Glance at the front page of the Wall Street Journal on any given day, and there is a good chance the term “private equity” will be mentioned at least once. Whether in a discussion on federal tax policy or in an announcement of the latest multi-billion dollar buyout, it seems everyone is talking about private equity. Despite the term’s newfound ubiquity, it is important to avoid painting the entire industry with the same brush. In this article, we note some key differences between various types of private equity and discuss our views on the opportunities and challenges present in an often overlooked sector, the lower middle market.

Generally speaking, private equity can refer to any sort of partnership which invests in the securities of a company, but it is most often used in the context of high-profile leveraged buyouts of large, mature companies. After these larger transactions are completed, the investors tend to focus on identifying operating efficiencies and optimizing the balance sheet, and to a lesser extent, shaping future corporate direction. For private equity deals on the smaller side, successful investors usually work closely with the company’s management team and devote significant resources to helping define and execute a growth strategy. This focus is especially important for investors focused on the lower middle market (LMM), which we define as the set of all companies with revenue between $10 and $50 million. LMM investing presents a unique set of challenges for the private equity investor, but also offers opportunities for solid returns.

One factor contributing to our optimism in the LMM is the sheer number of companies in the sector. According to the Small Business Administration, the lower middle market is comprised of nearly 125,000 U.S. companies, compared to only 30,000 companies with revenues exceeding $50 million. As a result, LMM-focused investors generally face less deal competition relative to their counterparts who target larger companies. Further, LMM companies are comparatively less likely to retain sell-side advisors, so fewer deals go through a formal auction process. Given these two factors, it is not surprising that larger transactions tend to be valued at higher earnings multiples compared to LMM transactions. This “multiple expansion” is clearly evident in a recent Standard & Poor’s study: the average leveraged acquisition in the first half of 2006 was valued at 10 times the target’s EBITDA, compared to a 7.5 multiple for transactions valued at less than $250 million¹. We believe that this valuation arbitrage could be a key reason why smaller funds average a 20-year rate of return of 25%, more than 10% higher than the average across all fund sizes (Exhibit)².

Another interesting aspect of the LMM is that the owners and managers of LMM companies who would not consider an outright sale to a strategic buyer are in many cases willing to partner with private equity firms. These investors can offer existing stakeholders upfront liquidity while allowing them to retain a portion of their equity stake and can also provide the resources and expertise necessary to facilitate the expansion of the company.

While there are a number of advantages to the lower middle market, private equity firms must be aware of the challenges as well. Firstly, companies in the lower middle market tend to be riskier than larger companies as they usually have less robust internal infrastructure and processes in place and are more likely to have issues with customer and product line concentration. Secondly, while the departure of key management is a serious risk to the success of any company, this is especially true in the lower middle market, mostly due to the aforementioned lack of formal infrastructure and process. Finally, deals in the LMM, though smaller in size, often require the same commitment and resources from private equity investors. Therefore, private equity firms need to ensure that the potential returns are sufficient both in terms of achievable IRR and absolute dollar returns.

In order to overcome these challenges and unlock the potential of the lower middle market, we believe it is necessary for private equity firms to focus on three key principles:

In conclusion, we believe that there are significant opportunities for the foreseeable future for vertically-focused private equity firms who are committed to the lower middle market. As more private equity firms enter the lower middle market and as more company owners become open to the idea of partnering with financial investors, those firms who have built a successful track record and a solid reputation in the lower middle market will be well-positioned to lead this important segment of the private equity landscape.

¹ Standard & Poor’s. Leveraged Commentary & Data. 2006.
² Thomson Financial. Buyouts, Net Performance as of 9/30/2006. 2007.