For the past several years, the middle market has been the engine of the heartland’s economy, consistently running stronger than most large corporations. The lower end of the middle market has been a particularly bright spot, exhibiting positive trends for an extended period.
The stability seen in the lower middle market over the last few years may inspire investors to anticipate a shift in the tide. Optimism can drive investors to be overzealous at peaks, while pessimism leads to excessive defensiveness and inactivity during rough patches. There are clearly challenges facing our market and indications that a broader slowdown might be on the horizon, but what do the data really tell us?
For more than three straight years, revenue growth in the lower middle market has far outpaced the S&P 500 index, running at 5.2 percent in the fourth quarter of 2015 and expected to stay positive this year, again outpacing the S&P. However, data from the National Center for the Middle Market included in SBIA’s Investment Insights find business owners expecting a meaningful decline in revenue growth going forward. It should come as no surprise that job growth in the lower middle market fell below 3 percent in the fourth quarter of last year; and while that employment level is well above the rates of large corporations, it was down sharply from growth of nearly 6 percent in the same period a year earlier.
The SBIA/NCMM Lower Middle Market Confidence Index also dropped significantly last quarter. With less confidence, smaller businesses have become defensive, shifting to a faster clip of debt repayment, while also holding cash in reserve. Small business owners are concerned about the future and they are adjusting.
“Optimism can drive investors to be overzealous at peaks, while pessimism leads to excessive defensiveness and inactivity during rough patches.”
Fund managers are making adjustments too. Investors are always looking for standout companies and the data suggest they are exceptionally hungry for businesses that can grow in the face of economic stress. GF Data’s analysis shows the “quality premium”—the reward in valuation applied to selling businesses with above-average EBITDA margins and sales growth rates—has never been greater. Firms offering these characteristics were valued in buyout transactions at an average 7.4 multiple in 2015. Other buyout targets traded at an average of six times EBITDA. This 23 percent premium dwarfs the historical spread of 6 percent, which may signal doubts about the economy’s future growth.
In the fourth quarter, multiples rose for businesses in the $50 million to $250 million range, but were down or relatively flat for the smaller categories of $25 million to $50 million, and $10 million to $25 million. These lower market bands tend to have less variation in multiples, but the froth of the upper middle market is pushing them down. I still hear from general partners about wildly overpriced deals driven by large strategic players stretching far down market. For now, at least from what anecdotal accounts reveal, the challenges of scale have slowed this froth from moving too far and too fast downstream.
Given the sheer volume and diversity of the lower middle market, there will always be great growth businesses for investment, but finding a deal at a great price that hasn’t already been over-shopped takes more effort than usual.
In an election year, we must consider another factor that wouldn’t normally drive business sentiment—politics. Investors and entrepreneurs embrace business risk, but they loathe political risk.
During this election cycle, the only time private equity is mentioned by policymakers and candidates is when it is called out as an example of greed, considered a potential catalyst for economic calamity. Private equity has become the poster child for an unfair tax code and reckless risk-taking, often lumped into a general investment category with hedge funds and mutual funds. Businesses never look to government as their savior, but this election cycle has provided a whole new list of things to worry about.
Under these circumstances, it is not irrational to be concerned. To be sure, the middle market—the heart and soul of a growing economy—is facing some strong headwinds. Lower middle-market businesses have become more defensive and risk averse. Economic growth is sketchy and politicians could make it worse.
Given this market volatility, the sellers’ market may be shifting. Even so, we must bear in mind that there are plenty of good opportunities for those willing to do their homework. The core private equity recipe for success has not changed: work hard to find good companies, pay reasonable prices, and work to grow those businesses. The stability in the lower middle market is not just the result of a lucky run, but instead reflects the underlying substance and volume of small businesses demanding capital. The lower middle market is feeling the pressure, but it ultimately remains a solid market segment for investors.
Brett Palmer is president of the Small Business Investor Alliance, the premier organization of lower middle-market private equity funds and investors. SBIA works on behalf of its members as a tireless advocate for policies that promote competitive markets and robust domestic investment for growing small businesses. SBIA has been playing a pivotal role in promoting the growth and vitality of the private equity industry for over 50 years. For more information, visit SBIA.org or call (202) 628-5055.