Lower-Middle-Market (LMM) companies are some of the most sought-after assets, providing one of the best environments for Mergers and Acquisitions (M&A) investors to create returns. With more companies to invest in, greater opportunities to improve companies, and lower valuations and barriers to entry, LMM companies are attractive to many private equity (PE) firms and strategic acquirers (strategics). COVID-19 has only increased the demand for LMM businesses, as investors who would normally seek larger deals are moving down the spectrum and now looking at smaller businesses. These deals are smaller, less risky, and require less debt – all of which means demand is continuing to grow during these times. We saw the same phenomenon in 2008-2009 – most of the M&A deals completed during that time were with LMM businesses.
Investment Sweet Spot
LMM firms operate in highly fragmented and very profitable industries, making them prime targets for acquisition and consolidation. The LMM is classified as companies with annual revenues between $1 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).
Over the past 12-18 months, there have been over 300 M&A transactions involving HVAC companies, illustrating the consolidation in that sector and hunger of investors for LMM businesses.
Contractor-based business are extremely fragmented industries. As an example, there are over 75,000 HVAC services business in the United States alone. Over the past 12-18 months, there have been over 300 M&A transactions involving HVAC companies, illustrating the consolidation in that sector and hunger of investors for LMM businesses.
Retiring with No Succession Plans
One cause of the increased number of M&A opportunities in the LMM is its large population of baby boomers. The owners and CEOs of LMM 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. Most LMM business owners tend to wait and think about succession after a trigger event such as health event, business decline, loss of key personnel, etc. These triggers are rarely positive, meaning it is a reactive activity rather than a proactive one.
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
Increased competition for middle-market or enterprise M&A targets are driving up valuations, making the hurdle rate for a return on those investments much higher and harder to obtain. By targeting the LMM 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 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.
Abundance of Capital
Investors and acquirers are sitting on record amounts of cash. They have raised money at record paces over the past few years, and that capital needs to find a home. And due to COVID, public capital markets are extremely volatile, so they look to the private markets to deploy capital and earn returns. This means they want to acquire and invest in private, LMM businesses. They want to help these companies grow substantially and share in the reward of that growth. There is currently over $3 Trillion dollars of un-used capital waiting to be deployed, which is another large driver of M&A demand. Investors don’t like their capital sitting idle, so they’re anxious to get out there and spend it.
Relevance for Lower Middle-Market
Companies
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 LMM 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. COVID has impacted the supply of available companies for acquisition, so the demand and competition has only increased further.
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 LMM 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.
