The economic power of the middle market is immense. If it were its own country, the US middle market would be the fifth largest economy in the world. But when private equity (PE) attempts to capitalize on the growth potential of the lower middle market, it faces a challenge: cultural literacy. The thing is, the cultural world of private equity and that of the lower-middle-market owner differ. First, there may be differences in education. Second, the business owners pursued by private equity investors are often new to M&A, and their lack of experience can easily cause misunderstandings. Finally, PE needs to work to overcome its less than stellar reputation. As the PE seeks to extract value from the lower end of the middle market, the industry would do well to bring cultural literacy as well as a capital stack – the PE and the owners will mutually benefit, as will the industry. American economy.
Private equity investors, bracing for another prolific year of deals, are increasingly eyeing hidden purchases in the lower middle market: companies valued between $10 million and $100 million. It’s not uncommon these days for these investors to seek out strong founder-led or family businesses with annual sales of $100, $50, or even $25 million. According to the National Center for the Middle Market, many are “B2B organizations that operate within the supply chains of other large companies” – strong complements or platforms that offer innovative product designs, compelling business models or a valuable stable of workers.
But when private equity (PE) attempts to capitalize on the growth potential of the lower middle market, it faces a challenge: cultural literacy. And as Peter Drucker would have observed, “culture eats strategy for breakfast”. Our years of dealings in this part of the market have taught us that without cultural literacy, one cannot build deep trust with these hardworking owners, close a deal, or even master a smooth post-closing integration.
The thing is, the cultural world of private equity and that of the lower-middle-market owner differ. The Economist observed wryly that “there has long been a gentlemen’s club element about the private equity industry,” which lower-middle-market business owners might find unrelated. If the PE community wants to get deals done quickly and create greater value throughout the deal lifecycle, they need to “speak” the language of those business owners, which is easier to say than to do.
First, there may be differences in education. Private equity decision makers often come from top universities. A report showed that the majority of MBA private equity firms sent to Europe came from just four schools: Harvard, Wharton, INSEAD and Stanford. Even if not educated at the “top” universities, virtually all physical education professionals have college degrees and usually graduate degrees. In contrast, many successful lower-middle-market business owners have millions in the bank, but no graduate or even undergraduate degrees.
At the auction of a company we represented a few years ago, a cavalcade of private equity investors marched through the conference room of a hotel near BWI airport, all eager to acquire our client’s company. It generated nearly $100 million in annual revenue, grew by the day, had always been profitable, boasted close client relationships with financial behemoths, and offered a nationwide network of skilled workers. As each PE group began their pitch, our client stopped them to ask, “How many of you have an MBA?” The visitors, who came from Los Angeles, Dallas, New York and Philadelphia, all raised their hands. Our client announced that he and his wife did not have a university degree. It was his way of inspiring admiration for the value he had been able to create without higher education. The PE group that got the deal treated the owners and the business they had built with genuine respect.
Even owners who have advanced degrees and are brilliant subject matter experts are probably not financial experts. In fact, a study by the National Middle Market Center found that 90% of middle market companies that sell or merge have “little or no experience” with mergers and acquisitions. On the other hand, private equity players are by nature M&A experts.
This is the second major mismatch: the owner of the company is a fan of mergers and acquisitions, and his lack of experience can easily cause misunderstandings. Adam Altus, Managing Partner of Sier Capital, told us, “I actually want an investment banker to represent the sellers. If a founder-owner is not professionally represented, the negotiation takes time and is unstable.
But cultural literacy goes beyond educational differences and the language of mergers and acquisitions. The values that a typical founder-owner brings to the boardroom table, as well as their life experience, often differ from the PE. Many founder-owners have raised their business as long as they have raised their children. These companies often have strong employee retention rates and a deep affection for their employees.
“When my parents, Tim and Jane Bennett, were building their manufacturing business, the Maiman Company in Springfield, Missouri, my mother personally signed each employee’s paycheck. She wrote ‘thank you’ on each one. It was important to her that every employee knew how much they meant to my parents and to the company,” recalls Adam Bennett of Bennett Partners in Alexandria, Virginia.
This deep kinship between owners and employees has often been forged over decades of struggle. When we represent founding owners selling a business with $10 million or $15 million in EBITDA, the owner will often care as much about what happens to their former employees as what the closing revenue will be. . The private equity buyer should understand that the purchase price is only part of the value owners seek – respect for key employees and the legacy of the business are also extremely important.
Finally, PEs have to deal with the notoriety that precedes their influence. This reputation – so toxic that “The Private Equity Council” literally had to rename itself “The American Investment Council” – leads to devastating poll results. For example, in 2019, Lake Research Partners and Chesapeake Beach Consulting found that majorities across political spectrums opposed “predatory private equity tactics.” With such credibility on the street, PE representatives face an uphill battle.
Meanwhile, business owners often fail to recognize that there are many types of private equity investors. The classic PE model of cutting expenses to the bone and increasing revenue to culminate in a profitable sale in three years is no longer the norm, certainly not in the lower middle market. A great question for owners looking for a suitable grow is, “How long do you hold your investments?” There are many private equity firms that seek to hold investments for many years or even decades. In fact, long-term investments often outperform the typical five- to seven-year buy-and-roll strategies.
Mastering enough cultural literacy – on both sides of the fence – for all parties to understand what is important to each other will improve the chances of mutual success. Rather than splitting the pie, understanding the other party’s needs opens the possibility of making the pie bigger: the founder-owner seller may place a very high value on the speed of closing, for example due to a health. The private equity buyer can focus on tax considerations. Properly determining what matters most to each party, then brokering an agreement that gracefully switches between a multitude of points of agreement to satisfy both, requires a culture of culture.
Of course, closure is not the end of the road. Post-closure integration is critical to a successful acquisition, and merging different corporate cultures can be difficult. Lower middle market companies may have processes that date back to the founding days and require change. In fact, installing better business practices is part of how PE can turn a $10 million EBIDTA business into a $20 million EBITDA business. But the challenge of integration will be better when all parties pay sufficient attention to cultural issues. No investor or seller these days wants to make an acquisition only to see an exodus of committed, skilled workers.
The economic power of the large middle market is immense. In terms of size, if it were its own country, the US middle market would be the fifth largest economy in the world. As private equity looks to extract value from the lower end of this market, the industry would do well to bring cultural literacy as well as a stack of capital – both private equity and owners will benefit each other, just like the American economy.