The Changing Structure of LMM Deals

It has been a historically chaotic year. Global health and social concerns are at the forefront in all of our thinking, as well as the resulting economic uncertainty. So how will all of this impact business owners in the Lower Middle Market?

The investment banking industry often breaks companies into groups based on the size of their Total Enterprise Value (TEV). Here at SDR Ventures, we help business owners operating in the Lower Middle Market (LMM) achieve their transaction-related goals. The LMM is typically composed of companies with TEVs between $10 and $250 million. While these companies may vary greatly in terms of industry and product or service profile, there are some common “size-based” criteria that impact market valuations.

It’s no secret that companies of all types and sizes have been impacted by the effects of COVID-19, both positively and negatively depending on their industry and customer base. However, across the entire LMM spectrum, there was an undeniable decrease in Q2-2020 M&A activity. A recent survey conducted by GF Data consolidated M&A activity data from 277 independent Private Equity firms. While several interesting findings resulted from this analysis, there are a few that we would highlight for business owners considering a transaction in the near future.

First and foremost, the industry saw a dramatic drop in LMM M&A activity involving Private Equity firms between Q1 and Q2 of 2020. Of the respondents surveyed, there was a 63% decrease in deal flow from Q1 to Q2. While this may trouble a business owner looking to transact, it is not all bad news. Despite the slow down in deal flow, Total Enterprise Valuations remained steady during the early phases of the COVID-19 shutdown. What our team found interesting, is that the use of Debt to finance these transactions dropped by approximately 15%. The figure below illustrates the stability of transaction values while experiencing a strong shift in both deal count and use of Debt to fund transactions in Q2.

Debt/Equity Financing Comparison

So, what exactly does this mean? This means that Private Equity firms have been using Equity (which is a more expensive form of capital) to bridge the gap created by the reduction in available Debt. In general, Senior Debt may cost 6-8% on average while the expected Equity returns in Private Equity range from 18-22%.

2020 Equity Usage

This makes sense to some degree because of the incredibly high amount of Equity “dry powder” looking to be deployed in the private markets. However, is this sustainable? This trend suggests that Private Equity investors will have to lower their overall return expectations on their investments to account for the gap.

SDR’s Insights:

We conjecture that the majority of deals that got done in Q2 were for very healthy “A” grade companies that were either not impacted by COVID or impacted positively. Thus, the fact that the overall multiples did not go down is skewed by the fact that assets of the “B” and “C” grades were taken out of the sample set because the M&A sales processes for those companies were either put on hold or shuddered by the effects of COVID-19. The graphic below illustrates our intuition on the quality of the assets that closed in Q2:

Illustrative Deal Pyramid

As we look to the future, the extremely aggressive pricing and leverage multiples in the Debt markets for M&A deals that existed in Q1-2020 and prior are gone. The only way that overall valuations can hold at historic levels is for Equity to make up the gap.

As a result, we are noticing that Private Equity firms are increasingly adding a “Debt-Like” structure or features to their Equity instead of making their Equity investment pari passu (in the same security as) a seller’s Equity reinvestment. That is, in transactions where the seller is reinvesting Equity in the company as part of the transaction, Private Equity firms are adding liquidation preferences, preferred coupons, and other structures to their Equity investment dollars to protect their COVID era investments, that they did not previously require.

Conclusions:

  • Private Equity firms adding more structure to their Equity will become the “new norm” as the aggressive leverage environment has dissipated.
  • As deals that were delayed in Q2-2020 get closed in the 2nd half of the year, we’ll see the overall TEV multiples decrease as “lower quality” deals that were initially sidelined due toCOVID-19 concerns & shutdowns finally close.