What constitutes an optimal investment? The answer depends, of course, on a wide range of variables that shape the attractiveness of any investment. Ultimately, however, these converge into a risk-reward equation, where the guiding principle is that risk and potential return must walk hand in hand.
Yet it is important to recognize that excessive caution can actually work against the investor’s own interests. Those who completely avoid risk also forgo the potential for higher returns. In fact, fear of loss does not necessarily protect returns, and may even lead to the opposite outcome – lower performance.
The opportunities that deliver significant returns are often those that involve a calculated level of risk, particularly in investments in small- and medium-sized enterprises (SMEs), where the greatest growth potential lies.
Small companies, big potential
This approach is rooted in the fact that while 99% of businesses worldwide are SMEs, only about 30% of capital is allocated to them. This imbalance between supply and demand creates a vacuum – an underexplored space that allows investors to capture opportunities where competition for capital is low, yet the potential for excess returns is high.
The rationale lies in the rapid growth that typically characterizes SMEs, including managerial agility and the ability to generate superior returns relative to their peer group. In our view, this reward justifies the controlled risk associated with investing in this segment.
However, one crucial point must be emphasized: value creation does not stem from the mere act of investing in SMEs. Particularly in this asset class, realizing the business potential relies heavily on the skills, knowledge, experience, and managerial capabilities of the general partner (GP).
From sourcing companies at attractive valuations, through actively enhancing value during the holding period, and ultimately to maximizing value at exit – the GP’s role is decisive.
Shaping the future
The case for investing in SMEs in private markets also lies in their strategic advantages. Many operate in niche sectors with strong growth trajectories; they are not burdened by the heavy corporate structures of large conglomerates; nor are they subject to the constant pressure of quarterly earnings.
This allows them to pursue long-term strategies, implement structural changes quickly, and focus on sustainable growth rather than short-term optics.
Another key advantage, especially in today’s environment, is that as private entities, these companies are shielded from the volatility of public markets.
Moreover, such investments provide fund managers with the ability to take an active role in shaping the future of the company, exerting direct managerial influence, a critical component in unlocking hidden value and generating long-term returns. This dynamic often explains why SMEs in private markets tend to deliver superior performance compared to their publicly traded counterparts.
It is true that risk is an inherent element of any investment, and higher loss ratios are not insignificant. Yet this should not necessarily be seen as a drawback, provided that overall returns compensate for the losses. A strategy of calculated and controlled risk-taking is precisely what enables the consistent generation of excess returns.
The bottom line
From our perspective – and drawing on the many years of experience in investing in SMEs by our asset management company, Schroders – the advantages of focusing on this segment are clear. It is a market less crowded with investors, where competition is lower, creating a wealth of opportunities to achieve consistent out-performance, regardless of the economic cycle.
Success in this arena requires the ability to identify promising companies early and accompany them along their growth journey – not only by providing capital, but also through strategic and business guidance. Investors prepared to take this approach may discover that in the world of investing, size – or rather, smallness – can be a decisive advantage in generating consistent superior returns.
Roi Avishay is CEO, and Lior Eldar is business development manager, of Schroders Israel. The views expressed here should not be considered investment advice or a recommendation.