|Middle-market special report|
Wall Street views the middle market through one lens, a factoring shop through another. A middle-market-oriented investment bank like Robert W. Baird & Co. or Piper Jaffray & Co. has one universe in mind, while a six-person boutique investment bank in Cleveland may be constellations apart.
By general consensus, the middle market comprises businesses with revenue between $5 million and $1 billion. That's an enormous universe. According to U.S. Census data, 369,122 companies constituted America's middle market in 2007, the latest data available. That is pretty much double the number registered in 1992.
A poorly defined middle market is understandable, given its lack of an institutional construct. The government's Small Business Administration claims to be all over America's galaxy of small-sized businesses, which the agency most broadly defines as less than 500 employees, including some 21.4 million or so firms "without employees." (The SBA actually breaks out small business by detailed industry category, a 38-page list with various worker caps and revenue limits that range from $750,000 for sheep farming to $30 million for recreational-vehicle dealers.) Wall Street, of course, obsesses over the upper end, with its enormous corporations. But surprisingly little definitional rigor is applied to the vast landscape of businesses in between. For whatever reason, academics, bureaucrats and financial analysts have all but ignored the subject of a detailed, quantitative assessment of the space in the middle.
The middle market is "understated and underanalyzed" maintains Trottier, 65, president of Sundial Partners Inc., an investment bank boutique based in Sarasota, Fla. "The characteristics of middle-market companies are vastly different from either large or small businesses. There are different business theories, different financing sources, different approaches to operations, different owners, managers, investors."
This lack of analytic rigor presents a major gap in economic understanding. Middle-market businesses account for fully 40% of America's GDP and an equal percentage of the country's workforce, according to census data. Trottier, who enlisted the help of the University of South Florida's Center for Economic Development Research to crunch the numbers, estimates middle-market capitalization totals about $4.2 trillion.
The middle market is critical to the health of the U.S. economy, even as its ownership structure is shifting. "Family ownership runs well through the middle market," Trottier says, noting that only 1,200 middle-market companies are publicly owned. However, he estimates that private equity owns 48% of midmarket businesses, by valuation. That compares to just 23% in 1997. Trottier further estimates that in the middle and upper reaches of the middle market, 25% to 30% of the companies are now private equity-owned.
If anything, those percentages should increase. Common estimates suggest private equity is now sitting on $500 billion in available capital. Add a further $1 trillion in leverage. Most of that money, Trottier and others believe, will be deployed in the middle market.
In the mergers and acquisitions arena, the numbers are equally impressive. According to data compiled by Baird and Dealogic, the U.S. witnessed about 5,300 middle-market M&A deals last year, totaling $347 billion. That compared with 185 deals of more than $1 billion. (An additional 5,400 deals were listed as "undisclosed." It's safe to assume most of these fell into the middle market as well.)
In this issue of The Deal magazine, we profile six middle-market advisers and buyout shops. They display both the enormous geographic span of the marketplace and the broad range of industry specialists. They speak to the vastness of the middle market itself.
Here's an attempt to give that expansive sprawl better shape and structure. It might help to think of the middle market as a pyramid inside a pyramid. According to Census Bureau data, approximately 6 million firms populated the United States in 2007, the latest complete report available. Of these, 4.6 million recorded revenue of less than $1 million. A further 1.1 million or so reported revenue of $1 million to $5 million. At the other end, 2,600 companies registered revenue in excess of $1 billion.
By number of firms, the middle market is highly skewed toward the lower end. More than 174,000 businesses reported revenue between $5 million and $10 million. That's just short of half the total middle market.
An additional 156,000, or 42% of the total, had revenue between $10 million and $50 million, while 21,000 recorded revenue between $50 million and $100 million.
That means the lower middle market -- which most define as $5 million to $150 million in revenue, but given census figures, we'll limit to $100 million -- accounts for more than 95% of the total number of middle-market companies. Left are about 15,800 firms in the mid-middle market and 2,182 in the upper-middle market.
By revenue totals, however, it's a very different picture. The 15,800 mid-middle-market firms accounted for more than $3.1 trillion in revenue in 2007. The 2,182 upper-middle-market firms added a further $1.5 trillion. To put these numbers in perspective, that $4.6 trillion revenue total is $200 billion more than that turned in by the 330,000 firms whose annual revenue fell between $5 million and $50 million.
Compartmentalizing the middle market is far more than just a matter of drawing boundaries around the numbers, Trottier emphasizes. Operations, management style, efficiency, expectations and motivation all differ from one slice of the middle market to another. The degree that a company mimics the attributes of those in the category above can be a pretty good predictor of upward mobility, Trottier suggests.
While we revel in high-profile companies that sprout from dorm rooms or garages and morph into gargantuan world-beaters, the odds are stacked against upward mobility. That's true even within the middle market, Trottier says. "Fully 95% of businesses never grow into the next category," he says.
As companies move from one category of the middle market to another, costs of capital diminish, investor pools and expectations increase, and valuation multiples move up.
Funding is the single biggest key. The upper end of the middle market operates much the same way as the big-cap market. With an array of capital sources, financial meltdown aside, it's a pretty well-oiled machine.
Climb down a few rings, and it's a different story. Asset-backed lending remains critically important for most of the middle market. That's a problem. The cost of accessing that capital is higher, as are the hurdle rates, Trottier says. That means the amount of available capital tends to be lower, which restricts growth.
Mezzanine debt is beginning to penetrate into the middle market. However, Trottier maintains, his research shows this kind of debt is almost entirely restricted to middle-market companies with private equity interests. "Individual owners are unlikely to have access," he says.
Debt is critical to the growth of the middle market and has become, by far, the biggest component of the capital structure. The ability of middle-market firms to access debt was severely curtailed after the financial meltdown in late 2008. "It's still the case," says Trottier. "Banks aren't lending to this market."
A lack of available finance hit the overall health of the middle market very hard. During the 2001-2002 downturn, the middle market "held its value reasonably well. It acted as a flywheel in the economy," says Trottier. "This time, it got the stuffing kicked out of it."
As widely reported, that pummeling curtailed middle-market M&A, with the total value of middle-market deals dropping by more than half from 2007 until 2009, according to Baird data. In number of deals, however, the middle market was virtually unchanged from 2007 to 2008 and dipped only by about 10% in 2009, compared to 2008. Last year, the number of middle-market deals registered a 60% gain.
While acquisition multiples rise or fall with the times, a substantial valuation differentiation within the middle market exists in rain or shine. Smaller businesses tend to sell for 3 times Ebitda, Trottier says.
The mid-middle market goes for 3 to 5 times earnings, while the larger middle market can garner 6 to 10 times earnings.
In a 2006 study, Trottier and investment banker Robert Slee defined lower-middle-market Ebitda as ranging from $500,000 to $15 million, mid-middle market as $15 million to $50 million and the upper end as more than $50 million.
The rate that middle-market businesses change hands has increased dramatically over the past three decades. Trottier and the University of South Florida estimate the number of middle-market "business transfers" in 1980 was at most 10,000. That number doubled by 2002 to 20,000. Trottier and the university's center had estimated middle-market transfers would almost double again from 2002 to 2010, to 38,000, although the investment banker now believes some of those were delayed until this year.
Trottier's study originally estimated the percentage of business transfers was expected to grow from 7% annually in 1980 to 11% last year. The financial crisis probably put that back a year as well.
Some reasons for this more active market in buying and selling middle-market companies are well documented: the generational change inherent with aging baby boomers and the astounding growth of private equity. Trottier adds other factors. On the sell side, corporate restructurings, spinoffs and divestitures source middle-market opportunities from large-company sellers. The pool of middle-market buyers has grown exponentially as private equity gains heft and as globalization kicks in. Acquisition funding is far more diversified. Transfer methods have proliferated -- everything from charitable trusts to employee buyouts. The middle market offers owners opportunities to retain equity stakes after they sell, something rare in decades past.
"There are more ways of doing it and more financing opportunities available," he says.
Few middle-market companies go public, however. "The odds of a lower midmarket company going public are worse than those of a college athlete making it to the big leagues," he writes. "And they are not improving."
With segments of the middle market, the advising community differs as well. Hundreds of business brokers serve small businesses and the lowest end of the middle market. "They're run more like real estate offices," Trottier says. "People show up and look at whatever business is available."
At the other end of the spectrum, maybe 10 investment banks dominate the upper part of the middle market. They have national reach, trumpet an ability to underwrite a public issue and can finance an eight-figure deal.
Dozens of boutiques populate the middle. Some have specific industry expertise. Others sit in one particular metropolis.
Trottier and the University of South Florida calibrated that 24% of all middle-market companies are in services, 20% in wholesale, 16% in retail and 13% in manufacturing. Nothing shocking there. What Trottier came away with after his three-year study of the middle market: Companies have an affinity across disciplines. "Regardless of what industry they're in, there's a similarity I found surprising."
For the past several months, The Deal has been involved in a long-range project to produce a database of advisory shops, private equity funds and lenders in the middle market. We now have four regions online under the heading of The Deal City by City.
To check out Cleveland, Milwaukee, Philadelphia and the most recent, San Diego, go here. Soon to come--Boston and Chicago--with many more in the works.