Middle Market M & A: Handbook for Advisors, Investors, and Business Owners

By Kenneth H. Marks, Christian W. Blees, Michael R. Nall and Thomas A. Stewart

An in-depth and practical exploration of middle-market mergers and acquisitions from leading experts in the field 

In the newly revised Second Edition of Middle Market M & A: Handbook for Advisors, Investors, and Business Owners, mergers and acquisitions experts Kenneth H. Marks, Christian W. Blees, Michael R. Nall, and Thomas A. Stewart deliver a comprehensive overview of mergers, acquisitions, divestitures, and strategic transactions of privately held companies with revenues between $5 and $500 million per year. 

You’ll discover the market trends, perspectives, and strategies commonly affecting business transitions in all phases of a deal, as well as the processes and core subject areas (e.g. valuation, structure, taxation, due diligence, etc.) required to successfully navigate and close transactions in the private capital markets. 

• The latest edition of this handbook includes new discussions about: 
• The middle market landscape and the evolution and impact of private equity on the private capital markets  
• The concepts of mergers and acquisitions from an owner’s point of view 
• Ways in which transition and value growth planning can optimize the value owners and investors can realize in sell-side and buy-side transactions  
• New technologies being used in the M&A process 

Perfect for advisors, investors, and business owners, the new edition of Middle Market M & A is a must-read roadmap of the strategic transaction landscape that provides solid, practical guidance for attorneys, accountants, investment bankers, corporate development, exit planners, investors, lenders and the owners, entrepreneurs, and leaders of middle market companies. 

• Language: English
• Publisher: Wiley
• Release date: Sep 21, 2022
• ISBN: 9781119828129

Book preview

Middle Market M & A

Handbook for Advisors, Investors, and Business Owners

Second Edition

KENNETH H. MARKS

CHRISTIAN W. BLEES

MICHAEL R. NALL

THOMAS A. STEWART

Logo: Wiley

Copyright © 2023 by Kenneth H. Marks, Christian W. Blees, Michael R. Nall, and Thomas A. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging‐in‐Publication Data

Names: Marks, Kenneth H., author. | Blees, Christian W., author. | Stewart, Thomas A., 1948‐ author.

Title: Middle market M & A : handbook for investment banking and business consulting / KENNETH H. MARKS, CHRISTIAN W. BLEES, THOMAS A. STEWART, MICHAEL R. NALL.

Description: Second Edition. | Hoboken, New Jersey : Wiley, [2023] | Series: Wiley finance series 6 x 9 | Revised edition of Middle market M & A, 2012.

Identifiers: LCCN 2022027387 (print) | LCCN 2022027388 (ebook) | ISBN 9781119828105 (hardback) | ISBN 9781119828143 (adobe pdf) | ISBN 9781119828129 (epub)

Subjects: LCSH: Consolidation and merger of corporations. | Small business—Mergers.

Classification: LCC HG4028.M4 M377 2023 (print) | LCC HG4028.M4 (ebook) | DDC 658.1/62—dc23/eng/20220713

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Preface

Deal markets go through cycles just as the broader economy does. The volume of deals flows or ebbs, influenced by interest rates, overall economic conditions, demographic or industry trends, the availability of capital, and other factors. These factors also affect the price of deals (i.e., the average multiple of revenue or EBITDA [earnings before interest, taxes, depreciation, and amortization] a buyer is willing to pay), which also rises and falls. The need for guidance is constant, however, whether the mergers and acquisitions market is bullish or bearish, whether it favors sellers or buyers. As you will see in this book, middle‐market capital markets, which are mostly private, are fundamentally different from public markets. Transactions are different in private markets. The participants—buyers, sellers, and the advisors who help each party—also tend to be different; many big investment banks do not do deals in the middle market, for example. Most sellers (and many buyers) are inexperienced—selling a founder‐led business is almost always a once‐in‐a‐lifetime event. Acquisitions involving private companies are largely unregulated by groups such as the Securities and Exchange Commission.

For all these reasons, the body of knowledge for middle market M&A differs in critical ways from what is taught in corporate finance classes and practiced by global enterprises, big investment banks, stock exchanges and their regulators, and others who are involved in deals that make headlines. Middle market M&A rarely moves markets or rates a mention on CNBC. But it makes all the difference to a founder and a founder's family; it can lead to an infusion of capital that transforms the economic life of a community; it can give employees a whole new range of opportunity; it can create large fortunes; it can transform a niche player into an industry powerhouse. Or it can be bungled.

If you own, operate, or advise a middle market company, one with $5 million to $1 billion in annual revenues, understanding middle market M&A is important for you and your clients when thinking about shareholder liquidity or selling or buying a business. How can you evaluate different options and opportunities? How can you improve the odds of getting a deal done? If you are the prospective buyer of middle market companies, how can you better understand sellers, and how can you make offers structured so that, once you close a deal, you can make it successful afterwards?

Middle Market M&A: Handbook for Advisors, Investors, and Business Owners is a foundational reference for those advisors, leaders, and executives involved in the lifecycle and process of M&A transactions. This is the second edition of this book. The first, published in 2012, was based on the program for the Certified M&A Advisor® (CM&AA) credential originated and led by the Alliance of Merger & Acquisition Advisors (AM&AA). When it was published, the market for private companies was beginning to come back as the financial crisis of 2008 faded and the subsequent Great Recession slowly began to release its grip on financial markets and a long drought in M&A activity was coming to an end.

This edition appears after a very different economic shock: the sudden stop‐and‐restart impact of the Covid‐19 pandemic. That event and its extraordinary human cost brought deal making to an almost complete halt in the first half of 2020. With employment and economic activity plunging, no one could have anything more than a gambler's instinct for the short‐ or long‐term prospects of a company or the true value of a deal. While Covid‐19 itself persisted (and persists, as of this writing), its impact on the deal market disappeared almost as quickly as it arrived. By the second half of 2020, middle market M&A activity was not just back, but at a record pace, and that pace continued into 2022, though we now face a potential recession.

But while the volume of activity is back to (or above) normal, the nature of middle market M&A has changed in fundamental, structural ways. Some of these changes were sparked or accelerated by economic shocks, but others are the result of long‐term trends. Five stand out.

First, middle market M&A has become a much bigger business. In 2021, the total global investment in middle market M&A was nearly $5 trillion, compared to just under $2.5 trillion in 2012. That is just the money that was put to work in deals. As of this writing, there is an estimated $1.3 trillion in dry powder—capital held by private equity funds, family offices, pension funds, and others whose owners are looking for middle market companies. The recent jump in the number of deals may be partly driven by pent‐up demand after the Covid shock, but it has long‐term causes, too, including the massive intergenerational wealth transfer now underway as the Baby Boom generation retires and boomer‐owned companies come on the market.

It is not just that the pool of capital has grown; a second major change is in who is providing the capital and who is making deals. A decade ago, institutional investors such as pension funds included private equity as a relatively minor part of their portfolio of so‐called alternative investments. Today middle market M&A is mainstream, not alternative, and there is scarcely a pension fund that does not have a separate asset category for middle market private equity investing. In 2012, more than 75% of middle market M&A was with strategic buyers—companies acquiring other companies to fit in or beside their existing business. Since then, the number of sponsor‐backed (i.e., private equity) deals has approximately doubled, and these account for nearly 40% of the total deals in 2021. For these financial buyers, as we call them in this book, the primary goal is to invest in a company that they will later sell. These buyers are not making acquisitions with the intent of integrating the target into a larger enterprise (although some are completing add‐on acquisitions as we describe in this book). Rather, these private equity investors intend to grow and develop their portfolio companies into stand‐alone valuable enterprises.

Third, with the expansion of the industry has come an increase in professionalism, process, and standards. Ten years ago, this book was needed as a guide to a Wild West where best practices were only beginning to emerge and become known and where the quality of the advice available to middle market sellers and buyers varied enormously. To take just one example, a quality of earnings analysis (see Chapter 12) was rarely part of the due diligence process then; now it is routine. As the industry has become more professional, we have in this edition attempted to capture, codify, and update best practice, and in some cases expand it.

The professionalization and standardization of middle market M&A will continue as the role of private capital in the U.S. economy expands. The number of U.S. publicly traded companies is about 3,500, half what it was at its peak in 1996. Initial public offerings are fewer and bigger. In 2017, according to Morgan Stanley,¹ companies raised $3.0 trillion in private markets, twice as much as they raised in public markets. While private capital markets remain unregulated by and large, their sheer importance in the economy means that bankers, brokers, investors, and sellers will expect and demand more consistency and adherence to the practices this book describes.

Fourth, the owners and managers of middle market companies are themselves becoming more skilled and professional. A decade ago, the middle market was the neglected middle child of American capitalism, largely ignored in academic research and business‐school curricula, not in the target market of those big advisory firms that do research as well as consulting, and mostly left to its own devices to discover and apply ideas to maximize enterprise value. While the knowledge gap persists, today's middle market leader can be part of peer advisory groups for CEOs, CFOs, and others, which provide research as well as networking and can enroll in programs designed to help midsized companies scale up and help entrepreneurs build an operating system for their enterprises. For some middle market companies, management expertise is provided by private equity owners—occasionally in operations and strategy, and certainly if they prepare for a sale or wish to make an acquisition themselves.

Fifth, digitalization has transformed middle market M&A, at least in part, as it has so much else. There has been a proliferation of online, self‐service tools for business valuation that owners, investors, and advisors can use. In the past decade, online marketplaces have arisen where companies, investors, and buyers can discover each other. Cybersecurity has become an important element of due diligence. And the whole transaction process has evolved as it has become more digital—think of the use of virtual data rooms to secure confidential information, to take just one example. We added Chapter 10 about technology in M&A to provide a primer on the topic.

Today, with capital more plentiful than target companies, the market is complex. The most attractive targets are in demand from strategic and financial buyers alike and can command prices that are extraordinarily high by historical standards—so much so that private‐equity‐firm returns to limited partners are declining. The scarcity of these companies has driven buyers to consider smaller and earlier‐stage companies, or to develop a platform strategy of buying several lower‐middle market companies with the intention of combining them into one substantial entity, or to take partial positions en route to a complete acquisition. Often multiples for these smaller companies lag well behind, and some companies find no buyers at all. As buyers' strategies have evolved, sellers have many more options to consider when thinking about liquidity, exit, or other transitions. And they have many more tools to use, as do sellers, advisors, and every other participant in the middle market M&A ecosystem.

Thus, the quandary: How does a seller seek and achieve the best possible outcome? What is the typical middle market company to do to create a partial or complete exit for its owners? This challenge creates an opportunity for resolute leaders and executives as well as for innovative and trusted advisors. With more money at stake, more ways to buy and sell, and more professionalism on the part of buyers, sellers, and their intermediaries and advisors, the need for this book, we believe, continues to grow.

Who generally wins at the deal table? The one with the most knowledge and experience! Historically, there exists an enormous asymmetry of knowledge, most often to the detriment of middle market company owners. Some experienced big buyers willingly admit to being bullies. That is why smart owners, investors, and advisors should arm themselves with any possible source of expert knowledge, reduce the asymmetry, and level the playing field.

This handbook is meant to be a practical guide and reference for practitioners, owners and operators, buyers and sellers, and educators and students. The term M&A advisor is used throughout the text as a reference to the many professionals involved in the M&A process, including investment bankers, M&A intermediaries and specialists, CPAs and accountants, deal and transaction attorneys, valuation experts, wealth managers and investors, and consultants and business advisors. The intent is to provide a holistic overview and guide concerning mergers, acquisitions, divestitures, and strategic transactions for middle market companies. It covers pretransaction planning, deal execution, and post‐transaction considerations, and addresses the processes and core subject areas required to successfully navigate and close deals in the private capital markets. Middle Market M&A can be thought of as providing a horizontal perspective for the many participants in the process, which typically bring expertise in one or more vertical subject areas.

The main content is divided into four parts, with Part One being an overview of the middle market, private capital markets, and private company valuation. In the first edition, this market perspective was heavily influenced by the work of Robert Slee, a co‐author, whose insights then continue to shape the discussion.

Part Two, new to this edition, hones in on M&A from the owner's perspective. It is written to help owners think through the issues of transition, succession, and exit planning from both personal and enterprise perspectives, and to help understand practical steps they can take that will enhance the value of their business to prospective buyers—and its performance in the meantime. This part is not for owners alone, of course: successful advisors on both the buy and sell side know that understanding owners' aspirations is a key to unlocking the best deals.

Part Three focuses on the M&A processes and practice management. It addresses sell‐side, buy‐side, and merger processes and introduces a framework for professional standards and ethics. In keeping with the growth and professionalization of middle market M&A, this part has been considerably rewritten and expanded.

Part Four delves more deeply into the technical subjects. Each chapter is a stand‐alone treatise on a specific topic. Together, they provide the supporting details to begin understanding the subtleties and intricacies in making a deal or transaction work. Keep in mind that this handbook is a guide. It is not intended as an endpoint in the search for understanding and clarity about M&A, nor is it a substitute for professional advice (from attorneys and tax specialists, for example); instead is a quick start to understanding the topics and processes and determining where more in‐depth knowledge and experience is required.

The authors of this handbook are Kenneth H. Marks, lead author of the Handbook of Financing Growth; Christian W. Blees, chair of the CM&AA credentialing program and a key instructor in developing its content; Michael R. Nall, CPA, founder of the Alliance of M&A Advisors and the MidMarket Alliance; and Thomas A. Stewart, former executive director of the National Center for the Middle Market at The Ohio State University. Although our names are on the title page, we also endeavored to generate and capture ideas, knowledge, and experiences from many industry and subject matter leaders to provide a holistic, practical, and balanced perspective. As you scan the list of contributors and reviewers involved in creating this edition, you will notice that the breadth and depth of experience, expertise, diversity, and backgrounds is vast, and we are deeply grateful to them for their help.

M&A is a careful blend of art and science. On the one hand it is multidisciplinary, complex, and analytical. On the other, it is all about people, relationships, nuances, timing, and instinct. This dynamic produces opportunity coupled with conflict, ambiguity, and challenges, all supporting an exhilarating business ripe for those seeking to create or capture value.

We invite you to send your comments, questions, and observations to us at: [e-mail], [e-mail], [e-mail], and [e-mail].

KENNETH H. MARKS

CHRISTIAN W. BLEES

MICHAEL R. NALL

THOMAS A. STEWART

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www.MiddleMarketMA.com

NOTE

1. Michael J. Mauboussin and Dan Callahan, Public to Private Equity in the United States: A Long‐Term Look, Morgan Stanley, August 4, 2020, https://www.morganstanley.com/im/en-us/financial-advisor/insights/articles/public-to-private-equity-in-the-us-a-long-term-look.html.

Acknowledgments

One goal in creating this handbook is to present solid factual, researched, and experience‐based practical insights into the world of middle market M&A. Part of our approach to assuring the best work product possible was to augment the author team with subject matter expert inputs and to pepper their knowledge and wisdom throughout the text for accuracy and clarity. To that end, we would like to recognize and thank each of the reviewers of and contributors to this handbook, and express our sincere appreciation for their interest, time, insights, and contribution. A biography of each is in the back section.

We are most appreciative to the teams at Dealogic, Pitchbook, and Private Equity Info for their help with supporting data, along with those technology companies listed at the end of Chapter 10 for their insights in our technology survey.

PART One

Middle Market Overview

CHAPTER 1

The Middle Market

The middle market is at once the most dynamic part of the U.S. economy and the least known. Smaller than the celebrated, multinational enterprises that participate in global markets, trade on public stock exchanges, are the subject of most academic research, and fill the pages of the Wall Street Journal, Fortune, Harvard Business Review, and other publications, middle market companies go about their business relatively undocumented and usually unheralded. The vast majority are privately held, so publications and broadcasts devoted to investment ideas ignore them. Academic studies are relatively rare. Most are too small to merit the interest of strategy consultancies like McKinsey and the Boston Consulting Group, whose publications about superior management practices focus on the multinationals that are their target market.

At the same time, middle market companies get less attention than small business. The U.S. federal government (and states, following the federal lead) tracks small business performance through the Small Business Administration (SBA), the Bureau of the Census, and other entities. The SBA, now a cabinet‐level agency, advocates for small firms in Congress and in the deliberations of other cabinet departments and government agencies. It orchestrates the provision of counseling services that reach over 1 million entrepreneurs and small business owners annually. Because there are so many small businesses—more than 30 million by the SBA's count—they attract the attention of local and regional chambers of commerce and other groups. American Express promotes Small Business Saturday after Thanksgiving each year and Shop Small programs year‐round. And, of course, the small business that grows into a giant is the stuff of entrepreneurial American mythology. The Palo Alto, California, garage in which David Packard and William Hewlett founded HP was declared a California landmark in 1987 and was listed on the National Registrar of Historic Places in 2007.

The middle? Not so much. Only in the past decade or so has the U.S. middle market been given sustained attention by researchers, notably through the National Center for the Middle Market (NCMM) at The Ohio State University, surveys and analysis produced by RSM, a tax, audit, and advisory firm, an annual private capital markets study by Pepperdine University, and a few other entities. A handful of chambers of commerce, notably in Chicago, Cleveland, and Philadelphia, have created special programs for middle market companies. Several city business journals produce annual rankings and celebrations of local middle market companies. A Congressional Caucus for Middle Market Growth existed for half a dozen years before disbanding. But there is nothing in the American business landscape comparable to the support for and celebration of the German Mittelstand, the cadre of midsized family businesses Germans consider the core of their economy and the reason for its enduring success.

PERFORMANCE AND IMPACT

Yet the American middle market is arguably as important to the U.S. economy as the Mittelstand is to the German. There are different definitions of the middle market (see the section further on) but however one counts, it produces about one‐third of private GDP, more than $6 trillion—half again as much as the entire German economy and more than the economies of France, Italy, and Spain combined.

The critical role of the middle market is not just a matter of its overall size. The resilience of these companies—Dun & Bradstreet data show that almost 70% of middle market companies have been in business for more than 20 years, compared with only 26% of small companies—makes them especially important to the communities in which they operate and the families whose members they employ. So does their growth. Although small businesses are the legendary engine of economic growth, on a net basis the middle market actually produces more growth, partly because fewer midsized companies fail, and partly because many small businesses are not built to scale (a neighborhood restaurant, for example). On average, middle market companies' revenues grew 7.0% between the first quarter of 2012 and the end of 2019, according to the National Center for the Middle Market data, and added employees at a 4.3% annual rate. Both numbers are substantially higher—about one and a half percentage points—than the growth rates for large or small companies. As they grow, many middle market companies become big companies—27% of large U.S. companies in 2010 had been middle market companies five years earlier.

One can make similar observations about the importance of the middle market to employment. During the 2007–2010 Great Recession, about 43% of small businesses went under, versus 18% for the middle market and 3% for big business. But the surviving middle market companies added 2 million jobs in 2007–2010, a period during which large companies reduced headcount by nearly 4 million.¹

Beyond these economy‐wide effects, the middle market plays a critical role in the industry clusters that, as Professor Michael Porter has shown, are sources of national competitiveness and metropolitan‐area vitality.² Companies of this size are frequently tier‐one suppliers to global manufacturers, delivering parts and components or offering business services like logistics and distribution. Of particular relevance to readers of this handbook, they are often the source of new intellectual property that makes them acquisition targets for large businesses, a phenomenon widely observed in pharmaceuticals, life sciences, fintech, software, and other industries. A barbell economy made up of large and small companies does not fare as well as one with a robust middle market.

The role middle market companies play in business ecosystems parallels the role they play in industry clusters. Middle market companies are rarely the keystone species in a business ecosystem, but they give it breadth and sustainability as suppliers to OEMs and providers of intermediary services. A business ecosystem like the tourism economy of Orlando or Las Vegas includes hundreds of middle market firms in the mix along with big companies like Disney and Southwest Airlines. The automotive ecosystem includes a full range of suppliers of parts and components, along with their suppliers, plus a downstream mix of dealerships, a large percentage of which fall into the middle market; a Brookings Institution study of the automotive industry in Tennessee showed that it depends on a supply base of 1,000 companies, all middle market.³

From a strategic point of view, the most successful middle market companies tend to have deep relationships with a few customers or suppliers, rather than shallow, transactional relationships with many. In some cases, this concentration is driven by big companies; for example, encouraged by Bath & Body Works (then part of L Brands), more than 14 suppliers have come together outside Columbus, Ohio, in an International Personal Care and Beauty Campus (inevitably nicknamed Beauty Park) that produces bottles, caps, pumps, and packaging—an estimated 50% of the supplies the big company needs.⁴

DEFINITION

Defining the middle market depends partly on statistics, partly on who is doing the defining, and partly on feel. NCMM defined the middle market as being comprised of companies with annual revenues between $10 million and $1 billion, based on analysis of the U.S. Census Bureau's 2007 Business Census, which showed that about one‐third of private‐sector GDP and employment was produced by companies in that range, with another third coming from smaller firms and another from larger enterprises. That definition has been broadly but not universally adopted. The idea that the middle market should be the middle third of the economy has obvious appeal and utility, but it is a moving target. First, GDP grew nearly 50% between 2007 and 2020, from $14.5 trillion to $20.9, which suggests that the sliders would be set differently today. Second, the definition was created by finding the middle third of the American private sector. In New Zealand, work by NCMM's then‐partner GE Capital found that country's middle market to consist of companies with revenues between $2 million and $50 million, in contrast with the U.S. middle market with its broader revenue range, described later in this chapter.

Other parties have defined the middle market according to how they organize themselves to pursue middle market opportunities. Banks tend to define three market segments—often called something like small business, commercial, and enterprise—roughly according to how the bank believes it can serve them well and profitably. Technology providers and others do the same. At JPMorgan Chase, the middle market thus defined extends from $20 million to $500 million in revenue. Dealmakers such as investment banks, private equity firms, and the like are more likely to segment by transaction size, in part because they often rank themselves in their industries by the number and size of transactions they make.

Some organizations define the middle by number of employees. ADP, whose core business is payroll services, segments its market that way: small (1–49 employees), midsized (50–499), and large (500 or more). Government organizations tend to count noses, too. Not to be outdone in a complex environment, the SBA sets the parameters for small business depending on revenue or headcount, plus industry—so that retail bakers are small if they have fewer than 500 employees, but a small commercial bakery must have fewer than 1,000 employees, and makers of cookies, crackers, and tortillas 1,250.

As shown in Figure 1.1, over 90% of U.S. and Canadian M&A transaction volume is with deals of less than $500 million in value, and about 70% of the volume is with those that are less than $150 million and averaging $47 million in transaction value in 2021.

For us, the middle market for M&A encompasses businesses with revenues from $5 million to $1 billion, often subdividing it further into three segments as discussed in Chapter 2.

Bar chart depicts U.S. and Canadian M&A Transactions Data

FIGURE 1.1 U.S. and Canadian M&A Transactions

Data source: Dealogic 2022.

CHARACTERISTICS OF MIDDLE MARKET COMPANIES

Hence the role of judgment—or art—in defining the middle market. It may be less important to define companies by size than by their characteristics, behavior, organization, and their interactions with customers, competitors, and capital markets.

Ownership

The overwhelming majority of middle market companies are privately held. Within that privately held group, roughly a third are family‐owned businesses, 10 to 15% are substantially or entirely owned by private equity investors, and the balance is other—a mix of entrepreneurial owners, family offices, partnerships, sole proprietorships, and so forth.

Companies change hands, of course; that is the reason for this handbook. Thirty‐three percent of middle market companies say they have undergone a major change in ownership (selling all or part of the company, bringing in a new investor, transitioning ownership within a family, etc.) in the previous five years.⁵ One change in ownership often leads to another; if a private equity group buys a company, it typically sells again within a few years—sometimes to another private equity firm group (thus restarting the process), sometimes to a strategic buyer, and sometimes to management. Private equity holding periods have been rising and averaged 6.9 years in 2018, according to the Cebron Group. These patterns were disrupted by the Covid‐19 pandemic, which made valuation very difficult.

Access to and Use of Capital

Broadly speaking, middle market companies manage their capital conservatively. Individual or family owners, a large part of whose wealth may be concentrated in the company they own, are reluctant to dilute that equity by seeking outside investors and are leery about taking on debt. This is particularly true for lower‐middle market companies whose cash flow may be uncertain and—perhaps more important—where debt is often personally guaranteed by the owner. Personal guarantees mean that debt and equity carry the same risk for the owner, and can have a profound impact on the capital decisions for these companies. When one is investing one's own capital—or one's mother's—prudence often trumps boldness. Smaller companies prefer to fund expansion from retained earnings rather than by borrowing. When they invest in innovation, established lower‐middle market companies are—again, broadly speaking—more likely to prefer safe, incremental innovations over risky, disruptive ones. Upper‐middle‐market companies are less likely to guarantee debt personally, more willing and able to use their balance sheets and relationships with capital providers strategically, and more likely to take on innovation risk in pursuit of greater reward.

Organization

As companies grow, they become more complex. A small business may be run by an entrepreneur, their family, and a handful of employees, each of whom wears many hats. When specialized knowledge is required, the small firm goes outside, retaining a lawyer or tax accountant. Small business may have experts, but they rarely have corporate functions—there is no department of human resources, marketing, or even finance. There's a computer guy to maintain the systems, but not an IT department.

The middle market is where functions appear. Somewhere in the lower‐middle market revenue range, a recognizable finance team appears; sales becomes a department, not just a sales leader and a few commission reps; people are put in charge of procurement, operations, and distribution. At first, those functions are skeletal. The Society for Human Resources Management says that as a rule of thumb a company has one dedicated HR staffer for every 75 full‐time employees, which means that even a 300‐person company will have an HR department of four—enough to manage basic tasks of pay and benefits, hiring, and compliance, but not enough to staff expertise in fields such as learning and development, executive compensation, succession planning, performance reviews, or diversity, equity, and inclusion. (Consequently, data show that middle market companies are more likely to fill skills gaps by hiring from outside than by developing from within.) In the core of the middle market, functions are much stronger, though still not deep. A middle market company might employ specialists in financial planning and analysis—but just two or three, not dozens or hundreds as large companies do. However, at the upper end of the middle market, functions are robust and the companies have more business management sophistication.

In the core and upper middle market, divisions appear alongside functions: divisions for different products, services, or geographies, perhaps with separate P&Ls. When functions and divisions meet, the result is a matrix, a complex organization in which different parties each vie for their share (or more than their share) of CEO attention and investment resources.

Management becomes more professional as these companies functionalize and divisionalize. Decisions that were made informally now go through processes. Accounting, which in the lower middle market has been done primarily to prepare tax returns, becomes more descriptive and useful for tracking business performance. People begin to complain about silos between departments. Family businesses may bring in outsiders to fill key management roles. Often the first act of a private equity buyer is to upgrade functions—particularly finance—by bringing in an operating partner to push for efficiencies or installing functional leaders from their own talent bank.

Governance, too, matures as companies grow. Small businesses often have no established governance; there's the owner, a kitchen cabinet of friends and family, and a triumvirate of advisors—lawyer, banker, accountant—who offer counsel but have no formal responsibility. Over time and as companies grow, they appoint boards whose role may initially be advisory but that often take on fiduciary duties; they may also create other governance bodies, such as family councils whose powers and duties are explicitly defined; and the roles of outside advisors may be strengthened, for example to include preparing audited financial statements according to GAAP.

These growth inflections—the emergence of functions, divisions, processes, and professional management—are what really describe the middle market landscape. Small businesses have not experienced them yet. For big business, they're old hat. The middle is where they emerge, and the decisions that a company's owners make about them will determine the company's prospects for growth, enduring success, reduction of business specific risks, and ultimately the enterprise value. Management expert Jim Collins likens middle market companies to adolescents, charting directions and making decisions that will define them: I've always thought that there's a journey and a progression in a company's story. You start with an idea and then turn an idea into a business. Then you turn a business into a company. Then you turn a company into a great company, and a great company into an enduring great company. The midsection of that chain—the shift from a business to a company and then to a great company—that's your mid‐market stage.⁶

The special characteristics of the middle market—its relative public obscurity; its dynamism; its ownership, governance, and attitude toward capital; its role in industry structures and economic ecosystems; and its own internal management processes and maturity—all explain why middle market M&A is a discipline of its own. It has a unique body of knowledge and there is a distinctive art to employing it.

NOTES

1. National Center for the Middle Market, The Market That Moves America, 2011, https://www.middlemarketcenter.org/research-reports/middle-market-insights-perspectives-opportunities; Anil Makhija, presentation to Middle Market Summit, The Ohio State University, 2011.

2. Michael E. Porter, Clusters and the New Economics of Competition, Harvard Business Review, November–December 1998, https://hbr.org/1998/11/clusters-and-the-new-economics-of-competition.

3. Mark Muro, Scott Andes, Kenan Fikri, Martha Ross, Jessica Lee, Neil Ruiz, and Nick Marchio, Drive! Moving Tennessee's Automotive Sector Up the Value Chain, Brookings Advanced Industries Series, 2013, https://www.brookings.edu/research/drive-moving-tennessees-automotive-sector-up-the-value-chain/.

4. Logistics: Production ‘Nirvana' in New Albany, Columbus CEO, April 4, 2017, https://www.columbusceo.com/business/20170403/logistics-production-nirvana-in-new-albany.

5. National Center for the Middle Market, Preparing for Major Business Transition, 2020, https://www.middlemarketcenter.org/research-reports/successful-middle-market-business-transition-planning.

6. Greatness Is a Choice: An Exclusive Conversation with Jim Collins, National Center for the Middle Market, 2014, https://www.middlemarketcenter.org/middle-market-academic-research-summaries/greatness-is-a-choice-an-exclusive-conversation-with-jim-collins.

CHAPTER 2

Private Capital Markets

A fundamental premise of this handbook is that there is a difference between the deals, transactions, and financings in the middle market and those in the large‐company, traditional‐corporate‐finance public market. As indicated in the Preface, the focus of this book is the middle market, primarily composed of private businesses. Chapter 1 described the middle market landscape—the definitions, scope, economic impact, and general characteristics of middle market companies. The purpose of this chapter is to set the stage for the balance of the discussion in this handbook by describing how these companies interact with the financial services, particularly with respect to M&A, by providing an overview and perspective of middle market and private capital market activity.

A capital market is a market for securities (debt or equity) where businesses can raise long‐term funds. Since the 1970s, public capital markets—by which we mean companies that trade on a public exchange and have a float of more than $500 million—have received much of the attention from academics in the literature and press. For many years it was assumed that insights and ideas about public markets could be applied in the private markets, but in recent years this assumption has been challenged by research studies showing that the two are different in many meaningful ways and across the whole spectrum of financing activities and capital transactions.¹

At a macro level, middle market mergers and acquisitions (M&A) activity is currently driven by the aging population of business owners, significant availability of private capital, and the need of publicly traded companies for revenue, earnings growth, innovation, and talent. As a backdrop in general, M&A is influenced by capital availability, liquidity, trends in the economy and industries, and motives of the players, which vary in each market and for each transaction. Whether one is a buyer, seller, M&A advisor, investor, or lender in the middle market, it is important to understand the market differences and dynamics.

A number of factors differentiate the public and private markets:

Risk and return are unique to each market.

Liquidity within each market is different.

Motives of private owners are different from those of professionalmanagers.

Underlying capital market theories that explain the behavior of players in each market are different.

Private companies are priced at a point in time, while public companies are continuously priced in the stock market.

Public markets allow ready access to capital, whereas private capital can be more difficult to arrange.

Public shareholders can diversify their holdings, whereas shareholders of closely held businesses have few opportunities to create liquidity or to reallocate their ownership in a private company.

There is little retail market for shares in private companies; transactions usually involve buying or selling large stakes or the entire company.

Private markets are inefficient, whereas public markets are fairly efficient.

Market mechanisms have differing effects on each market.

Costs of capital are substantially different for each market.

The expected holding period for investors is different.

The role of institutional investors is different.

The transaction costs of buying versus selling a business are different.

The differences between public and private capital markets are important because acquisition pricing and behavior vary by market, or more specifically, by market segment. Further, much of what is taught in traditional corporate finance is not easily applied, and is not appropriate to apply, to the private capital markets and to many middle market deals. Last, a clearer understanding of market behaviors, drivers, processes, and dynamics will enable those on all sides of a transaction to put greater focus on creating value and meeting the strategic objectives of owners and shareholders.

SEGMENTED MARKETS

The private markets contain numerous marketplaces. For example, there are different submarkets for raising debt and equity and for transferring business interests. Markets are also segmented by company size and by ownership type. This handbook consistently uses the collective term markets to describe activity within the private capital markets, rather than attempting to describe particular submarkets with a confusing array of terminology. While there are no definitive size boundaries, as we discussed in Chapter 1, Figure 2.1 depicts market segmentation by size of business.²

Small businesses with annual sales of less than $5 million are at the bottom of the ladder. There are more than 5 million small businesses in the United States and together this group generates approximately 15% of the U.S. private‐sector gross domestic product (GDP). These businesses generally are handled by the business banking group of community or smaller regional banks and are almost always owner managed. These businesses have limited access to the private capital markets beyond bank loans, assistance from the Small Business Administration (SBA), and business brokers. Capital access improves as the business moves into the upper segments.

The entire middle market generates roughly 40% of the U.S. private‐sector GDP. The lower‐middle market segment includes companies with annual sales of $5 million to $150 million. The lower‐middle market is the main province of the private capital markets as described in this book. These companies generally have good relationships with local or regional banks, or with regional leaders of national commercial banks. They may deal with investment banks when a transaction happens or use business brokers, but many times they engage with middle market M&A advisors. Companies in this segment have a number of unique characteristics:

There is owner management.

Owners have virtually unlimited liability and personally guarantee the debt.

An illustration of Segmented Capital Markets

FIGURE 2.1 Segmented Capital Markets

Owners typically have most of their personal wealth tied to the business.

A vast majority of these businesses will not transfer to the next generation of the same family.

Access to capital varies greatly, is situation dependent, and is difficult to prescribe.

The enterprise value (EV) of the company can vary widely from year to year.

As a practical matter, lower‐middle market companies are more likely to be sellers and much less likely to be acquirers in an M&A transaction.

The middle‐middle market includes companies with annual sales of $150 million to $500 million. They are serviced by regional investment banks and draw the attention of the bank's top lenders—their corporate bankers. Generally, capital market access and efficiency improve at this level as the sophistication and robustness of the business increase. Companies with sales over $150 million begin to have access to nearly all capital market alternatives in some form, though selectively and usually at a higher price than larger companies pay.

The upper‐middle market is comprised of companies with sales of between $500 million and $1 billion. These companies have access to most of the capital market alternatives available to the largest public companies. This group of companies attracts the secondary attention of the largest Wall Street investment banking firms; the largest regional bankers also take notice. In this tier, capital is accessible and priced to reflect the riskiness of the borrower. Some of these companies are publicly held, but they are increasingly likely to be in private hands, part of a trend that has seen the overall number of U.S. public companies decline from a peak of more than 8,000 in 1996 to below 3,500 today.

The large‐company market, which is almost entirely composed of public companies, is estimated to generate about 35% of the U.S. private‐sector GDP. Large companies have the complete arsenal of capital alternatives at their disposal. Many use discounted‐cash‐flow techniques to make capital decisions because they can fund projects at their marginal cost of capital. Those that are private have most of the financial capabilities of public companies. Wall Street bankers focus primarily on these companies. This segment of the market is where the finance theory, research, and rules of traditional capital markets were developed and typically applied.

Each market segment yields information and liquidity, which form the basis for particular investor return expectations manifested by acquisition multiples paid for companies within it. Acquisition multiples based on EBITDA (earnings before interest, taxes, depreciation, and amortization) represent capital structure decisions. The reciprocal of EBITDA multiples yields an expected return on total capital. For instance, equity investors traditionally require 30 to 40% compounded returns from small businesses, 20 to 30% from investments in the middle market, and 10 to 20% from investments in large companies, which implies lower acquisition multiples in the middle market than in the large‐company market.³ Some funds define their targets in terms of the difference between private‐market investment returns and those attainable in the public markets—for example, aiming for a return 2.5 times greater than they could get in public markets.

Markets segment by investor return expectations because players within a segment view valuation parochially. The relationship between investor return expectations and valuation is straightforward: Greater perceived risk requires greater returns to compensate for the risk. Using a capital market–determined discount rate is another way of looking at this risk/return relationship. The discount rate then is the expected rate of return required to attract capital to an investment, taking into account the rate of return available from other investments of comparable risk. Risk is the largest determinant of return expectations, but not the only one. A surfeit of capital (such as we see at this writing) may drive investors to accept lower expected returns; also, the possibility of greater reward may increase multiples regardless of the risk of an investment.

Calculating the reciprocal of a selling multiple is a shorthand method for determining the capitalization rate or, once we account for assumed long‐term growth, the discount rate. EBITDA acquisition multiples for the lower‐middle market typically fall between 4 and 10 times. Expressed as a reciprocal, this roughly corresponds to a 10 to 25% capitalization rate, or assuming a long‐term EBITDA growth rate of 2%, a discount rate (investor return expectation) of 12 to 27%. Return expectations can be expressed as discount rates and can be tested. Assume a buyer uses a capital structure in an acquisition with 30% equity, carrying a 30% return expectation, and 70% debt, which costs 9%. The discount rate implied in this capital structure is about 15%, within the return range cited above. Thus, as Figure 2.1 implies, there is a correlation between investor return expectations and pricing. Although much of Figure 2.1 is definitional, support for these findings can be found in several private company transactional databases.⁴

Since a number of factors form boundaries in the capital markets, appraisers must correctly identify the segment within which the subject will be viewed. Characteristics need to be weighed in their totality. For example, some companies have annual sales of $3 million, but meet other criteria that may allow them to be viewed as lower‐middle market entities. On the contrary, companies with sales over $5 million may be viewed by the markets as small businesses if they don't have certain characteristics. An incorrect assessment will lead to improper valuation. Table 2.1 provides criteria appraisers can use to define the segment within which their subject should be viewed.⁵

Some criteria warrant further explanation. Owners significantly influence the segment in which their company will be viewed. For instance, if an owner decides to personally manage every aspect of the business and desires