The mergers and acquisitions (M&A) landscape has seen a significant shift, with private equity (PE) firms increasingly focusing on middle-market businesses. Several key factors have driven this trend, presenting both unique opportunities and challenges for family and founder-owned businesses. To help business owners understand this dynamic, Walden M&A’s President John Phillips and Principal Dean McDonald shared their perspectives on why private equity is interested in the middle market and what business owners should know.
A Growing Market of Buyers
A factor driving this trend is the sheer number of private equity groups in the market. McDonald notes a dramatic increase, stating a decade ago, there were around 2,500 private equity firms, and now there are approximately 8,000. This growth has created more competition for deals, prompting many PE firms to consider companies they might not have considered before.
Phillips notes a significant trend is the retirement of the baby boomer generation. This demographic shift is creating one of the largest transfers of wealth in U.S. history, much of it tied to privately owned businesses. As the next generation is less inclined to take over, many of these companies are being sold, which feeds the demand for acquisitions. This increased competition for larger deals is also a factor, as it forces PE firms to look “downstream” to lower middle market transactions to find opportunities.
The Private Equity Valuation Approach
While a private equity firm’s valuation process may not differ from other buyers, their desired outcome is very distinct. Phillips explains that a family office, for example, often takes a long-term hold approach, looking for a return on its investment through the company’s cash flows. An individual buyer, on the other hand, is often looking for a permanent place of employment.
A private equity firm, however, is looking to sell the company in a three- to six-year period. Their financial return comes from the appreciated value of the company, which they aim to stimulate through strategic add-on acquisitions and other advantages. According to McDonald, because PE firms see a high volume of deals, they often move quickly. They may focus on a few key metrics to get to a “quick no” if a deal doesn’t fit their criteria.
What Makes a Business Attractive to Private Equity?
Private equity firms seek specific attributes in a business. McDonald lists several key metrics, including:
- Management depth
- The company’s growth rate
- The owner’s willingness to stay on as a consultant or in a leadership role
- Potential for growth in the industry and geographic area
- Customer concentration
Above all, PE firms are looking for businesses poised for scalability. Phillips notes they want to know what they can do to significantly increase the company’s value in a short amount of time. This includes the ability to make strategic add-on acquisitions and leverage synergies with their existing portfolio companies. A good example of this is the Walden M&A transaction with Artisan Custom Closets, a company that a PE firm acquired. The owner, Lisa, stayed on in a leadership role to help run the business after the sale.
Common Misconceptions About Private Equity
Many business owners have misconceptions about working with a private equity firm. Some may have heard negative stories from other owners, but as McDonald explains, like any buyer, there are good and bad PE groups. Phillips identifies a significant source of discomfort as the extreme focus on performance. This is often different from the culture of a family-owned business. An outside investor is looking to achieve specific financial goals within a particular timeframe, which can create a sense of urgency which may be uncomfortable for previous owners and employees.
Private equity, however, has made a very positive contribution to the financial marketplace by creating a true market for lower-middle-market companies. Phillips says businesses historically were illiquid investments, often winding down if there was no family member to take over. Now, owners can sell their performing company and receive cash, which can provide a retirement or generational wealth for their families.
The Post-Acquisition Partnership
A partnership with a private equity firm does not end when the deal closes. There is a lot of regular interaction between the PE group and the business owner. If the owner stays on to run the company, they may have weekly calls with the PE group. If they are on a board, they may
have a monthly meeting. The nature of the relationship depends on how the private equity group operates and if a “platform company” is involved.
A platform is typically a larger company, often an industry key player, with an EBITDA of $5 million and up. Private equity groups will make a platform investment and then do strategic “add-ons”—rolling smaller companies up into the larger one to create a conglomerate. This strategy allows the PE firm to sell the combined entities for a much higher multiple than they would have received for the individual companies.
The Walden M&A Advantage
Walden M&A’s role in this process is to guide the seller and ensure their interests are aligned with the private equity firm. Phillips says Walden works all year to build relationships with PE firms and understands their culture and perspective. By carefully matching clients with the appropriate firm, Walden helps the seller find a good cultural fit. They also help the seller ask the right questions to feel comfortable with their new partner after the transaction.