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Searching for bigger returns? Think smaller.
As the private equity industry matures and competition for middle-market acquisition targets becomes super heated, some private equity firms are moving downstream into the lower brackets of the middle market in search of additional opportunities and higher returns. Though not without risks, the lower middle market provides opportunities for outsized returns to those private equity investors willing to roll up their sleeves and take a hands-on approach to operational improvements.
 
First and foremost, the lower middle market simply offers a greater number of potential targets. There are approximately 350,000 companies with annual revenues between $5 million and $100 million, while there are only 25,000 companies with annual revenues between $100 million and $500 million, and only a few thousand companies with annual revenues in excess of $500 million. The lower end of the middle market also has the most new entrants. New companies are constantly being formed, maturing, and looking for growth capital.
 
The lower middle market presents opportunities for smaller, more specialized private equity investors who focus on specific industries and have significant operational experience. Lower middle-market deals can be difficult because target companies often lack sophisticated infrastructure, operational experience, and/or experienced management teams—all of which are critical for a business’ ultimate success. Private equity investors (with management and operational experience in specific industries) are able to leverage their industry knowledge to grow these companies, scale up operations, and increase revenue. Private equity investors in the lower middle market must be willing to step in as CFO, or CEO, and must recognize that these investments are operational partnerships, not just financial transactions.
 
In part, this shift toward the lower middle market is being driven (as are other recent trends in the private equity industry) by structural changes in the private equity industry itself. As first-generation private equity firms mature and the original general partners look to retire or limit their contributions, some are branching out and opening up their own smaller and more specialized shops. These general partners already have a track record of successful deals and often focused much of their career on a specific industry. The lower middle market offers abundant opportunities for these newer, smaller shops to buy attractive assets at potentially lower multiples.
 
Transactions in the lower middle market are not, of course, without risk. Competition remains high and valuations, currently around seven times EBITDA, are the highest they have ever been—according to the alternative asset analysis firm Preqin’s 2017 report on the lower middle-market. Additionally, low EBITDA-generating companies face difficulties entering the market and are often too small to retain an investment bank to run a full auction process. Lower middle market deals often use a compressed deal process—offering limited exposure to the seller and management and limited opportunities for diligence. If multiple suitors are involved and transaction expenses spiral out of control, the economics of the deal may become unworkable. Finally, because of their smaller size it can be difficult for lower middle-market private equity firms to provide the significant management, operational, and back-office support their targets often require.
 
Despite these challenges, acquisitions of lower middle-market targets can be an attractive alternative for private equity firms looking for increased deal opportunities in today’s highly competitive market.
 

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