Unlocking the lower mid-market opportunity
Strategic buyers and private equity firms are increasingly chasing acquisition opportunities in the lower middle market.
Research has long shown that the most effective M&A strategy is to buy small and often, and technology is now making this approach more accessible than ever. Buyers can source deals easily, see information about targets earlier in the process and move to discussions quickly.
This is creating a step change in the market for companies with revenues between $5 million and $100 million, where valuations are still highly attractive.
Deals in this size range tend to be valued lower because smaller companies are more likely to depend on key customers, suppliers or staff. If one of these key stakeholders disappears, the company could be significantly affected. The so-called small firm premium reflects the added uncertainty associated with buying such companies.
That means individual deals in the lower mid-market can be risky, but buyers are finding that these risks can be minimised through a programmatic approach to M&A — and this is backed by research.
A long-term study by McKinsey has shown that a series of smaller deals built around a specific business case or theme delivers better returns at lower risk compared to large one-off deals, selective acquisitions or organic growth. In almost every sector, programmatic M&A comfortably outperformed all other strategies. This was especially the case in advanced industries and energy and materials, but also evident across transport, pharma, financial services, retail and healthcare.
As in previous downturns, this trend has held up throughout the pandemic. A large part of this outperformance may be due to the discipline and understanding that companies gain by adopting a programmatic M&A mindset. Buyers that are highly active tend to have a good understanding of their own competitive advantage, are confident in pursuing deals and know their limits.
This means they are well positioned to take advantage of downturns, when other buyers may be overly cautious or are simply unable to see where the best opportunities lie. Such confidence has helped fuel European private equity deal values to an all-time high of €98 billion during the third quarter of 2021, according to Unquote.
The lower mid-market is extremely fragmented. Across Europe, there are many thousands of companies in the $5-$100 million range, often serving small geographic areas or business segments. These types of companies are prime candidates for consolidation by buyers with a clear strategy — and the diversity of businesses means that there is no shortage of specialist strategies that can be accommodated.
Another driver of lower valuations in this space is the big amount of firms. There is a glut of businesses founded by the baby boomer generation that are on the market to fund a retirement or an inheritance. Many have long track records of solid profits and excellent relationships but are below the radar of buyers who target hand-picked opportunities or trophy deals.
Indeed, there are still abundant opportunities in the lower mid-market even as more buyers start to recognise the opportunity. This is in stark contrast to the market for larger companies, where there is intense competition for fewer opportunities and, as a result, less opportunity for value-creating deals.
While the evidence supporting a programmatic approach is clear, many buyers continue to employ traditional M&A strategies. There are a variety of reasons, but the most common is that organisations are typically conservative and resistant to change.
Such caution is understandable. From the outside, many of the positive factors that support the case for investing in the lower mid-market are also intimidating — thousands of small companies in highly fragmented markets with risky characteristics. In the past, it was justifiable to view investing in this space as too complicated.
That has changed today as technology has emerged that can unlock the opportunity. To access this fragmented market, buyers need new ways of sourcing deals. With more incoming dealflow, they need to be present. Those who are embracing technology in M&A are emerging as the winners.