What Is The Lower Middle Market?
What Is The Lower Middle Market?
The term "Lower Middle Market" refers to a specific segment of businesses in the economy, and it's determined by these firms' yearly income. In simple terms, it's like sorting companies based on their yearly earnings.
Companies in the lower middle market are typically rated just above small and medium-sized businesses (SMEs), with annual revenues under $5 million.
The employed capital assets and the number of employees are other measures that may be utilized in specific situations, even though the annual revenue is the most typical criterion.
With more than 90% of all middle-market businesses being lower-middle-market, this is often the largest number of businesses in most economies throughout the world. Lower-middle-market businesses typically contribute significantly to both the national and international economies.
They frequently contribute significantly to the creation of jobs and the gross domestic product (GDP) in their respective national economies.
Why M&A Is Moving Toward The Lower Middle Market
As some of the most sought-after assets, middle-market businesses offer one of the best environments for M&A investors to generate returns. Middle-market companies appeal to many private equity (PE) firms and strategic acquirers.
This is because there are more companies to invest in, more potential to develop enterprises, and lower valuations and entry hurdles (strategics). That allure, though, comes at a price—increased competition in a middle market that is already oversaturated.
The lower middle market is becoming more and more popular among strategic investors and PE firms as a result.
The rise in opportunities offered by the lower end of the market, combined with other elements that make it a gold mine for investors, are the main reasons for this market segment's growth.
Despite the size of deals in the upper middle market, rising M&A target rivalry is raising valuations in this industry, raising the bar for returns on investments and making it more difficult to meet.
Investors can acquire companies at better prices and expand those companies to generate the requisite return for their portfolios by focusing on the lower middle market instead. That’s why this segment of the market is becoming more competitive.
Challenges And Opportunities In The Lower Middle Market
Small- to medium-sized businesses with annual sales between $5 million and $50 million are considered to be part of this market. Businesses in this group typically receive more offers from investors interested in buying them, even though it takes a lot of work to obtain them.
A large number of people frequently underestimate the difficulty of a business to enter the lower middle market. The intricacy of the firm rises in the lower middle market.
You must learn how to manage managers if you want to go upstream from being a microbusiness to a medium market firm. Therefore, management and hiring abilities are crucial in the lower middle market.
The owner of the organization must develop management skills and understand how to define and monitor standards.
Because there are so many alternative capital sources available, lower-middle-market companies can compare them all and choose the capital structure that best suits their needs.
At this end of the market, there are a lot of businesses that work in very fragmented sectors.
Simply by driving around any local area, you can observe this fragmentation in anything from HVAC equipment suppliers and servicers to pool maintenance and other small companies.
It creates a "sweet spot" for strategic and financial purchasers when a sector is highly fragmented and profitable.
For instance, private equity plans frequently use a strategy that involves purchasing a larger "platform company" before looking for smaller "bolt-on" acquisitions in the lower middle market to expand the business from there.
The tactic is frequently known as a "roll-up." If executed properly, it can result in substantial gains for both the buyer and the acquired business. In the lower middle market, owners and managers frequently seek retirement-related exits. Buyers and sellers can both benefit from this reality.
Before deciding to retire or leave, it's common for there to be no succession plan in place. A transfer is frequently difficult for small enterprises without a strong network of senior executives, and passing the company down to one's offspring is frequently not a viable choice either.
Other times, the idea of selling the company pops into someone's head on the spur of the moment in response to personal "black swan"occurrences like health issues.
How To Manage Lower Middle Market Businesses
Numerous boutique investment banks and private equity firms concentrate on this market category and develop their skills in closing acquisitions there.
Investors often utilize the classification to weigh the category's strong growth potential against the associated risk to arrive at reasonable valuations.
Due to the lower valuation multiples in such a market, many prospective buyers frequently look there for purchase prospects.
For companies in the lower middle market, skilled business buyers can also get operational upgrades more quickly. A valuation premium is generally demanded by these companies since they have a greater chance of expanding and joining the upper sector.
As a result, the classification causes a market for divestitures to grow healthily.
Although it is not always the case, the majority of top management positions in lower middle market companies are held by family members. You must develop good interpersonal skills to run a profitable firm in the lower-middle market.
Your ability to perform well will determine how successful your firm is. In general, hiring is important, but it is considerably more critical in the lower middle market.
The success or failure of the firm will depend on whether the appropriate people are in the proper positions because the business owner can no longer participate in every decision.
This indicates that there is a large amount of available capital in the market. According to reports, 70 percent of these companies are expected to change hands in the next ten years.
In addition to the enterprise value, it's critical to comprehend the goals of investors and any potential synergies that could result from a purchase. The total is larger than the sum of its parts, as they say.
Capital Sources Used By Lower Middle Market Companies
While some strategic firms use M&A to purchase new goods and services to be competitive in their sectors, PE companies are chasing high portfolio returns. Deal flow and values will remain robust due to these two market drivers.
Therefore, business owners considering exiting their company must be flexible and quick to seize chances. Owners must be well prepared and aware of their obligations before they can reap the potentially huge financial rewards.
1. Bank Loans
For lower-middle-market businesses in good financial standing, bank debt is the most prevalent and reliable source of finance. Typically, banks require an operating history of at least five years, with the most recent years being profitable.
You may be wondering what financing choices are accessible to these companies. They’re in an awkward spot between larger, more established enterprises that rely on bank loans and startups that rely on angel investors and venture capital. So what do they do?
The answer is middle market lending, a term used to highlight the adaptable funding choices available to these firms to advance their businesses.
Although banks have historically offered few lending options to middle-market businesses, this issue worsened after the recession due to heightened regulation and compliance worries for banks.
In response to these more stringent regulations, banks prioritized upper-market companies with reliable cash flow, adequate collateral, and low debt-to-income ratios. Since private lenders do not have the same restrictions as banks, middle market enterprises have started using them.
Because of this, these institutions can assume more risk, build stronger partnerships with businesses, and offer flexible, multi-layered financing that encourages rapid growth.
2. Mezzanine Debt
Mezzanine debt is a category of debt that resembles equity in some ways. Mezzanine financing is mostly utilized by lower-middle-market companies as a source of funding for acquisitions, while it can also be used for growth capital and other financial requirements.
It has several advantages, including little to no dilution and a comparatively higher investment quantity. This makes it the perfect method for funding family-run enterprises.
Mezzanine financing combines debt and equity financing, giving lenders the option of converting equity interest in the event of a loan default, which is one common type of middle-market loan.
Unlike typical bank loans, a mezzanine loan is very flexible, requires little collateral, and finances a business according to its capital flow. It is possible to organize the loan as preferred equity for capital financing or according to the order in which it is paid.
Due to the financial stake it provides, mezzanine financing is especially enticing to entrepreneurs and family-owned enterprises. This is because it enables them to collect profits they might not otherwise realize. They can diversify their investments and get liquidity as a result.
3. Loans based on assets
Asset-based lending can provide the necessary funding when a company's assets are used as security for a line of credit.
With some funds being advanced against capital assets as well, the asset-lending class primarily focuses on inventories at 61% and accounts receivable at an average of 86%.
Senior debt loans allow businesses to borrow money at low-interest rates with low risk to the lender. In exchange, firms pledge their tangible assets as collateral.
Because the loans they provide are considered senior debt, the holders are secured creditors. These are lenders who are protected by the company's assets and will be paid before other creditors if a company ceases to exist and/or files for bankruptcy.
The term "asset-backed" or "asset-based loans" is another name for these types of loans.
4. Companies with a public or government sponsorship
If you need money for recapitalization, growth acquisitions, expansion buyouts, etc., public entities and government-sponsored entities are good places to start looking.
Summary
The proper buyer, whether financial (private equity) or strategic, will always offer profitable options that enable the off-ramp and transition that the current ownership is looking for.
As a result, there has been a sharp rise in the demand for businesses at this end of the market, along with a commensurate awakening of ownership to understand and evaluate the advantages of a sale procedure.
A steadily expanding pool of capital is held by investors who are eager to invest it to get returns that they cannot acquire from other sources. Compared to much larger enterprises, they enable investors of all stripes to buy assets with very little debt and, consequently, risk.
Another factor that must be reviewed when selling your company is the impact of the COVID-19 pandemic. Numerous small enterprises at the lower end of the market have been harmed, if not destroyed, by COVID.
Additionally, it prolonged the mergers and acquisitions process. These two conditions have resulted in boosted demand and constrained supply, leading to notable increases in activity and deal volumes as the economy starts recovering.
Owners of businesses must be prepared to seize possibilities for sales as they arise. Selling your business involves several considerations. Different people and organizations will drop by to ask questions regarding the potential sale of your business.
It may be tempting to accept the first offer that comes along. However, it is important to gain a thorough grasp of the larger market and where the greatest synergies/motivations and, hence, the best valuations may be discovered.
There are usually more business opportunities than one might anticipate and prospective purchasers for all kinds of businesses.
Investors increasingly view these vehicles as sources of greater returns, which is why the trend toward middle-market funds goes beyond a cost-cutting measure for specialist funds.
Compared to co-investments and small- to medium-sized generalist funds, "small to medium-sized sector specialist funds" had a higher potential performance rating.
Author(s): David Bickerton
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