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The Lower Middle Market: An Explosion of M&A Activity

The entire middle market is witnessing a flurry of M&A activity, with much of this activity concentrated in the lower middle market. Sellers are seeing strong markets with high valuations. Multiples are at an all-time high—often seven times EBITDA.

Understanding the M&A Explosion
Numerous factors have birthed the new, frenetic pace of M&A activity. There’s a lot of capital in the market right now. Lending markets have also added fuel to the fire, with debt multiples reaching 4.2 times EBITDA on the senior side, and 3.4 times EBITDA in lower middle markets. Buyers are now willing to over-equitize transactions. So lower middle market businesses with a decent story can get record high valuations.

Strategic acquirers also play a role in the surge. They’re moving down market in search of good deals. In many cases, they’re seeking add-ons for platform companies they’ve purchased at high valuations. About half of all global buyouts are add-ons. In the US, add-ons comprised 70% of first quarter buyout activity.

Creating Value in Today’s Marketing
The buy and build strategy is one of the most popular for creating value. But even long-term business owners can capitalize on this strategy by building their company into something valuable, or positioning themselves as either add-ons or platform acquisitions.

Just like with real estate, though, this bubble could burst. Even low-quality deals are getting bid up to high rates. So when there’s a downturn, high quality assets will survive. Lower quality ones will struggle. If buyers aren’t able to grow their assets, their could be a nasty downturn.

When Will the Tide Turn?
While owners are loving the boom, buyers hope that things will stabilize. The market is competitive. Everyone is seeking to buy, and buyers must remain disciplined. This may mean passing on companies because the price is just so high. With larger funds so well capitalized, smaller buyers just can’t compete.

Most analysts see little indication that the tide will soon turn. The traditional signs of a slow-down are absent—which is good news for owners. While the growth of private lending in the lower middle market would traditionally be a red flag, there’s little reason to believe things won’t continue the way they have. There’s no underlying reason for them to stop. Of course, the economy operates according to boom and bust cycles, so it must end soon. We just don’t know when—or why, or how.

The rule has always been that, when lower middle market companies meet a certain benchmark, their multiples go up. The increase today is more significant. Buyers are purchasing smaller and smaller businesses and merging them together. This can mean increasing value from 5-6 times EBITDA to as much as 10 times EBITDA. Sellers love it. Small buyers hate it. And this leaves analysts to look at the big picture—what will happen next? What about the low quality businesses that will eventually tank? A change is coming, but it could be years away.