The Case for Middle-Market Private Equity

However:

The results cited previously are driven by macroeconomic issues that impact megafunds but not the middle-market.

Large Deals Require Even Larger Buyers

To hit their return targets, megafunds and upper middle-market funds often need to exit deals at enterprise values in the billions. Companies of this size may have less than 10 realistic buyers, which will typically be:

Each of these exit strategies are influenced by the availability of cheap financing. Megafunds undertake significant leverage to fund their deals. Higher interest rates and tighter lending standards make it harder for buyers to support the high valuations many megafund assets require. When debt becomes more expensive, the math does not work for many potential buyers, reducing the number of feasible transactions. Additionally for megafunds, financing constraints create a feedback loop where higher interest rates result in fewer deals completed. Fewer deals results in fewer exits, which results in lower fundraising. With lower fundraising, there is less capital available for completing new deals, which further suppresses deal activity and exit volume.

When borrowing costs rise or economic outlooks become less predictable, strategic buyers often shift their priorities toward preserving cash, paying down debt, or investing internally rather than pursuing large acquisitions. Corporate buyers may also face pressure from shareholders to maintain disciplined capital allocation, which can limit their willingness to pay the premium valuations private equity sponsors often expect from a strategic.

Public markets are also highly sensitive to interest rates, macroeconomic volatility, and investor sentiment. As a result, IPO windows tend to open only briefly and sporadically, creating bottlenecks for private equity funds hoping to take companies public. When equity markets are uncertain, companies and their investors frequently delay IPO plans in hopes of achieving higher valuations later.

Middle-market and lower middle-market investors, however, have a significantly larger universe of buyers and are not as impacted by macroeconomic conditions. The buyer lists for companies between $50 million and $500 million can include smaller strategic acquirers, a significantly wider range of private equity firms, independent sponsors, family offices, and even management teams through operator-led buyouts. These transactions can be consummated with less leverage and smaller banking relationships or private credit, rather than syndicated loan markets. This optionality allows middle-market deal flow to persist in less-than-optimal market conditions.

Middle Market Deal Velocity and Terms

In 2024, middle-market PE investors tended to simultaneously achieve more favorable entry valuations and higher EBITDA growth compared to large cap firms and public markets. Large cap funds face a natural supply issue that constrains their ability to purchase companies at discounted valuations. 92% of private companies have between $10 million and $250 million of revenue, while only 8% of private companies generate over $250 million of revenue. Deals large enough to be considered by megafunds are relatively scarce.

At the same time, for private equity funds with vintages between 2010 and 2024, 26% of fundraising went to sub-$1.5 billion funds. The remaining 74% of private fundraising went to large cap buyout funds, many of which will all be targeting this same concentrated group of large private companies. This competition drives up the price of already well-performing, premium-priced companies.

Megafunds can also target public companies, but they have transparent market prices and tend to trade at higher multiples than private companies. To get lower valuation multiples, megafunds can pursue platform consolidation to form a company of their typical size range. This strategy requires significant operational work and can be outside the core strategy for some firms. Regardless, LP capital continues to flow to megafunds because these commitments are generally less risky from an institutional perspective. Megafunds have more established track records and teams, and these firms grew to their size because of their ability to continuously generate returns over time. However, as funds grow larger, they face the decision to either deploy capital in more deals or deploy capital in larger deals. Many firms choose to grow their check size over growing their investment team.

Middle-market investors, however, are currently benefitting from a wave of baby boomer retirements. 11,000+ Americans are reaching retirement age each day. This aging population demographic transition provides ample opportunity for smaller funds to participate in sales of family businesses. Unlike large corporate transactions, these sales often have a stricter timing component and are driven more by personal considerations rather than pure financial optimization. More generally, middle-market investors can also participate in a broader range of deals that also have lower competition and potentially no banker or broker representation. Smaller companies also tend to have greater operational inefficiencies than mature, large-cap companies, which can both reduce price at entry and create stronger opportunities for value creation. Taken together, middle-market firms face fewer structural disadvantages to executing a traditional private equity playbook, which is reflected in the aforementioned deal velocity statistics.