The M&A market remains white hot and the lower middle market is no exception. Sellers are undoubtedly benefiting from today’s strong market conditions. “The market is as robust as it’s ever been. We are seeing high valuations. Average purchase price multiples are at an all-time high in mid seven times EBITDA,” says Graeme Frazier, president of Private Capital Research LLC and a founder of GF Data, a data provider that tracks companies with enterprise values of $5 million to $250 million. “Even rising interest rates are not quelling demand.”
There are multiple factors leading to the frenzied deal pace in the lower middle market. First, there’s a tremendous amount of capital in the market. The abundance of dry powder has been well documented over the years. Second, the lending markets are feeding the frenzy. According to GF Data, debt multiples have reached a total of 4.2 times EBITDA and on the senior side they have inched up to 3.4 times EBITDA in the lower middle market. “It’s not a record, but there is sustained strength in the lending market for sure,” says Frazier.
Robin Engleson, a managing partner with Sapphire Financial, which provides debt and equity to middle and lower middle market companies, says it’s the combination of both the dry powder and equity available fueling activity. “You have an abundance of debt, and buyers are willing to over equitize these transactions today. Today, lower middle market companies that have a reasonable story have a good shot of getting the highest valuations they could ever get,” she says.
Additionally, some of the frothiness in the lower middle market can be attributed to larger buyout firms and strategic acquirers—perhaps priced out of their own markets—coming down market to find good deals. One of the main reasons private equity firms look down market is to average out their cost of capital. After buying a platform company at a high valuation they more frequently move down market to find add-on opportunities at a better price to average down their costs. According to Pitchbook, as of Q2 2018 roughly half of all buyouts globally and more than two-thirds of all buyouts in the U.S. are add-ons. In the first quarter alone add-ons accounted for 70 percent of all buyout activity.
Despite feeling like the market is at the top or close to it, market professionals don’t see anything on the horizon that will change market conditions anytime soon. “There’s no sign of a slow down. We are seeing a lack of good target companies, but there’s nothing to make us believe that demand for lower middle market companies will slow. It’s certainly a compelling market to be a seller,” says Frazier.
Sapphire’s Engleson says she is seeing creative lending structures put in place to help boost returns from lower middle market companies. “As soon as lower middle market companies reach a certain threshold, their valuation multiples go up. This has always been true, but the increase is more significant now. Buyers are entertaining the purchase of smaller and smaller companies as combining them and bringing them to that next level today can mean increasing their value from five to six times EBITDA to 10 times EBITDA. This scenario is happening a lot more frequently. It’s a great time to be a seller.”