Over the last year there
has been a consistent theme communicated by the larger private equity and
alternative investment funds: there is a significant under exploited
opportunity to invest in smaller companies. Pursuing a more attractively priced
market seems like a perfect solution when facing tepid deal flow and a highly
competitive market where substantial capital has been raised. However, these funds do not appreciate the
fact that this price differential exists for a reason. Investing in smaller companies entails a
unique set of risks and this segment is already highly efficient.
The lower middle market has
lower acquisition multiples and more expensive financing, but it is more risky
for a myriad of reasons. Smaller
companies often find themselves with significant customer or supplier
concentration, do not have robust accounting systems, rely heavily on one or
two key individuals, have limited ability to invest to maintain their
competitive advantage, and don’t have the benefits of economies of scale.
Additionally, one cancelled order or the bankruptcy of a key customer can
have a draconian impact on the company.
In my opinion the most
significant characteristic of the lower middle market the mega funds are
underappreciating is the competition. It is one of the most efficient markets in the
world, despite common anecdotal assertions to the contrary. There are
thousands of lenders serving this sector including banks, second lien lenders,
unitranche providers, mezzanine funds, sale/leaseback firms, and other specialty
finance companies. Countless private equity firms and strategic acquirers
are actively seeking to buy smaller businesses.
The SBA’s (Small Business Administration, a federal agency) SBIC program
has become a massively popular structure and offers a plethora of financing
options to creditworthy companies. It
provides heavily subsidized long term financing to specialty and mezzanine
lenders that target the lower middle market. Today there are 300 SBIC's
managing $17 billion.
I view this trend of larger
funds turning to smaller company investments as an impulse response to
difficult market conditions. Ironically,
Catalus is currently facing the same challenge.
Given the flexibility in our fund mandate we've decided to pursue
larger and more creative deal structures, keeping in mind, of course, the grass
is always greener…
