Private Equity’s Big Appetite for LMM Acquisitions

In terms of mergers and acquisitions (M&A), private equity continues to show strong interest in acquiring lower middle market (LMM) companies. While large M&A deal volumes declined in the first half of 2024, the attractiveness of LMM acquisitions remains high. This trend is driven by several factors that make these companies particularly attractive to investors, including relatively low costs, high potential growth, and business agility.

Dena Jalbert, CEO of Align Business Advisory Services, one of the leading mid-market and lower-cap M&A advisory firms, has seen strong interest from private equity investors.

Jalbert said: “We are seeing increased interest in LMM firms, although not necessarily a strong preference for larger firms. PE firms are diversifying their portfolios, and many see LMM as an attractive segment that can help them achieve that goal. Lower purchase prices allow firms to make multiple acquisitions and spread risk.”

Jalbert also shed light on several factors affecting demand for LMM companies, including:

Abundance of dry powder

One of the main factors driving PE interest in LMM companies is the huge amount of available capital, often referred to as “dry powder.” PE companies have raised significant funds that need to be invested. LMM companies offer an attractive opportunity for such investments, allowing PE companies to effectively deploy their capital.

Investors expect PE firms to be proactive with their funds. In other words, they can’t just sit back and wait for conditions to improve. Instead, they need to strategically use available capital to acquire companies with relatively low risk and high growth potential.

Less competition and greater potential for value creation

The LMM space faces less competition, making it easier for PE firms to strike good deals. LMMs also don’t have as many potential suitors, meaning that stakeholders may be more willing to accept any reasonable offer that comes their way. PE firms, in turn, benefit because they can avoid the intense bidding wars that often come with larger deals.

LMM firms also have greater potential for operational improvements and value creation. PE firms can deploy their management expertise, process optimization, and scaling of operations to unlock significant value. Additionally, PE firms find the opportunity for a buy-and-build strategy attractive. They can acquire a platform company and then make additional acquisitions to strengthen its market position and capabilities.

More reasonable valuations

Valuations in the LMM space are typically more reasonable compared to those of larger companies, which makes these investments more financially attractive. The lower purchase price allows companies to make multiple acquisitions and spread risk rather than putting too much capital into one company.

On that topic, Jalbert said, “LMM valuations tend to be more stable and less susceptible to multiple compression than large-caps,” adding that the degree of compression varies significantly by “sector and company quality.”

Impact of higher borrowing costs

The current economic environment is characterized by higher borrowing costs, which have a mixed impact. PE firms with strong cash positions are aggressively pursuing opportunities while their competitors are struggling to secure financing. Cash-strapped entities may have difficulty completing some deals due to higher borrowing costs.

The current climate has given well-capitalized companies a competitive advantage. They can continue to pursue M&A deals and diversify their portfolios, while others may struggle to close deals due to financing issues.

Stability in the face of market fluctuations

One of the most notable advantages of the LMM space is its stability. Larger-cap stocks often experience multiple compressions, while LMM valuations are much more stable.

However, LMMs are not immune to compression. And this is a factor that PE firms need to be aware of during the due diligence period. The quality of the company and the industry will have a direct impact on the overall stability, with some sectors being much more volatile than others.

Sectors attracting PE interest

Jalbert noted that LMM firms in several key sectors are attracting the most interest from PE firms. These industries are more resistant to economic cycles while also experiencing strong growth:

Healthcare Services and Technology

According to McKinsey & Company, the healthcare market will experience a compound annual growth rate (CAGR) of 7% through 2027. Both the technology and services sides of the industry are expected to grow over the next three years, with healthcare profit pools expected to reach a valuation of $819 billion.

Home services

The home services sector includes all businesses that offer repairs, maintenance, improvements, design solutions, and installations. While the current economic climate may reduce demand for optional home services (such as pool installations), needs such as roofing, plumbing, and appliance installation remain stable.

Businesses using software and technology

Technology companies often provide steady cash flow and growth opportunities. LMM companies that rely on recurring revenue models (i.e. subscription-based offerings) are particularly attractive to PE firms.

Industrial services and specialized production

Both of these sectors offer unique value propositions and opportunities for operational improvements. PE firms can leverage these acquisitions to expand the capabilities of other investments, increasing their value.

Consumer products with a strong e-commerce presence

Consumer goods continue to experience growth in demand and profits. Brands with a strong e-commerce presence are particularly well-positioned to achieve growth targets. According to Statista, the e-commerce market will experience a CAGR of 9.49% through 2029.

Will LMM fever last?

The continued strong interest from PE firms in LMMs underscores the strategic value that LMMs offer. PE firms are diversifying their portfolios and see LMMs as attractive segments that will help them achieve this goal. The current landscape provides a favorable environment for LMMs seeking exits or investment opportunities.