3 Reasons Why M&A Investors Should Focus on Lower Middle Market Firms

To create returns, there has been a trend among M&A investors to invest in middle-market companies, those with revenues between $100 million and $500 million. The firms are plentiful, with opportunities for improvement, lower valuations, and reduced barriers to entry.

Yet, their popularity among investors has increased competition in an already saturated market. As a result, M&A investors are increasingly looking at the lower middle market, companies with annual revenues between $5 million and $100 million, to find returns. There are three reasons why investors should focus on lower middle-market businesses.

Opportunities are plentiful

Lower middle-market firms are good targets for acquisition and consolidation because they operate in highly fragmented and profitable industries. According to Forbes, there are approximately 350,000 lower middle-market companies; 25,000 middle-market companies; and only a few thousand upper middle-market companies with revenues above $500 million. While firms in the lower middle market have lower revenue valuations, this segment of the market offers many more opportunities.

Owners and CEOs are motivated to sell

Seventy percent of businesses in the lower middle market are expected to change hands in the next 10 years. One salient fact of the lower middle market is the predominance of baby-boom generation CEOs and owners who want to retire. Yet, many of these owners and managers lack a succession plan because they do not employ a C-suite. Their children have also pursued higher education and established their own careers, so they have little interest in running the family business.

The lack of a viable succession plan and a desire to enjoy retirement means that many of these business owners and CEOs are eager to sell up. This presents investors and corporations with unique opportunities to acquire, consolidate, and grow lower middle-market companies.

Better valuations and lower hurdle rates

Increased competition for M&A targets in the upper middle market is driving up valuations. This increases the hurdle rate for a return on those investments and makes returns harder to achieve. While competition in the lower middle market is intensifying, investors can still acquire businesses at better valuations and grow those businesses to achieve the return they need.

For leveraged buyouts of businesses with enterprise values below $250 million, the 10-year average purchase price multiple is currently at a peak: 7.3 times EBITDA. While the market is increasingly competitive for buyers, new companies are ready for investment. Investors are discovering value in lower middle-market portfolios, as they can generate up to 50 percent invested capital return.

Invest in understanding the lower middle market to be successful

Because PE firms are chasing large portfolio returns, and existing firms are using inorganic growth to remain competitive, there is a lot of capital ready to be put to work. As a result, deal flow and valuations will remain strong.

Business owners considering an exit need to be ready to respond quickly to emerging opportunities. While the financial rewards can be high, owners need to understand the motivations of investors and the potential synergies that might be gained through a transaction in addition to the enterprise value.

Investors who take the time now to understand lower middle market M&A dynamics, including the numbers that highlight the opportunity and the skills needed to be successful, will more fully establish themselves in a market that, due to its sheer volume, is far more difficult to saturate.

Please contact us for a confidential discussion of your specific situation. We have experience helping business owners across various industries sell their businesses, as well as relationships with buyers interested in new opportunities.