Fragmented Lower Middle Market with Lower Risks and Higher Growth Potential will Drive M&A

Given the global pandemic, M&A activity in the first three quarters trails the previous year significantly. Worldwide M&A activity totals $2.342 trillion during year-to-date 2020, down 18 percent compared with the same period last year, according to Refinitiv. The year-to-date tally marks the lowest year to date period for dealmaking since 2016, when it was $2.339 trillion. For more, see M&A Rebound Going Strong.

One segment that is still holding up well and is attracting buyers is the lower middle market. Mergers & Acquisitions spoke with Dena Jalbert, the founder and CEO of Winter Park, Florida-based lower middle-market advisory firm Align Business Advisory Services about what is driving deal activity and her predicitions for 2021.

What is driving deal activity in the lower middle-market?
Financial investors, specifically private equity, are sitting on record amounts of capital. “Buy-and-Build” investments comprise nearly 67% of overall PE portfolio investment strategy. The lower middle market is very fragmented, comprised of thousands of smaller businesses, making it a prime candidate for consolidation in a buy-and-build strategy. Here PE investors acquire several smaller businesses, pool them together to achieve economies of scale and rapid growth, and then exit the larger business at a higher return. The returns are much higher in lower middle-market consolidation strategies because there is more greenfield market share for lower middle-market businesses to obtain. Larger, enterprise businesses, don’t have as much room to grow as they have saturated their markets, so the returns on growth are much smaller. This is what makes lower middle-market investment so appealing and why so many investors are competitively pursuing investments in the sector.

Which sectors are standing out and why?
Many lower middle-market sectors are recession resistant as they provide essential services – as demonstrated the past 6 months – things like heating, ventilation, and air conditioning, healthcare services, waste management, distribution, cleaning services, and so forth. These sectors are good, old fashioned “need to have” businesses that generate consistent, strong cash flow. They are less risk and the income streams are more predictable, which has made them very attractive investment targets.

How has the pandemic impacted the lower middle-market compared to others?
Covid-related macroeconomic conditions have caused investors who would traditionally invest in larger businesses to move down the spectrum and invest in smaller businesses. They do this because lower middle-market deals are smaller, less risky, and don’t require a large amount of leverage (or any leverage at all). The businesses deemed “essential” have all remained stable, and some have grown, making them attractive investment targets. As mentioned previously, investors are still eager to deploy capital so they focus their efforts on the sectors who haven’t been as impacted by Covid.

What challenges have you faced closing deals during the pandemic and how have you overcome them?
M&A is a relationship game. When a buyer and seller come together, it’s essentially a marriage. As such, face-to-face meetings are critical to ensure rapport and synergies. Not being able to travel and be face to face has been a challenge in getting deals done. Virtual solutions like video conferencing and video facility tours have been good short-term substitutes, but it’s not a permanent replacement. Risk underwriting for Covid conditions has also been challenging – because we have never experienced something like this before, it’s difficult to underwrite potential risk scenarios. This has impacted representation and warranties insurance underwriting and availability of debt in deals.

What advice are you giving clients who are considering making a deal in this environment?
Do it. Don’t be deterred by what they’re seeing in the media, as that is geared toward much larger entities. For the lower middle market, it is a sellers’ market with heightened competition for good assets. However, on the other hand, for those who have been severely impacted by Covid, we are recommending they wait until their business stabilizes, or they risk giving up too much value.

What advice do you have for other dealmakers who are looking to do the same?
Not to let any deals potentially affected by Covid impact their momentum. Network with investors and understand their current mandates, and let it guide your efforts in replenishing your pipeline. We’ve been very fortunate and saw our deal pipeline grow through the pandemic, which signals to us the strength of the lower middle market.

What is your forecast for lower middle-market M&A in 2021?
We believe lower middle-market dealmaking will continue to be strong. Lower middle-market businesses will continue to flourish due to their anti-recession characteristics, drawing even more attention from investors. Competition for good assets will increase among investors, causing valuations to hold strong and likely increase. Our phone is ringing constantly with investors looking for deals, and we expect that to continue into 2021. The risk of rising capital gains tax will also spur M&A activity, as sellers will want to execute deals before those changes become law.