WHITEPAPER: Tapping the Growth Potential at the Lower End of the Lower Middle-Market


Tapping the Growth Potential at the Lower End of the Lower Middle-Market

Why Private Equity can be the Solution

 

By Chris Joseph and Robert Shuford

Clovis Point Capital

August 2015

 

According to the most recent U.S. Census data, the lower middle-market is by far the largest segment of the economy by number of companies, representing 90 percent of all businesses in the United States. Traditional private equity investors, along with other financial and strategic investors, have long been active in the lower middle-market. However, at the lower end of the lower middle-market, defined as businesses that earn $500,000 to $3 million before interest, taxes, depreciation and amortization, or EBITDA, lies one of the largest and growing pools of investment opportunity.

Within this sector lies a capital gap, which offers some of the greatest opportunities for long-term growth and wealth creation to experienced investors. For several reasons, these companies are often overlooked by most forms of institutional capital. At the same time, traditional lending to these small businesses has dramatically lagged behind loans to larger companies coming out the Great Recession. As such, despite numerous investment opportunities, these businesses have experienced slower growth compared to the broader market.

Generally, the lower middle-market is composed of companies with between $10 million and $100 million in annual revenue. In the U.S. alone, according to census data, there are more than 32,000 companies that fit this criterion. Furthermore, a survey of small and middle-market businesses conducted by the Milken Institute and the National Center for the Middle Market showed a significant number of these businesses plan expansions in the near term. This has forced business owners to examine their financing alternatives, as even cash-flowing businesses struggle at times to finance larger strategic initiatives internally. However, despite the large number of businesses, properly capitalizing companies in this market has become increasing inefficient in recent years and is, in many cases, not available.

A large portion of this problem can be attributed to the fact that banks remain reluctant to lend to this market. A report from the Federal Reserve Bank of Cleveland found that the volume of loans under $1 million dropped significantly between 2008 and 2012, and lending at this level has struggled to recover.

The report also found that small and commercial and industrial loans grew just 3.4 percent over the last year, and the lending rate stands 17 percent below the peak reached prior to the recession. At the same time, lending to larger businesses bounced back quickly, and loans outstanding are now 24 percent higher than prerecession levels. It is undeniable that smaller businesses are at a greater risk of failure in any down cycle. Even for an entrepreneur who can obtain a loan, the principal and interest payments accompanied with restrictive covenants can make loans unattractive. Furthermore, the increasing requirements of personal guarantees, especially for those asset-light businesses looking for loans, is forcing business owners, who already have the vast majority of their personal wealth tied up in their business, to look elsewhere.

Although the Milken survey indicated most small firms prefer to go to banks and lenders with whom they can or have an established relationship when they need growth capital, it also notes that many have limited knowledge of alternative sources of financing that might be available to them.

Private capital represents that alternative solution. Private capital encompasses a large array of investors including friends and family, angels, family offices, venture capital funds and, of course, traditional private-equity funds. An added benefit of these investors is that they offer professional guidance in addition to the capital necessary to help lower middle-market companies pursue growth initiatives. However, the appropriate type of private capital depends on the company and its management objectives.

Friends, family, angel investors and family offices can be extremely valuable to finance the startup stage of a company and smaller subsequent growth rounds. However, as businesses grow, the ability of these lenders to provide larger, more significant amounts of capital quickly dries up. Family offices may have the excess liquidity to fund larger initiatives, but that capital can be very hard to access, especially for an entrepreneur with a limited network, and family offices tend to move slower.

Venture capital is typically the next avenue pursued. These funds target extremely high growth companies. They have significant capital bases that allow them to fund both organic and inorganic growth initiatives. But, venture capital investors will want significant if not outright control of a company, which many entrepreneurs are reluctant to give up.

Generally, sales to or partnerships with private-equity firms offer the maximum value to lower middle-market companies, according to acquisition and strategy expert Joseph Feldman. Like venture funds, private-equity firms also offer access to abundant capital, executive talent, industry connections and knowledge of new products and technologies.

However, getting the attention of private equity firms is increasingly difficult for those companies operating at the lower end of the lower middle-market. For one, many investors have become more focused on larger transactions. No matter the size of a company, due diligence is the essentially the same. With so much capital currently on the sidelines, it is more efficient for investors to deploy more capital in a few transactions than vice versa. Furthermore, larger companies typically are more sophisticated from a management and financial perspective, making due diligence less cumbersome. There is also less perceived risk associated with larger businesses, as they tend to have a more established market presence and cash flow characteristics.

Clovis Point seeks to address this capital deficiency. We are investors who look to partner with management teams operating in the lower end of the lower middle-market to help them build value in their businesses. We are actively pursuing change of control and growth equity investments for those businesses that have looked everywhere else. Let our professionals work with you to build great growth stories together.