Lower Middle Market Private Equity: Often Overlooked, Potential for Outsized Returns

LMMPE is generally defined as companies generating revenues between $1 - $40 million. This encompasses 99.9% of businesses in the USA. Based on data from the SBA, about 33 million small businesses meet this definition.1 This gives LMMPE a massive opportunity set compared to much larger private equity firms that can only focus on a select number of companies. For example, large-cap billion-dollar private equity funds are more efficient and cost-effective at making 10-20 large acquisitions per fund as opposed to making hundreds of $10 - $30 million investments in portfolio companies due to the sheer amount of effort that goes into sourcing, diligence, and execution of a single deal. This keeps larger funds out of the lower-middle market and allows smaller fund managers to shine.

In LMMPE, one of the quickest ways to grow is through inorganic M&A. LMMPE funds will spend significant time shopping for a “platform” investment they can build around. Once the platform is acquired, the execution team shops for add-on acquisition opportunities. The typical add-on candidate provides a complimentary product or service to the platform and can give diversification or expansion into other geographies or technologies. These are generally acquired at lower multiples than the platform due to the size discount of add-ons.

An illustrative example of an LMMPE add-on strategy is below2:

Illustrative Example - LMMPE Multiple Arbitrage

The very basic illustrative example above ignores the time and growth of both the platform and add-on businesses, but it demonstrates how powerful multiple arbitrages can be in LMMPE. Assuming the same entry and exit multiple, LMMPE can quickly increase the value of platform investments through small add-on acquisitions.

Many of the target companies for LMMPE have never taken an investment from institutional capital. As a result, these targets lack the resources and institutional knowledge of their larger competitors. Many LMMPE firms specialize in instant value creation by utilizing their in-house network of experienced operating partners to focus on improving the operations of the business on day one.

These firms can also improve financial controls and optimize the capital structure of these businesses to execute a long-term strategy.

We can expect an increase in transactions for family and founder-owned businesses because of the generational shift taking place. A recent Wells Fargo study found that 52% of families do not want to pass their family business down to their children.3 This has owners of these businesses looking for liquidity events, like an exit to private equity. Another UBS survey found that 21% of business owners - most of whom generate $1 - $10 million in annual revenue - are contemplating a sale to private equity firms.4 In addition to the amount of founder-owned businesses looking for exit opportunities, these targets are generally attractive to LMMPE firms for several reasons, including little to no outside capital, value-creation and business scaling opportunities, and high willingness to sell. All in all, there is no shortage of supply for LMMPE targets with expectations pointing to an increase in deal volume.5

Deal expectations

A survey of more than 260 corporate executives and advisers this year shows expectations for more deals involving the middle and smaller ends of the market. The survey asked: What is your prediction for the volume of small, midmarket, and large=market/megadeal in the next 12 months compared to the previous 12 months?

Source: 19th Annual Mergers & Acquisitions Outlook Survey, Dykema Gossett P.L.L.C. • Note: Large-market/maegadeals are valued more than $1 billion. Mid-market deals are valued between $100 million and $1 billion. Small-market deals are valued less than $100 million.

LMMPE has a lot of flexibility in terms of exit options compared to its big brothers in large-cap PE. In LMMPE, these firms can sell small—to medium-sized businesses to a much larger set of strategic and financial buyers compared to large-cap PE. In large-cap PE, firms are limited to a strict list of massive strategic buyers or an IPO. The availability of many exit opportunities in LMMPE only increases the negotiation leverage when it comes time to sell.

99.9% of businesses in America are considered small businesses. These small businesses and public sector entities are not naïve. They know they will have to incorporate artificial intelligence into the infrastructure of their business to survive and grow over the next decade. Many of these businesses and entities do not have the in-house capabilities to implement AI. Therefore, these businesses and entities will turn to IT service businesses that have the capabilities to set up an AI infrastructure for small to mid-sized companies. This props up small to mid-sized IT service businesses as premier targets for LMMPE firms looking to deploy capital around an AI strategy. IT services will not be a winner-take-all market; there are simply too many customers that will need servicing. Select LMMPE firms are perfectly positioned to take advantage of this AI market opportunity using strategies like add-on acquisitions and operational efficiency improvements.

Investing in LMMPE has risks that should be considered. Investors should be mindful of liquidity risks generally associated with private equity investments. Additionally, private equity firms typically employ leverage in their investments, thereby exposing underlying businesses to debt- related risks, including changes in interest rates. Escalations in interest rates can adversely affect businesses and hinder their ability to execute strategic plans effectively. LMMPE businesses can also be more volatile given the size of the businesses. These businesses can suffer from intense customer or supplier concentration. It is thus critical to understand the manager’s strategy and due diligence process for new portfolio companies. Diversification amongst LMMPE strategies and managers can help mitigate certain risks, but investors should consider their risk tolerance and overall strategy before investing in LMMPE.

LMMPE has historically generated significant returns and is poised to continue to do so. However, it is crucial to understand fund managers’ strategies. Not every manager or portfolio company is equal. It is critical to ensure that managers are experienced, have a defined strategy, and have strong financing relationships. LMMPE managers are generally much scrappier than large-cap private equity fund managers, which can lead to higher returns, but understanding their skill and ability to execute is vital.

Sources:

1. Forbes, Jan 2024. "Small Business Statistics Of 2024"
2. A Simple Model, Nov 2022. "Private Equity Roll Up"
3. Leaders, Jun 2023. “Nepotism No Longer Driving Force In Family Business”
4. Institutional Investor, Aug 2023. “Not All Private Equity Dealmaking Is Slowing Down”
5. Crain’s Grand Rapids Business, Nov 2023. “More small, mid-market M&A expected in 2024, survey finds”