Why Middle-Market Co-Investment Opportunities Make Sense Now

Executive Summary

• A choppier macro environment has created challenges within the private markets, but with challenges come opportunities – particularly across the co-investment landscape.
• In the current environment, middle-market co-investments can provide a broader opportunity set than mega and large deals, along with more paths to value creation and lower leverage levels with limited downside.
• Co-investment funds can provide enhanced diversification – across GPs, sectors and the number of deals in a fund – in a fee-efficient structure.
• Having a large primary platform is critical to seeing diverse, high-quality deal flow and selecting the right deals. 

Timing the market is never a good idea. Maintaining exposure through diversified investments, on the other hand, can be a useful tool, even when capital seems scarce. Through nearly three decades of co-investing and across our $14.3 billion in direct equity AUM¹, we have seen firsthand how co-investments can diversify an LP's portfolio and enhance return potential. And the current environment looks ripe with opportunity.  

The Current Co-Investment Environment 

A choppier macro environment has created challenges within the private markets… but with challenges come opportunities – particularly across the co-investment landscape. The limits of the current market, including higher debt costs, a difficult fundraising environment – down ~35% from peak levels in 2021 – and a need to over-equitize deals, have prompted GPs to seek out co-investors with greater fervor than in prior cycles. In this context, GPs need to manage fund exposures while still expanding the size of their investment universe.  

For co-investors, this is great news. Despite the anemic fundraising landscape, which for most strategies has meant a slight decline in the number of opportunities screened in 2023, our direct equity team saw that number jump by 38% over 2022 – which was also a record year. The area we’ve been seeing the most opportunity? Middle-market buyout. This segment of the market provides a broader opportunity set – there are 10x as many small and middle-market funds than there are large and mega – and more paths to create value. 

Private Equity and Private Credit Opportunities By Strategy 
Opportunities Received by Hamilton Lane

Why the Middle Market? 

Against the backdrop of a fruitful co-investment environment and a target-rich middle-market landscape, why else do we love the middle market? Let us count the ways. 

1. More Opportunities to Drive Value 

Middle-market deals tend to have greater revenue and EBITDA growth when compared to mega/large deals. One reason is that these companies have been less picked over by private equity or may be founder/family owned. Middle-market companies also tend to offer more revenue growth opportunities as outlined in the charts below – from product and geographic expansion to customer cross-sell and up-sell opportunities – and benefit from accretive acquisitions offering multiple value creation levers that GPs can implement. In the middle market, these initiatives tend to make a bigger impact faster and allow the company to pivot more efficiently in challenging times. 

Median Revenue Growth

Median EBITDA Growth

2. More Conservative Valuations and Leverage Levels 

Middle-market deals generally exhibit more conservative purchase multiples when compared to mega/large deals, driven by this segment of the market being less intermediated and the general perception that these businesses are riskier. Mid-market deals tend to be moderately levered versus their mega/large counterparts because middle-market returns are less reliant on financial engineering and, therefore, are less sensitive to changes in interest rates. The need for leverage to engineer returns is less so given the many vectors of value creation in the middle market versus the large end. 

Historical Purchase Multiples
Median EV/EBITDA at Entry by Deal Year; Deal Vintages 2000-2023

Historical Leverage Levels
Median Debt/EBITDA at Entry by Deal Year; Deal Vintages 2004-2023

3. Greater Exit Optionality Potential Drives Shorter Hold Periods 

An important driving factor is that middle-market deals have shorter hold periods due to their ability to grow and generate value faster, combined with greater exit optionality. There are simply more paths to liquidity in the middle market, including exits via PE firms, strategics, IPOs and single asset continuation vehicles. In contrast, mega/large deals are subject to the whims of the IPO market.  

Holding Period of Exited Buyout Deals

Over the last 10 years, middle-market deals have exited via IPOs 15% of the time, whereas mega/large deals have exited via IPOs 78% of the time. This dynamic was especially fruitful over the last few years as the IPO market was weak – especially in an asset class so concerned with liquidity. Another point on the board for the middle market: More exit avenues give these deals greater potential to be realized. 

Exit Type by Size
Deal Vintages 2003-2023

4. Attractive Risk-Adjusted Returns  

Middle-market deals have a higher percentage of outperformance compared to mega and large deals, with only slightly higher loss ratios across market cycles. This translates to better growth and valuation potential, with lower leverage and downside protection. Is it too good to be true? We asked ourselves the same question. Just look at the data.  

Loss Ratios of Realized Buyout Deals
Deal Vintages 2003-2023, Realized Deals Only

How to Effectively Access the Middle Market 

By now, we hope we’ve sufficiently defined the advantages of the middle market, but with various ways to access the market, is it worth considering a co-investment fund versus a traditional middle-market buyout fund or executing co-investments on your own?  

Building middle-market exposure through primaries and sourcing effectively is expensive, labor intensive and creates an over-diversified portfolio. LPs tend to pay a 2% management fee and 20% carried interest via typical commingled buyout funds, while fee structures within co-investment funds are typically half the cost, which can result in over 200 bps of alpha assuming equivalent gross returns². On the other hand, executing co-investments yourself can be labor intensive, costly, and can result in concentration by “doubling down” on potentially an already limited sponsor portfolio (depending on the size of your platform – for perspective HL has 600+ GP relationships). Co-investment funds can provide enhanced diversification – across GPs, sectors and the number of deals in a fund – in a more fee-efficient structure. 

If accessing the middle market via building a co-investment program, there are certain barriers to entry LPs must consider. Creating a diversified co-investment program requires resources, expertise and, importantly, a primary platform to drive deal flow and build relationships with GPs. An institutionalized sourcing program or initiative is imperative, but it takes time and resources to execute effectively. At Hamilton Lane, we have senior investment teams coordinating across the firm and product teams tracking our sourcing efforts to achieve the deal flow necessary to be highly selective. Having a large primary platform is critical to seeing diverse, high-quality deal flow and selecting the right deals. Case in point: We saw more than $43 billion - over 1,000 transactions - of co-investment opportunities in 2023 yet only invested in 6%³.  

Our Final Two Cents on Middle-Market Co-Investments 

Now that we've counted the ways in which we love the middle market and how co-investments funds can provide access to these deals, what advice is left? In the words of Shakespeare, "Listen to many, speak to few." The benefits of middle-market co-investments are only attainable when you choose the right partner. Look for large, experienced platforms that have the scale and relationships through primary capital as well as the technology, data and investment expertise to bring it all together.   

We find that middle-market co-investments exist in a target-rich environment where there is enough autonomy and influence for GPs to be selective. We also find that middle-market investments can offer more opportunities for PE ownership at more conservative valuations with better leverage levels. In commingled funds, middle-market co-investments can provide LPs access to fee-efficient and diversified risk-adjusted return potential. And when compared to the mega and large end of the spectrum, a higher percentage of middle-market deals tend to result in outperformance, with protection to the downside, as we saw very similar loss ratios between the two. Add that to favorable exit optionality and it's easy to see why middle-market co-investments make sense now. What's left is selecting the right partner.