where we saw interest rates go up by 500 basis points, we didn't see a major effect. And the other big difference in our part of the market related to interest rates and leverage is that the vast majority of the deals and the debt that's provided in our part of the market is not from the traditional money banks. And it's certainly not syndicated debt. It is generally private credit funds, right? About maybe 70, 80 % of the debt is probably private credit funds. And so they have capital to put to work.

11:09They tend to be more risk on. So even in times when the debt markets in the bigger part of the market have sort of seized up, we've seen activity continue in our part of the market in a much more healthy way. Now, sometimes that debt can be more expensive, right? So that's certainly a downside to that. But because our managers are generally using so much less of it in the transactions, it doesn't really, that additional sort of spread, let's call it, doesn't have a significant effect on their decision-making around investment activity or how much leverage they're going to use because they already use very relatively small leverage at the time that they make their initial acquisitions.

11:39Just to make an apples-to-apples comparison over that 16-year period, what was the average return for large buyouts versus lower middle market? So over the last decade, we've seen significant outperformance in the small buyout market. So So the last 10-year returns is around 21 % annualized, right, compared to just over 16 % for the larger buyout. And you've been in this part of the market really for two decades. You mentioned there's 1 ,200 managers, so there's much more managers to diligence. How long did it take before you had a good sense for what a great manager looks like? It takes a number of years.

12:12So I started this role as a limited partner right out of business school, and that was 25 years ago. And it started with Hewlett-Packard's Pension Fund. And at that time, you start taking manager meetings. At that point, it was focused on a variety of things, not just lower middle market. And you really build up almost like a muscle memory, right? So when you first take your first meetings with a GP, if they're good at pitching their fund and their strategy, then you come out of it loving, right? And what you don't have is the sort of mental comparison of the 100 other managers you've met with up until that point, or maybe thousands of other managers you met up to that point.

12:44So today, I think that having met with so many different managers, lots of different strategies. I started working for RCP about 11 years ago and started focusing exclusively on this part of the market. At that point, you start to realize pattern recognition of what types of things are you looking for in a manager that you believe and the data shows leads to outperformance. And you only get that from experience and being around people that are smarter than you and have the ability to teach you and mentor you through those years that you're learning how to identify those things. I'm sure you do hours and hours of diligence on every manager, but how quickly do you have a really good sense for this is going to be good or this is going to be bad?

13:22Your initial reaction is important, right? So we obviously don't make decisions on just one meeting, but you can tell a lot in a first meeting about whether or not you believe that this is, one, a team that has something about them that's unique, that allows them to create repeatable returns. Is there something about their strategy that you learned in that meeting? Again, having seen tons of different lower middle market private equity firms, you can start to sort of zero in on the things that you're looking for that can lead to that outperformance. And finally, what you're looking for is how they go about executing that strategy, right?

13:50The process. And so you can learn a little bit about that in a first meeting. And usually it takes several sort of follow-up meetings, the review of the materials. And then, of course, I think that for us, the biggest moment of realization is generally after what we call an on-site visit, where we spend maybe a full day working with that manager, meeting other members of the team, going through case studies, really understanding what has led to the performance numbers that you're looking at in those tables. And then identifying something about that manager that one way I like to describe it is their superpower.

14:21What is it about what they do that's different than everybody else that gives them the ability to have not just great returns, but also repeatable great returns, where there's something that they're doing that can consistently be pointed to as a way of generating those outsized returns? You mentioned what you look for in a manager in terms of what makes them great. Double click on that. I would say that initially, it's really a qualitative assessment, right? So we're looking for people that have experience and a background that fits the strategy, right? That it makes sense that they are executing on the strategy.

14:49And as I mentioned, they have the ability to do something that is unique and differentiated from all the other managers that we're looking at, right? So we may see 300 or 400 managers fundraising every year. We're going to do 10, right? So those 10 managers have to separate themselves out in some way. And sometimes it could be how they source deals that's unique, that gives them an advantage in buying and finding unique deal flow. It could be operational resources or expertise that they have that is unique, that helps them do all those things that I talked about that add value to these companies that actually generate really good returns.

15:20Sometimes it's the exit and sometimes it's just their ability to understand a sector or a certain subsector or market in a way that's much better than their peers. And so we have qualitative assessments that allow us to do that. We meet with them. We talk to references, which are an extremely important part of the process. And then I'll go back to the quantitative. right? So their track record. So one of the things that makes track record so difficult in private equity is that most people rely on vintage or benchmarking, right? And vintage or benchmarking has some problems. Part of it is that the most relevant fund that you want to benchmark is their last fund.

15:52And I can guarantee you, especially in this environment, their last fund is probably made up of mostly deals that are unrealized, right? That have not actually achieved a return that's real, right? It's a mark and that's helpful, but it's not a realized outcome. And so as you start to go back in their historical track record, you start moving farther and farther away, usually from both the people that are actually doing the deals today, as well as the strategy, right? Because again, successful funds do tend to raise larger and larger funds. So they may have started off doing companies that are under 100 million enterprise value, and now they're doing companies that are 300 million enterprise value.

16:22So part of the way that we try to counteract that is through our data. So one of the things that RCP is very well known for in our market is we have an extensive database that has over 50 ,000 deals in it. And in those deal data, we have the ability to benchmark not just things like outcome, which is certainly important, but also things like revenue growth and EBITDA growth and what they bought these companies at compared to what the market was buying companies at, right? So we have the ability to benchmark these managers in very unique ways that most other LPs, frankly, don't have the ability to do because we've been collecting data in this part of the market for 25 years.

16:53And that, we think, gives us certainly an advantage in making the picture that we're trying to sort of take of this manager clear. You've essentially created your own internal benchmark that may be more representative than just taking something off the shelf. Two things really strikes me about what you were saying. One is obviously strategy creep. If you're investing in companies under a hundred million, now they're a 500 million and your team has all changed. Your track record is not going to be predictive of the future. It's just a different activity. The other thing is this interesting incentive mechanism between TVPI turning into DPI.

17:22Professor Steve Kaplan, the University of Chicago did the study that showed that first, second, third time funds over inflate their TVPI versus more established managers under inflate. And the intuition behind that is early stage, early vintages are just really focused on raising the next fund. And then later funds are all focused on under promising, over delivering because they want to build, they want to take that$10 million check into a hundred million, that a hundred million to 200 million. They're more able to think long-term. Do you find that as well? And is this one of the things that you really have to focus on is this TVPI going to turn into DPI?

17:56Let's be honest. subscriptions out of fast streaming services, apps, memberships you forgot you even signed up for, and canceling them is usually a pain. That's where Experian subscription cancellation comes in. Experian can take the pain out of canceling subscriptions by handling it for you. You just keep the ones you want and put money back in your pocket. Over 200 subscriptions are cancelable. You can also save money by letting Experian negotiate the rates on your bills. They'll keep an eye out for new deals and saving opportunities and negotiate directly with your provider on your behalf. And the best part, you keep 100 % of your savings.

18:35Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. Savings not guaranteed. Paid memberships with a connected payment account required. See Experian.com for details. Let's be honest. Subscriptions out of fast. Streaming services, apps, memberships you forgot you even signed up for. And canceling them is usually a pain. That's where Experian subscription cancellation comes in. Experian can take the pain out of canceling subscriptions by handling it for you. You just keep the ones you want and put money back in your pocket. Over 200 subscriptions are cancelable.

19:12You can also save money by letting Experian negotiate the rates on your bills. They'll keep an eye out for new deals and saving opportunities and negotiate directly with your provider on your behalf. And the best part, you keep 100 % of your savings. Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. Savings not guaranteed. Paid memberships with a connected payment account required. See Experian.com for details. Let's be honest. Subscriptions out of fast. Streaming services, apps, memberships you forgot you even signed up for, and canceling them is usually a pain.

19:50That's where Experian subscription cancellation comes in. Experian can take the pain out of canceling subscriptions by handling it for you. You just keep the ones you want and put money back in your pocket. Over 200 subscriptions are cancelable. You can also save money by letting Experian negotiate the rates on your bills. They'll keep an eye out for new deals and saving opportunities and negotiate directly with your provider on your behalf. And the best part, You keep 100 % of your savings. Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. Savings not guaranteed.

20:28Paid memberships with a connected payment account required. See Experian.com for details. That's a really important part of this. One of the things that you even mentioned in the question is that how people mark their portfolios can be either conservative or aggressive. And what we generally see, it's interesting, so I know Kaplan's work on the earlier managers, and we definitely see that in emerging managers. But we also see it in, let's say, less accomplished managers that are raising their third or fourth fund or fifth fund even, but where they have some issue that they're trying to deal with in their fundraise.

20:57Because maybe a partner left, maybe their performance is not that great. And so for them, we see usually more aggressive marks, not surprisingly, marks that might not hold up to what's going on in the real world today. And what we tend to see is that our best managers tend to sandbag. They tend to put marks that are much lower than what they probably can sell that company for today, in part because they're not worried about fundraising, because our best managers, again, are highly oversubscribed. They might fundraise for three to six months and be done, right? And it's really just existing or maybe some folks that they're bringing in, and they don't have the need to sort of bolster up their track record with marks that could be, let's say, seen as aggressive.

21:32We have a number of managers where the average exit compared to what they were valuing the company at, let's say one or two quarters before, was as high as 100%. The average across most of our managers is 30 % or 40%. And when you look at the upper part of the market today, there's actually, I think, a pitch book analysis that showed that you're actually getting a retraction on average in terms of the marks. So if you held it at 2.5x, you might be getting an exit at 2.3x because you were holding an unrealistic valuation. That's a much more precise way to say it, which is, it's not second vintage or fifth vintage or 10th vintage.