The middle market is the major driving force of the US economy, supporting one-third of the total GDP. It’s no wonder, then, that middle-market companies make up the lion’s share of private equity deal value. In this blog, we’ll explore the middle market, discuss what makes it so attractive to private equity investors, and see how the space is responding to current market dynamics.
The middle market and private equity
Middle-market businesses are generally defined as having revenues between $10 million and $1 billion. In the US alone, there are nearly 200,000 middle-market businesses. Collectively, they employ approximately 48 million people—almost one-third of the US workforce.
PitchBook defines the middle market for private equity as companies that have $25 million to $1 billion in PE backing. There is a lower-middle market, often defined as companies valued at as low as $10 million. Typically, large-cap private equity deals are $1 billion and above.
The middle market represents two-thirds of total US PE deal value. Because it’s such a large portion of PE investment, it serves as a highly informative indicator of the broader PE industry.
What makes the middle market attractive to private equity investors?
The middle market is the Goldilocks of private equity—not too big, nor too small. These companies stand in the sweet spot of being established enough to weather economic headwinds while remaining small enough to be nimble and flexible. Companies in the middle market tend to be competently managed with developed products and services, along with predictable revenue streams. These characteristics of middle-market companies make them a prime target for private equity investors.
The middle market is attractive because it’s so fragmented—there are no monoliths. There are an array of companies delivering a variety of products and services, creating room for organic growth and accretive acquisitions.
Middle-market firms also tend to offer more opportunities for operational enhancement compared to their larger peers. There is room to deploy technologies that drive operational efficiency. There may also be opportunities to build stronger teams or move into more profitable geographies. Middle-market companies are able to take advantage of opportunities to grow market share.
Middle market strategies in the current environment
Given its strengths, middle-market companies performed well through the last financial crisis, and sustained year-over-year growth going in to 2022. But they weren’t impervious to the challenges felt in financial markets across the globe. On the heels of a historic dealmaking run in 2021, middle-market PE firms were hit hard in 2022 by inflation, the threat of higher interest rates, supply chain woes, and the Russian invasion of Ukraine.
With funding for large deals growing increasingly scarce and prohibitively expensive, deals in the middle market space have become smaller and more digestible. The financing challenges at play today have investment firms favoring deals with lower valuations, where they can write higher equity checks for transactions.
In 2021, small deals under $25 million made up 30.3% of the deals—by Q3 2022, the share of deals under $25 million increased to 39.3% of the total deals made. These lower deal values have cut into the middle-market segment, which declined in Q3 2022 to 59.8% of all PE deals, down from 68.8% the year prior.
Other forms of creative financing like seller financing, deferred equity and over-equitizing transactions with an eye toward reconfiguring the balance sheet later are all levers that will allow firms to remain active.
REPORT
Q3 2022 US PE Middle Market Report
Download PitchBook's Q3 2022 US PE Middle Market Report, sponsored by Antares Capital and LBMC for a deep dive on shifts in dealmaking in middle-market private equity.
Download report
Add-on acquisitions in middle market private equity
The prevailing strategy of middle market PE today is toward smaller, add-on deals. So prevalent is this trend that it accounted for 72.3% of all PE middle-market buyouts by Q3 2022.
An add-on acquisition in private equity refers to the purchase of a smaller company to be integrated into the existing portfolio company in an effort to grow the company and increase its value. This buy and build strategy can improve the overall company value by strengthening capabilities, market share and revenue streams. These add-on acquisitions are almost always accretive from the start, in terms of technical capability, geographic, or brand expansion.
PitchBook will watch with interest to see the outcome of the add-on acquisition era in middle-market PE. The sector’s relative strength through the turbulence of late, navigating a compressed labor market and supply chain woes, gives every indication that they will continue to find new ways to solve old problems, leveraging areas of strength to tackle expected and unexpected challenges head on.
