In recent years, there has been heightened interests from private equity firms in the lower middle market. In this market segment, companies are predominantly family/founder owned and privately held. With that, comes a variety of opportunities and challenges for a private equity owner.
Differences between lower mid-market and more mature businesses…
As you said, the lower middle market is largely comprised of smaller, family-owned businesses. We have a great deal of respect and admiration for the entrepreneurs who founded and built a company from scratch. A key difference in this segment of the market is that a business owner is often looking for a partner in the truest sense of that word – someone they can trust to bring into their business, someone who brings skills and perspectives they may not have, and someone who will carry on the legacy and reputation of their company. Larger middle market companies have often been owned one or more times by outside investors, and the “pride of ownership” may not be as present as when the company was smaller.
A common theme we see in smaller companies is that they are often managed to support a lifestyle, rather than to build long-term equity value. One approach isn’t necessarily better than the other, but the mentality and mode of operation can produce quite different results.
Companies that consistently generate $1 million+ in annual earnings can provide a nice lifestyle for an owner and their family, however, taking current income versus investing in future growth has consequences. As private equity investors we are tasked with providing a meaningful return on capital for our limited partners. Given the relatively short window of time we have to meet return expectations (typical hold period of 5 to 7 years), we usually must grow an investment two to three times its original revenues to accomplish our goals. This requires us to pro-actively manage risks while addressing the typical impediments to growth – the market, people, capital, and product/service offerings to successfully meet our investment objectives.
Each company is different, but many investments have similar issues centered around strategy and people – having the right person in place to properly execute mission critical activities. It’s less about the rate of change at the start and more about maintaining a steady cadence of continuous improvement throughout our involvement as investors.
What do you find missing from owner/founders that prevents them from scaling the business further (i.e. risk appetite, balance sheet, skills)?