Why Less is More: The Case for Private Equity in the Lower Middle Market

(5 minute read)

Every year, hundreds of private equity funds raise billions of dollars, all with the goal of acquiring business interests, creating value, and realizing returns for investors. Against macroeconomic uncertainty and rising rates, 2022 saw a notable drop-off in fund count (-42%) and dollars raised (-20%) following a banner year in 2021. Even still, 742 funds raised $464.2B in 2022, and through March 31, 2023, 103 private equity funds raised $97.1B with approximately 71% raised in North America according to PitchBook. [1] With a finite amount of capital to invest and an overwhelming selection of investment options, Brightside Partners’ investment team focuses on the best potential risk-adjusted returns for our clients. We have and continue to believe that the lower middle market segment of private equity can provide compelling risk-adjusted returns given its inherent inefficiencies and position in the capital markets. 

Large pool of investment opportunities

To start, the lower middle market provides a large pool of investment opportunities. According to the National Center for the Middle Market (“NCMM”), there are nearly 200,000 middle market companies in the U.S. The NCMM defines the middle market as businesses with revenues ranging from $10M to $1B, which includes the following segments: upper middle market (revenues between $100M and $1B), core middle market (revenues between $50M and $100M), and lower middle market (revenues between $10M and $50M). Moreover, the NCMM reports that lower middle market companies grew revenue by 11.6% in 2022. [2]  We believe the size of the middle market reduces the likelihood of private equity sponsors competing against one another to acquire businesses. Instead, the sponsors with which we invest are often sourcing investments proprietarily through industry conferences, networking, and referrals. 

Limited alternatives for Capital

Following the Global Financial Crisis (GFC) in 2007-2009, the Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was enacted. Among the many impacts of this massive piece of legislation were stricter capital reserve requirements for banks, which led to a pullback in lending to the middle market. Furthermore, Dodd-Frank accelerated consolidation of small and regional banks through acquisitions by larger banks. This exacerbated the pullback in middle market lending as larger banks are less likely to lend to regional businesses with smaller financial profiles (i.e., lower revenue and profitability). As a result, lower middle market companies are increasingly relying on non-bank financial institutions to secure funding for growth, which has led to increasing investment by private equity firms. As the opportunity set grows, private equity firms attempt to differentiate themselves from their peers by providing both capital and hands-on support to help their portfolio companies take their businesses to the next level.

Compelling value-add opportunities

By their very nature, smaller companies can grow faster than their larger counterparts, but that alone does not warrant investment. More importantly, many companies in the lower middle market have “low hanging fruit” for unlocking value for owners. Many lower middle market businesses are family- or founder-operated and have simply done things a certain way without considering the alternatives. Private equity sponsors in the lower middle market are often the first institutional capital invested in these family businesses. Therefore, skilled private equity sponsors can implement best practices and improve financial reporting, technology, management, efficiency, and more to increase profitability and create value. For this reason, we pay attention to whether a private equity team has meaningful operating experience. Examples of common value-add initiatives include building out sales teams, bringing on C-suite talent, and implementing ERP software; these are often “easy fixes” that have meaningful positive effects.

Direct sourcing of investment opportunities

RCP Advisors is one of the largest investors in the lower middle market segment of private equity in North America. According to their internal database, which contains information on more than 36,000 transactions, median purchase price multiples on <$100M enterprise value companies were 8.4x (EV/EBITDA) in 2022 and averaged 6.9x since 2005. In contrast, PitchBook data on the broader U.S. private equity buyout market reported a median purchase price multiple of 11.5x in 2022 and 9.5x average since 2005. [3] This dynamic in the lower middle market provides private equity investors the opportunity to acquire businesses at more attractive valuations (relative to the upper middle market), grow them into the upper end of the middle market, and exit them at higher valuation multiples. 

Lower leverage

RCP Advisors’ data also show that lower middle market companies tend to transact with lower debt levels than their larger counterparts. According to their internal database, median entry net debt levels on transactions involving <$100M enterprise value companies were 3.7x (Net Debt/EBITDA) in 2022 and averaged 2.9x since 2005. In contrast, PitchBook data on the broader U.S. private equity buyout market reported a median Debt/EBITDA multiple of 5.9x in 2022 and 5.4x average since 2005. [4] With less debt in their capital structures (i.e., lower debt service costs), we believe lower middle market companies are more resilient in the face of economic downturns or rising rate environments. This thesis is supported by lower defaults rates in the lower middle market direct lending market versus the leveraged loan market.

Multiple exit opportunities

[1] Pitchbook. Global Private Market Fundraising Report Q1 2023. May 24, 2023.

[2] National Center for the Middle Market. Mid-Year 2023 Middle Market Indicator. 2023.

[3] RCP Advisors: GPScout – RCP’s proprietary analytics database – provides private fund and investment-level performance data and analytics drawn from fundraising and diligence documents produced by general partners and publicly available information, as well as quarterly unaudited and audited annual financial statements produced by RCP’s underlying fund managers. RCP has not independently verified any such information provided or available to RCP.

[4} RCP Advisors:GPScout

Disclaimer

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