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Why M&A Investors Are Moving To The Lower Middle Market

Middle-market companies are some of the most sought—after assets, providing one of the best environments for M&A investors to create returns.

M&AMiddle-market companies are some of the most sought—after assets, providing one of the best environments for M&A investors to create returns. With more companies to invest in, greater opportunities to improve companies, and lower valuations and barriers to entry, middle market companies are attractive to many private equity (PE) firms and strategic acquirers (strategics). However, that attractiveness comes with a cost – increased competition in an oversaturated middle market.

As a result, the lower middle market is gaining popularity among PE firms and strategics. This market segment is gaining traction due to the increased number of opportunities provided by the lower end of the market, along with other factors that make it an investors’ gold mine.

The Investment Sweet Spot 

Lower middle-market firms operate in highly fragmented and very profitable industries, making them prime targets for acquisition and consolidation. The lower middle market is classified as companies with annual revenues between $5 million and $100 million. Currently there are about 350,000 companies in this segment, compared to 25,000 companies with revenues between $100 million and $500 million (the middle market) and only a few thousand companies with revenues above $500 million (the upper middle market), according to Forbes. The lower revenue valuations for the lower middle market are balanced against the exponentially higher volume of opportunities.

Retiring With No Succession Plans

One cause of the increased number of M&A opportunities in the lower middle market is its large population of baby boomers. The owners and CEOs of lower middle-market companies are predominately of the baby boomer generation. Now retiring, and in some cases, facing mortality, these CEOs and owners find themselves without a succession plan in place. Many do not employ a full C-Suite of executives, and their children, a generation that has embraced higher education at a larger rate than generations prior, have found their own dreams as doctors, lawyers, engineers, and more. Those that would have traditionally taken the helm when their parents and grandparents retired have no interest in running the family business.

This lack of a succession plan, coupled with impending retirement, creates an urgency for these businesses to change hands, and bodes well for investors and corporations to acquire, consolidate and grow them.

Better Valuations in the Lower Middle Market

Though deals in the upper middle market are large, increasing competition for M&A targets are driving up valuations in this sector, making the hurdle rate for a return on those investments much higher and harder to obtain. By targeting the lower middle market instead, investors can acquire businesses at better valuations and grow those businesses to achieve the required return for their portfolios. However, the competition in the lower middle market is intensifying.

The 10-year average purchase price multiple for leveraged buyouts of businesses with enterprise values below $250 million is currently 7.3 times EBITDA, the highest it’s ever been.  While it is increasingly competitive as a buyer, new companies are born daily, growing up, and are ready for investment. In turn, investors are finding increased value in lower middle market portfolios, attracted to them for their returns, as these platforms can generate upwards of 50 percent invested capital return.

What This Means for You

So what does this mean for lower middle-market companies? It means there is a lot of capital in the market ready to be put to work. It is reported that 70 percent of businesses in the lower middle market are projected to change hands in the next 10 years. PE firms are chasing large portfolio returns, and strategics are using M&A to buy new products and services to remain competitive in their industries. Both of these market dynamics mean that deal flow and valuations will remain strong.

Therefore, business owners considering an exit need to be ready to move and react to opportunities quickly. The financial rewards can be extremely high, but owners need to know what they’re getting into and be thoroughly prepared. It is important to understand the motivations of investors and the potential synergies gained through a transaction in addition to the enterprise value. As they say, the whole is greater than the sum of its parts.

Understanding the full lower middle market M&A equation—from the hard numbers that showcase the opportunity in the segment, to the skills that will drive the most success with in it— is critical to fully embracing its potential. Those that begin doing so now will establish themselves fully in a market that, by design, is much more difficult to oversaturate due to its sheer volume.

Read more: How to Embrace Business Transformation Without Making a Huge Investment


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