There are 350,000 middle-market companies in the United States, but when it comes to accessing capital — whether they’re looking for debt, an equity investment, an acquisition, or a company exit — they’ve been mostly left wandering in the dark. They struggle to get the attention of banks, investment banks, and other financial services providers — and worse, when they do make a connection, they often pay outsized fees compared to large companies. So how can middle-market companies and the many deep-pocketed capital providers overcome this capital transaction chaos? The key to improving the velocity of successful capital transactions in the middle market is new tools that facilitate access to secure information exchange so that the parties on each side of a transaction can 1) get to know each other and 2) expeditiously gather, organize, and exchange critical information on a confidential basis.
Large companies have never had a problem with capital transactions. As long as they’re not on the verge of insolvency, there’s a relatively small, well-known universe of banks, private equity firms, conglomerates, and other institutional investors available to look at their deals, whether it’s an injection of new capital, a loan, or an outright sale of their company. Moreover, large companies have sophisticated senior financial executives on board, and they have access to the best third-party advisors that money can buy. Everyone wants a piece of a big deal.
On the other hand, the smaller cousins of these large corporations, middle-market companies, are not so fortunate. There are 350,000 middle-market companies in the United States, accounting for over 33% of U.S. GDP. Yet over the years, when it comes to capital markets, they’ve been mostly left wandering in the dark. Whether they’re looking for debt, an equity investment, an acquisition, or a company exit, midsize companies have, for the most part, been ignored. They struggle to get the attention of banks, investment banks, and other financial services providers — and worse, when they do make a connection, they often pay outsized fees compared to large companies. The internet made it easy for an individual to get a mortgage approved in 15 minutes or less, so why is it so hard to harness the same potential for the middle market?
Midsize Companies Are Underserved and Overcharged
With so many middle-market companies in play looking for capital and wanting to do deals, why aren’t capital providers and deal makers all over them? After all, there’s no shortage of capital available. At the end of 2020, it’s estimated that almost $750 billion of funding was available from middle-market investment sponsors — plenty of dry powder for loans, equity, and acquisitions — and that number is expected to climb to $1.7 trillion in 2021. Yet only about $200 billion was spent on middle-market M&A in 2020, leaving $500 billion on the table. A recent article in The Wall Street Journal reported that big banks across the country were loaded with cash and looking for more lending opportunities. So, there’s no shortage of money available to support loans, deals, and investments.
On the other side of the ledger, there are hundreds of thousands of middle-market companies with pent-up demand for loans, new equity investments, acquisitions, and company exits. However, unlike big companies, most middle-market firms tend to be sedentary when it comes to banking relationships. Historically, they’ve picked a lender and stuck with them, mostly out of inertia but often out of fear. Lack of financial sophistication, preoccupation with operating demands, and concern about “word getting out” if they shop other local banks has created for many an atmosphere of fear that they might be left with no good alternatives to their long-time lending source.
That fear was realized in 2020 when the pandemic hit. Many companies had to completely close down, while others suddenly had to shop for alternative sources of cash. Of course, many turned to PPP and EIDL government-backed loans. In just the latest round of PPP loans, the SBA reports that, as of February 28h, there have been 2.2 million loans totaling $156 billion. Importantly, all these loans have been consummated through an online lending process.
These government programs have led many borrowers to new SBA-backed lenders they’ve never worked with before. This is part of a gradual awakening that middle-market companies can do something about being “underserved.” Well before Covid-19 arrived, the Deloitte Center for Financial Services reported that 20% of middle-market companies were prepared to actively shop for new lenders. Although the pandemic led to many new middle-market banking relationships, it exacerbated the feelings of many that they’ve been “overcharged.” This is due in no small part to most banks implementing a pandemic-inspired review of their middle-market relationships in 2020. Not surprisingly, these reviews led to more stringent loan terms (i.e., higher interest rates and lower loan sizes) and tighter covenants (restrictions on asset sales, financial reporting requirements, use of cash, and accounts receivable, etc.).
In addition to having historically limited borrowing choices compared to larger companies, middle-market companies tend to pay higher rates for their loans. Many lenders not only require personal guarantees from company owners, but they also charge higher interest rates. (If you own a business, consider the rate on your personal credit card and compare it to the rate on your company card.) Another factor is that many middle-market companies will engage a commercial loan broker to seek out the best terms and conditions. These brokers will get a 1% or 2% commission on the loan amount at closing. Those fees are passed along to the borrower in most cases.
Now let’s look at middle-market company sales and acquisitions. About 10,000 middle-market companies are sold each year. That number is expected to grow as business-owning baby boomers retire from family-owned companies. According to a study by the National Center for the Middle Market, at any point in time, about 70% of business owners are thinking about selling their business, and 50% are expecting to acquire a company. Middle-market leaders say that finding the right buyer for their company or the best target to acquire is one of the most confusing aspects of M&A. Nevertheless, they don’t seek much help with the process. Both buyers and sellers of companies tend to rely heavily on their internal executives and top managers when searching for companies to buy or sell to. During the search process, about a third of buyers consulted an external law firm, and even fewer talked to consultants or investment bankers. Sellers were even less likely to bring in external advisors as part of their search for the right buyer. Only one in five sellers uses an investment banker.
Why is this? It’s not because these company owners are so experienced that they don’t need help. Only half of sellers have ever sold a company before. On the buy side, only 10% have multiple acquisitions under their belts. It’s therefore not surprising that two-thirds of middle-market companies are dissatisfied with the results of their M&A experiences. With this background, why don’t they seek professional assistance from the investment banking community that their bigger siblings use?
First, most bankers aren’t interested in these smaller deals. And worse, the bankers who will work with middle-market companies charge fees that are outrageously high in the view of their clients. In addition to monthly retainers, bankers will ask for a “success fee” ranging from 5% to as much as 10% of the sale price. This is also the fee structure bankers apply when raising equity capital for middle-market companies. For an “exiting” owner of a $50 million company, that could amount to $5 million or more off their ultimate reward for building up a business over the years. Moreover, bankers are thought of as “glorified real estate brokers.” As one owner said to me, “All they want to do is flip my company and get on to the next deal.” Company owners object to the pressure put on them by outside advisors to hurry up and get a deal done, fear leakage of confidential company information, and dislike the loss of control over the process. Most sellers and acquirers get a case of cold feet at some point along the way.
The historical track record of success for capital transaction deals in the middle market is grim — only one in ten deals get done.
What Needs to Happen
How can middle-market companies and the many deep-pocketed capital providers overcome this capital transaction chaos? First, they have to use available and forthcoming technology to get to know each other. The use of online application techniques in the PPP program shows that company executives can adapt to the use of internet deal making. Think again about fintech in the consumer sector: An overwhelming majority of working-age Americans use apps to access money, pay bills, apply for loans, and exchange information over the internet. The key to improving the velocity of successful capital transactions in the middle market is new tools that facilitate access to secure information exchange so that the parties on each side of a transaction can 1) get to know each other and 2) expeditiously gather, organize, and exchange critical information on a confidential basis.
Fortunately, the market is showing signs of moving in this direction, albeit belatedly. The dramatic dislocations created by the pandemic have many companies shopping for loans, some desperately seeking buyers, others opportunistically seeking acquisitions, and more comparing alternative costs of capital to foster post-Covid growth. Middle-market business leaders are ready for this shift to digital — 49% of them report that they’ve implemented new ways of utilizing technology during the pandemic.
In addition to the SBA programs, there are many innovative companies creating new tools for middle-market capital transactions, including:
- Cerebro Capital: A middle-market lending platform
- NepFin: Another lending platform
- ValuSource: An online company valuation product
- BizEquity: Another set of online valuation tools
- Opus Connect: Equity fundraising networking
- Axial: Another equity fundraising network
- RealAtom: An online commercial property financing service
- iBorrow: Online bridge financing for commercial property
Time will tell how deeply these and other applications will affect their respective middle-market capital segments. In any case, there will continue to be an extremely large number of middle-market companies, and they will continue to have a real impact on the U.S. economy. Extant marketplace inefficiencies and the need for rationalization is equally obvious. It’s time for innovators to more comprehensively emulate fintech in consumer markets and empower increasingly ready middle-market executives. Whether they’re capital seekers or capital providers, management teams can handle capital transaction apps. In the coming years, our rebounding economy will be boosted by new tools and expertise that reduce capital chaos, simplify and streamline debt, equity, company exits, and acquisitions in the middle market.