Private equity: Remember the little guys

NEW YORK (Fortune) -- With Blackstone going public, KKR doing more deals than ever, and rumors of a $50 billion buyout of Dow Chemical (Charts) swirling (despite the company's denials), it seems like the story of private equity over the past few years is a constant march toward bigger and richer. Mega-buyouts of public companies like TXU (Charts) and First Data (Charts) have earned front-page headlines, and the number of transactions over $1 billion has exploded, going from 12 in 2002 to 80 in 2006, according to Thomson Financial.

So it's easy to lose sight of the fact that private equity is not all huge deals and superstar firms. In fact, the vast majority - nearly nine out of ten - of all private equity deals are still under $1 billion.

There are now 1,700 private equity firms in the U.S., according to Thomson Financial, up from 900 in 2000. They manage over 3,700 funds with an average size of $180 million, if you don't count the top 10 firms. That's a rounding error next to Blackstone's $20 billion fund currently being raised.

"Private equity is a 25-year-old industry," says Justin Abelow, managing director at Houlihan Lokey, which advises on more transactions under $1 billion than any other investment bank. "The first year the deals weren't exclusively confined to the middle-market, aside from a few notable exceptions, was last year."

Private-equity shops specializing in the mid-market run the gamut from boutique operations that do only one or two deals a year to globe-trotting enterprises that execute dozens. Like their bigger brethren, mid-market firms also target popular brand names (small firms own Old Country Buffet, Eight O'Clock Coffee, Ronzoni Pasta and Burt's Bees, for example), but tend to specialize in unsexy industries like manufacturing and health care.

Many of the mega players in private equity - like Blackstone, KKR, and Texas Pacific Group - have criteria that limit them to investments of at least $1 billion and will contribute less only in club deals. The investment banks that typically lend to or pitch huge deals, like Goldman Sachs (Charts), Lehman Brothers (Charts), and Morgan Stanley (Charts), often won't participate for less than $500 million, leaving the market for specialists like Houlihan Lokey, Robert W. Baird, and ML Capital (a division of Merrill Lynch (Charts)).

Last year, there were 385 deals disclosed valued at under $1 billion, with an average value of $200 million, according to Robert W. Baird, an investment bank that also specializes in small and mid-market deals. That total is growing steadily but not explosively: 211 such deals in 2001, with an average value of $100 million.

"The number of small deals has been marching up more steadily," says Stewart Kohl, co-president of the Riverside Company, a Cleveland-based firm with $1.6 billion invested in 35 companies in the U.S. and Europe under management. "There are more and more owners of smaller businesses who are aware that private equity is a good alternative to selling."

According to Kohl, a veteran of Citigroup's venture capital group who's overseen dozens of mid-market transactions in his career, most of what happens in the private equity industry is the antithesis of the splashy headline deal. "Smaller deals are driven by fundamental things in life," he says. "Death of business owners, divorces, owners who have a change in lifestyle."

Unlike the mega-deals that are leveraged buyouts of public companies, mid-market deals are typically sales of private companies. Only 19% of them end up being sold to the public, according to a 2006 survey by Deloitte. Despite their modest size, some of the highest-returning deals in recent years have been relatively tiny ones. Take the buyout of Anteon, a Virginia-based defense contractor, by Caxton-Iseman Capital in New York. Caxton's original investment of $32.5 million starting in 1996 turned into nearly $750 million when it finally exited last year - a return of nearly 25 times the original investment.

"In the so-called middle market, there's sometimes more creativity than in the so-called bulge bracket," says Fred Iseman, founder of Caxton-Iseman, which has $2 billion in assets under management. Of the industry magazine The Deal's 11 best deals of 2006, which included Anteon, nine were done for under $1 billion.

The drawback is that small private equity deals typically don't return money as quickly as big deals. According to the National Venture Capital Association's latest index of private equity returns, small deals (under $250 million) returned 11.3% over one year, versus 23.4% for mega buyouts (over $1 billion). But over a 20 year horizon, small buyouts returned 25% versus 11% for mega buyouts. "Small firms tend over their history to be a higher risk, higher return strategy," says Erik Hirsch, chief investment officer of the $68 billion fund-of-funds Hamilton Lane.

That's why most private equity investors - mostly pension funds, endowments, and wealthy individuals - have a portfolio of many small funds, often put together by third parties like Hamilton Lane. Only in the last couple of years has that shifted toward large investments in a few funds. "Now what you're finding is huge concentrations among the biggest funds," says a New York-based manager of a small private equity firm that co-invests in big deals. "If private equity returns ever start to come down, investors will want to make sure there is some balance."

Smaller-fund investments also help to avoid the big question mark surrounding private equity: Is it a bubble? "The smaller deals are much less dependent on a favorable environment," says Steven Bernard, a director of M&A at Baird. He says smaller firms often don't depend on cheap financing provided by low-interest loans and hungry debt markets - the conditions some call frothy - to fuel returns. They tend to buy companies that can produce returns by growing significantly, say from $50 million to $300 million in revenue, through operational expertise or by combining it with other companies in their portfolio.

Huge companies can't grow like that, no matter what great ideas a private equity firm can bring to the table. Small firms can find such companies because their investors are used to being very patient. At a mega-deal firm, giant funds mean more lots of money for buyouts, but also more pressure to quickly find targets and not tie up massive amounts of investable capital. It's also easier to convince one or two investors to stick around if the growth strategy doesn't go immediately as planned. "For us, the size of the deal is less important than the capital gain," says Iseman. His firm, Caxton-Iseman, is solely funded by the hedge fund Caxton Associates and has only five companies in its portfolio, but has a gross internal rate of return of 86% since its founding in 1993.

As one fund manager said to me, every morning he wakes up and asks himself " 'Which of these companies am I going to buy?' But I get to wake up and say 'Which of these companies would I want to buy?'" That's why many private equity firms prefer to stay small. Sure, the next Blackstone or KKR might be lurking among today's middle-market players. But many intentionally limit their size and are happy to stay small as long as they can keep making money. "We'd love to have the huge management fees," says John Pouschine, of Pouschine Cook Capital Management, whose latest fund raised was capped at just $175 million. "But we just don't want to sit on a billion dollars."