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Opportunity in the US Lower Middle Market

Economic and fiscal uncertainty have resulted in major shifts in the domestic mergers and acquisitions landscape, affecting transactions of all sizes. However, there are several trends underway, some developing and some well-established, which suggest that a once-niche, but now increasingly popular segment of the market stands to benefit (especially as it pertains to private-equity backed deals): Unbacked companies in the lower middle market.

It's no secret that Slane Hill specializes in working with this specific market segment, but before you accuse us of shamelessly talking up our book, let's first review the trends in question to show how we arrived at this conclusion in an unbiased manner.

As a baseline, private equity (PE) deal activity has unequivocally slowed over the past 2 years, with Pitchbook's 2023 annual deal value estimate showing a pullback of -29.5% YoY and -45.5% from the record highs seen in 2021.

Much of the apparent slowdown can be directly attributed to the absurd flurry of deal activity that unfolded in the wake of COVID, with the record highs seen in both deal value and volume due in large part to the "easy money" low interest rate environment. Now that rates look set to remain higher for longer, private equity firms are adapting their strategies to contend with the increased cost of debt capital.

The classic leveraged buyout (LBO) has been the hardest hit by this development. According to Debtwire Par, the value of new LBO loans plummeted by -52.3% YoY in 2023, down a further -68.2% from the relative high seen in 2021. Furthermore, Pitchbook data shows a distinct downtrend in platform LBOs as a share of total deal volume, with growth/expansion investments surpassing platform LBOs in terms of total PE deals made.

In addition to making LBOs less attractive, prevailing market conditions have had a profound impact on the structure of all deals utilizing leverage.
For debt-funded deals in the US and Europe, a decade-long trend of stable debt multiples and fluctuating equity multiples came to an abrupt end in 2023—
Equity multiples remained stable on a year-over-year basis, while debt multiples plummeted an entire "turn" from 5.9x down to 4.9x.

Alongside the sizable shift lower in Debt multiples, 2023 also marked the first time in over a decade that equity surpassed debt as a funding source for leveraged deals.
Private equity groups are shying away from leverage and the sizable risk it presents in a high-rate environment.
And, "sizable" really is the operative word when it comes to changes in risk appetite. A slowdown in  "megadeals" (>$2B or higher) has an outsized impact on the year-over-year decline in total deal value. Meanwhile, the total deal count in 2023 remained 48.7% higher than the pre-COVID average (2013-2019) —
PEs are certainly still keeping busy...They've just shifted their sights towards smaller targets, especially when it comes to buyouts. Pitchbook data shows that middle market buyouts were on pace to account for a record high 73.6% of total PE buyouts in the third quarter of 2023, a trend that is likely to continue in the current environment (Pitchbook).

Private Equity as an investment vehicle has exploded in popularity over the past decade, and even with debt multiples shrinking, the amount of outstanding "dry powder", money earmarked for equity purchases, has risen steadily, approaching a staggering $1T amongst firms explicitly operating in the US middle market. And, with traditionally larger players beginning to move downmarket, there's now GDPs-worth of funds competing for the same pool of businesses.

Within that pool, there's no ownership structure on the market that's more coveted than the unbacked, "first time sellers," and once again, this is even more true when it comes to to buyouts. For 8 consecutive quarters, founder-owned businesses have comprised more than half of all middle-market buyouts, accounting for over 30% of total middle-market deal value in 2023...This discrepancy between deal value and volume leads us even further downmarket, pointing towards unbacked companies, specifically in the lower middle-market, as the hottest commodity.

Pitchbook published an incredibly topical article on the subject last year ('Founder-Owned Businesses Are Attractive M&A Targets'), which further confirms this fact, with data showing that 85.8% of global M&A deals without backing took place at a value below $100M. Smaller companies sell for smaller multiples, but if the businesses has a clear growth trajectory, being the first infusion of institutional capital provides the double benefit of organic growth AND multiple arbitrage when it comes time to divest

To summarize the trends.

- Total Deal value is declining
- PEs are using less leverage, especially when it comes to buyouts
- Buyouts are still taking place, but at smaller deal sizes
- PE dry powder stores are at record highs
- Unbacked, founder owned businesses have become the most attractive target for buyouts

And with an estimated 32.5 million small and medium sized businesses in the US alone, there's no dearth of potential candidates.