How Private Equity Unlocks the Hidden Opportunities of the Lower Middle Market

The lower middle market consists of profitable companies that are major players in the global economy. But unlike their larger capitalized peers, they are fragmented and difficult to identify, and given their smaller size, these firms are typically under-resourced and under-invested.

These companies are ready to ramp up, and private equity can provide the capital, access to resources and dry powder to allow them to reach the next level.

Businesses with revenue between $10 million and $100 million are defined as lower middle market. But while they may be smaller than their counterparts, these firms typically comprise the largest segment in most economies based on the number of companies—and they make significant contributions to both employment and growth.

Based on figures from JPMorgan, there are approximately 250,000 businesses1 that fit into the classification of the lower middle market. But these companies are generally difficult to identify, which is why fund managers developed dedicated strategies to invest capital and build sophisticated deal sourcing infrastructure.

These firms present a unique opportunity to private equity, as they lack sophisticated financial guidance and may not be aware of their strategic options.

Lower middle market companies trade at attractive valuations. The sale process for firms led by founders is typically less competitive compared to investment banks. Lower middle market companies also typically trade at lower multiples than larger companies, creating an opportunity for investors who can grow them to scale and create value through multiple expansion, not just operational improvement.

Suboptimized growth. While there is evidence of historical growth, companies are typically under-resourced and under-invested, which can be improved with access to the resources of private equity firms. This includes the lack of sophisticated management systems, manual processes, and limited use of data analytics for decision-making.

Additionally, key roles are often unfilled or filled by under-qualified personnel, there is an informal human resources process, and limited-succession planning -- all factors that lead these firms to have limited access to growth capital and expansion limited by resources.

Private equity firms can address these limitations and create a clear pathway to value creation by improving operations and removing growth constraints that have historically limited the company's potential.

Through buying smaller companies at lower valuations and implementing operational improvements and synergies across the combined organization, the buy and build strategy is especially beneficial for the lower middle market.

The vast number of lower middle market businesses creates abundant acquisition opportunities and, when brought together by private equity, can provide economies of scale, enhanced market presence, and improved operational efficiency. Using a systematic approach to building larger, more professional organizations can help drive profitability.

One example of a buy and build strategy is Certara (CERT), a firm that primarily acquires companies that provide technology and services related to biosimulation, a critical aspect of drug development that uses mathematical models to predict drug behavior in the body.

Certara was formed through several acquisitions, beginning in 2007 with Tripos, 2008 with Pharsight and 2012 with Simcyp.2

Certara has continued acquiring numerous businesses as well as receiving investments from private equity. The firm recently completed its latest acquisition of Chemaxon, a developer of leading scientific informatics software products used by the life sciences industry for in-silico research.3 Through its buy and build strategy, Certara now has a market cap of $1.67 billion.4

As baby boomers reach retirement and consider succession plans, an interesting trend is arising. Instead of wanting to keep their businesses “in the family,” they are instead looking elsewhere. A survey from 20235 showed that over half of those surveyed (U.S. adults aged 50 or over who have at least $1 million in investable assets, and did not inherit most of their assets) did not want to pass their businesses to their families.

As these buyers prepare their exit strategies, there is a focus on driving profitable growth, professionalizing operations, and building a solid management team for growth acquisitions. This presents a huge entry point for private equity that specializes in lower middle markets.

As the middle market becomes more saturated, investors are turning to the lower middle market. Added in a favorable political and economic landscape, this presents private equity with an opportune time to embark on buy and build strategies for the lower middle market.

The untapped potential of smaller businesses—that total about 350,0006— can be scaled with strategic guidance, and capital infusion offered by private equity can also help unlock significant value. In this highly complex field, it is vital to choose managers with a defined strategy and strong financing relationships.

Sources:

1. Understanding middle market companies | BlackRock
2. Vector Capital | Investments | Certara
3. Certara Completes Acquisition of Chemaxon
4. Certara (CERT) Market Cap & Net Worth - Stock Analysis
5. Half of Business Owners Do Not Want Their Children to Inherit, Run Business
6. Middle Market M&A -- Is Your Private Equity Buyer About To Become An Endangered Species?