Lower Middle-Market M&A to Remain on Pace

Uncertainty: It’s the sentiment that markets abhor, that spooks institutional investors and that wreaks havoc on deal activity.

Despite the sluggish performance of the second quarter, there are still fundamentals especially in the lower end of the middle-market that suggest deal activity will continue despite the current economic backdrop.

According to Bain & Company, the long-term outlook for private equity (PE) as an asset class remains strong. Limited partners (LPs) have consistently signaled their intent to maintain or increase PE allocations and remain confident in the fact that PE returns outpace other asset classes. A recent The Wall Street Journal article also noted that there are 2,845 funds currently in market, collectively aiming to raise over $1 trillion in new capital.

Some valuations and multiples may yet come off their peaks, especially in sectors that have been the frothiest over the past year. We may see these numbers drop if economic data continues to suggest entrenched recessionary pressures and if the current uncertainty persists. But not all segments of the market will feel the effects equally as 2022 continues.

Those of us who serve clients in the lower end of the middle-market—companies with EBITDAs of between $2 million and $10 million—know that there are reasons to suggest that this segment of the market will prove more resilient:

  • Commercial bankers in this area of the middle-market have continued to be a source of deals for investors. Compare that with deal flow at the larger “flow banks” which has ebbed in the last quarter.
  • Deals under $100 million represented nearly 70% of all PE deals during the first half of 2022 according to Pitchbook.
  • In addition, off-market proprietary deals that investors either source themselves or source from other advisors continue to make up a significant portion of the completed deals. One PE firm reported that “In the last year, we’ve done 12 transactions, and all were proprietary and sourced from internal resources.”
  • Investors in the lower end of the middle-market look to achieve returns through improving operations—better ERP systems, investing in executive talent, building business development synergies—rather than using leverage. With a lower amount of leverage, they can absorb an increase in the cost of debt, for a time, without compromising returns to their investors.
  • Many of these investors have been focused on sectors that have fundamentals allowing them to weather downturns and remain resistant to pricing pressures and other factors that erode margins, for example essential business services, critical components manufacturing and healthcare services. As an investor based in the Midwest put it, “We want to be investing in companies that produce the component that makes the conveyor belt work.”

The capital overhang that exists now in the market—estimated to be around $1 trillion—is considered the safety net since it will continue to fuel deal activity. And there are additional reasons to believe that investors in the lower middle-market can continue to raise new capital or successfully recycle capital more readily than the large PE firms:

  • The fund size of most lower middle-market sponsors is intentionally smaller—less than $500 million—than the funds investing at the higher end of the middle market.
  • With more LPs—institutional investors—struggling with over commitments of capital, the smaller funds are not as dependent on increasing re-ups from fund to fund. “If an LP participated at $20 million in our last fund, we don’t necessarily need them to go to $25 million, whereas the larger firms have to get larger (commitments),” reported a partner of a middle-market PE firm that specializes in founder-led businesses below $10 million in EBITDA.
  • Right now, this flexibility is critical because most LPs are over-committed with a pipeline that runs through 2023 and have little room to add new managers or expand existing relationships. Even if commitments didn’t have an 18-month tail, the downturn in the market has created the classic “denominator effect,” which means the market value of the overall fund has declined, making the allocation to private assets increase dramatically.

Activity in the lower end of the middle-market may also prove resilient because it involves founder owners who built and grew their companies through market downturns, a global financial crisis and the pandemic. They’ve weathered storms before and will either wait this out or decide they’ve had enough. If it’s the former, they may see this as a time to bring on a strategic investment partner with operational expertise and investment capital; if it’s the latter, they may decide this is the moment to sell and start the next chapter of their life.

There is a lot of uncertainty in the market not only for investors but for business owners as well. Unlike their counterparts in the higher end of the middle-market where EBITDAs and multiples are solidly in the double-digits, investors in the lower end of the middle-market fully expect to earn their return through operational gains. While those gains will be challenging in the coming months or years, these investors will stay the course, continuing to deploy capital, structuring deals with more equity than debt, and recycling capital.