To Make Deals in the Middle Market, Private Equity Needs Cultural Literacy
The economic power of the middle market is immense. If it was its own country, the U.S. middle market would be the fifth-largest economy in the world. But when private equity (PE) tries to capitalize on the growth potential of the lower middle market, they face a challenge: cultural literacy. The fact is, the cultural world of PE and that of the lower middle market owner differ. First, there can be differences in education. Second, the business owners being pursued by PE investors are often new to M&A, and their lack of experience can easily cause misunderstandings. Finally, PE must work to overcome its less-than-stellar reputation. As PE looks to scoop out value from the lower end of the middle market, the industry would do well to bring along cultural literacy as well as a capital stack — PE and owners will mutually benefit, as will the U.S. economy.
Private equity investors, roaring ahead to another prolific year of deals, are increasingly eyeing buys hidden away in the lower middle market: companies valued between $10 million and $100 million. It’s not uncommon these days for these investors to pursue strong founder-led or family-owned companies in the $100 million, $50 million, or even $25 million annual revenue size. According to The National Center for the Middle Market, many are “B2B organizations that operate within the supply chains of other larger businesses” — sturdy bolt-ons or platforms that offer innovative product designs, compelling business models, or a valuable stable of workers.
But when private equity (PE) tries to capitalize on the growth potential of the lower middle market, they face a challenge: cultural literacy. And as Peter Drucker is said to have observed, “Culture eats strategy for breakfast.” Our years of doing deals in this part of the market have taught us that without cultural literacy, one cannot build a depth of trust with these hardworking owners, clinch a deal, or even master a smooth post-close integration.
The fact is, the cultural world of PE and that of the lower middle market owner differ. The Economist wryly observed that “there has long been an element of the gentlemen’s club about the private-equity industry,” which lower-middle-market business owners might find unrelatable. If the PE community wishes to move deals to close quickly and create greater value throughout the transaction lifecycle, they need to “speak” the language of these business owners, which is easier said than done.
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First, there can be differences in education. Private equity decision makers often hail from top universities. One report showed that the majority of MBAs PE firms sent to Europe hailed from just four schools: Harvard, Wharton, INSEAD, and Stanford. Even if not educated at the “top” universities, virtually all PE 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 degree.
At the auction of a business we represented a few years ago, a cavalcade of PE investors tromped through a hotel conference room near BWI airport, all eager to acquire our client’s company. It was spinning off nearly $100 million in annual revenue, was growing by the day, had always been profitable, boasted deep customer relationships with financial behemoths, and offered a national network of trained workers. As each PE group began their pitch, our client stopped them to ask, “How many of you have MBAs?” The visitors, hailing from Los Angeles, Dallas, New York, and Philadelphia, all held up their hands. Our client announced that he and his wife didn’t have college degrees. 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 company they had built with true respect.
Even those owners who do have advanced degrees and are brilliant subject matter experts are unlikely to be finance experts. In fact, a study from the National Center for the Middle Market found that a full 90% of middle-market companies that sell or merge have “little or no previous experience” in M&A. In contrast, PE players are by their very nature M&A experts.
That’s the second big mismatch: The business owner is an M&A amateur, and their lack of experience can easily cause misunderstandings. Adam Altus, managing partner of Sier Capital, told us, “I actually want an investment banker to represent sellers. If a founder-owner isn’t professionally represented, negotiating is time consuming and unstable.”
But cultural literacy goes beyond educational differences and M&A-speak. The values that a typical founder-owner brings to the conference table, along with their life experience, often differ from PE. Many founder-owners have been raising their companies as long as they’ve been raising their children. Such companies often have strong employee retention rates and a deep affection for their workers.
“When my parents, Tim and Jane Bennett, were building their manufacturing business, the Maiman Company in Springfield, Missouri, my mother would personally sign every employee’s paycheck. She would write ‘thank you’ on each one. It was important to her that each employee knew how much they meant to my parents and the company,” recalls Adam Bennett of Bennett Partners in Alexandria, Virginia.
This deep kinship between owners and employees is often forged over decades of struggle. When we represent founder-owners selling a $10 or $15 million EBITDA company, the owner will often care as much about what will happen to their legacy employees as what the cash-at-close figure will be. The PE buyer needs to understand that the purchase price is only part of the value owners are seeking — respect for key employees and the company’s legacy are extremely important as well.
Finally, PE must cope with the reputation that precedes their outreach. That reputation — so toxic that “The Private Equity Council” had to literally rebrand itself as “The American Investment Council” — drives devastating poll results. For example, in 2019, Lake Research Partners and Chesapeake Beach Consulting found majorities across the political spectrum oppose the “predatory tactics of private equity.” With street cred like that, PE representatives face an uphill battle.
Meanwhile, business owners often fail to recognize that there are many different kinds of PE investors. The classic PE model of cutting expenses to the bone and jacking up revenues to lead to a profitable sale in three years is no longer the norm, certainly not in the lower middle market. A great question for owners seeking a culture fit is, “How long do you hold your investments?” There are many PE firms that seek to hold investments for many years, even decades. In fact, long-hold investments often outperform typical five-to-seven-year buy-and-flip strategies.
Mastering enough cultural literacy — on both sides of the fence — so that all parties understand what’s important to the other will improve the chances for mutual success. Rather than dividing the pie, understanding the needs of the other party opens the possibility of enlarging the pie: The founder-owner seller may value the speed of close very highly, for example, because of a health concern. The PE buyer may be focused on tax considerations. Correctly ascertaining what each party cares most about and then negotiating a deal that gracefully toggles between a host of deal points to deliver satisfaction to both takes cultural literacy.
Of course, closing is not the end of the road. Post-close integration is essential to a successful acquisition, and the fusion of different business cultures can be challenging. Lower-middle-market companies may have processes that trace back to founding days and require change. In fact, installing better business practices is part of how PE can turn a $10 million EBIDTA company into a $20 million EBITDA company. But the integration challenge will go better when all parties give cultural issues sufficient attention. No investor and no seller these days wants to close an acquisition only to see an exodus of committed, skilled workers.
The economic power of the larger middle market is immense. In terms of size, if it was its own country, the U.S. middle market would be the fifth-largest economy in the world. As private equity looks ahead to scoop out value from the lower end of that market, the industry would do well to bring along cultural literacy as well as a capital stack — PE and owners will mutually benefit, as will the U.S. economy.