U.S. Lower Middle Market Opportunities

rising demand for private equity in the u.s. lower middle market: opportunities versus challenges

Since ancient times, investors have sought to invest in strategies with the potential to outperform the markets, through boom-and-bust cycles, across asset classes, and on both a relative and absolute basis.  In modern financial times, institutional investors committing to private equity strategies as part of a diversified portfolio invest under a premise that the inefficiencies of the private market and a perceived “illiquidity premium” will increase their overall returns. Going even further, investors are applying lessons learned on the benefits of diversification in a portfolio, and appear to be evaluating the lower middle-market (“LMM”) with the commensurate opportunities and challenges in this segment.

Many believe this segment of the private equity landscape can exhibit an attractive risk-reward profile and value creation opportunity for investors. Not only can a successful private equity firm capitalize on the often less competitive and less efficient market dynamics in this market segment through lower entry valuations, there is also significant potential for value creation, as these LMM companies seek to benefit from the strategic guidance and operational enhancements/improvements provided by an experienced private equity partner. As a result, the LMM sector of the private equity marketplace has historically been able to yield compelling returns for investors¹. 

From 2021 to 2024, the number of LMM-focused funds raising capital each year was significantly greater than that of large and mega buyout funds².  As funds have been allocated to the space, investors have diligence which LMM fund managers are able to convert the opportunity into performance.  What increases the chances for success of any particular LMM fund manager?  What can a private equity investor, seeking to capitalize on LMM opportunities, look for in order to be able to discover and access those GPs with the competitive advantages necessary to unlock the potential of the U.S. LMM?

the opportunity

Less Efficient Company Dynamics

LMM private equity fund managers often target smaller companies for investment when compared to the companies targeted by the large and mega buyout firms. Often, these companies are managed in a less than efficient manner due to several reasons:

• Limited risk appetite of founders and/or business owners whose net worth may be tied to the company
• Limited access to capital to invest in organic or inorganic growth
• Underdeveloped and/or less professional management teams that may not have the tools or skill sets to take the company to the next level
• Challenges in attracting high-quality talent to a smaller business
• Underinvestment in IT and internal control functions
• Insufficient data and systems to understand growth vectors or potential for pricing improvements

Given LMM fund managers typically seek companies with the above characteristics, they are often the first institutional investors in these businesses, allowing them the opportunity to make evolutionary changes that may be more difficult for a founder.  LMM fund managers generally believe that an injection of external capital, and more importantly application of the manager’s strategic, operational and historical expertise in helping other similar companies scale, will translate into success and produce attractive returns for investors.

Lower Entry Multiples

Often due to the less efficient business characteristics noted above, LMM businesses can be acquired at lower entry multiples relative to larger businesses. 

The LMM market segment is also generally considered more fragmented, and as a result LMM funds may face less competition allowing for attractive entry points at favorable valuations.  Commensurate with lower entry prices, these businesses may be able to utilize less leverage, and as a result can be less reliant on the capital markets.  As LMM fund managers work with company management teams to address the issues inhibiting growth for these smaller companies, and help them scale to the size of their larger peers, these businesses may be able to realize benefits from multiple expansion and trade at higher exit multiples. 

Figure 1 data source: Pitchbook, Jan 27 2025

Broader Exit Alternatives and Less Market Correlation

LMM businesses may have a lower correlation to broader market movements, particularly with regards to exits.  In addition, LMM businesses generally have multiple exit alternatives.  In some cases, there may be an opportunity to take a company public, assuming the LMM fund manager scaled the asset significantly enough to warrant public investor demand.  More likely, however, are potential sales to trade buyers, or corporate investors that are interested in filling holes in their strategic portfolios.  Strategic buyers may even be willing to pay premium prices given the potential synergies they can extract from the acquired businesses.

While an IPO or strategic sale is a welcome exit option, another exit alternative for a LMM business is through a sale to a larger private equity firm.  Large and mega private equity firms typically amass tremendous amounts of “dry powder,” or capital raised that has yet to be deployed into investments. To put this in perspective, as of mid-2024, 21% of all private equity and venture capital dry powder globally was held by just 25 large funds³. Partners at these larger private equity firms will likely feel pressure to deploy capital as the expiration of their investment periods begin to draw near. Large and mega buyout funds seeking to deploy this dry powder can acquire a business that has become more professional and institutionalized through ownership by the LMM fund sponsor. In many circumstances the acquiring large sponsor may bring different capabilities, resources and skill sets to bear, such as the ability to begin an M&A strategy or expand internationally, that can help take these LMM companies to the next level.

The lower middle market has also experienced an increase in the sale of smaller portfolio companies to private equity-backed consolidation strategies. A private equity consolidation platform can effectively serve as a strategic investor to fill gaps in product suites and/or geographies.

Figure 2 data source: Preqin, Jan 28 2025

Historical LMM Fund Performance

It is said that a picture is worth a thousand words. Figure 3 represents the U.S. buyout fund universe according to Preqin and graphically illustrates a wider dispersion of returns among LMM funds to the left relative to the more banded returns of the large and mega funds to the right. 

Figure 3 data source: Preqin, Jan 28 2025

This illustration may be sufficient to end the discussion on whether small and medium-sized funds can outperform their larger brethren.  Historically, this data suggests that top quartile LMM funds have outperformed their larger peers, with a greater upside for the strongest managers.  However, the efficient frontier has taught us that there is no free lunch, and that with the possibility of higher returns, there is also the potential for higher losses, reflected in the wider dispersion of returns.  The goal for investors is to capture the upside, while avoiding the potential losses within LMM funds. Addressing the challenges inherent in LMM investing may be able to mitigate this risk.  

Figure 4 & 5 data source: Preqin, Jan 28 2025

the challenge

Given the plethora of LMM funds being raised and the wider dispersion of returns, a challenge for investors is the ability to execute thorough and sufficient diligence and apply a tight filter for selection. 

Simply put, manager selection matters.  Over the last 15 years, having top quartile LMM funds in a diversified private equity portfolio would have been significantly additive to returns. Investors seeking to invest in funds focused on the LMM often encounter obstacles, from identifying and monitoring a vast number of funds to building relationships with managers over time. These challenges can be compounded by the resource-intensive nature of due diligence and the capacity constraints inherent in the LMM sector.

Sourcing and Selection

The sourcing and diligence efforts for LMM funds can, indeed, be challenging.  Compared to large and mega buyout funds, there are many more LMM funds to identify and monitor, which can be taxing even for limited partners with larger teams.  In addition, an investor without sufficient scale to maintain relationships with multiple LMM fund managers over time may be overwhelmed with the sheer number of funds in the market. Regular interaction to build a relationship, potentially over several years, may be necessary to gain access to an in-demand, capacity-constrained manager. 

Furthermore, diligencing LMM fund managers can be a resource-intensive exercise.  Often the track records of these managers are shallower than those of their larger peers, with fewer investments, realizations, and resources to evaluate.  It can take more time, effort, and better networks to diligence the less familiar names in the LMM market.

Access and Allocation

Even after having selected the right funds, investors may still face obstacles with respect to access and allocation.  The lower middle market is often capacity-constrained given the investments are in smaller private companies.  Limited partners need to not only identify the strongest managers, but also gain access to their latest fund.  Once LPs gain access, the question then remains whether they can secure their desired allocation to a constrained opportunity.  For example, fund managers may place a cap on the amount they make available to a single investor.  Similarly, an investor may have their own constraints on the total percentage of a fund they wish to represent.  Investors with a desire to invest larger amounts may find that they are unable to commit as much capital as they would like to a single fund or to the LMM strategy as a whole. 

Even engaging an allocator with extensive LMM relationships to act as an advisor may not completely mitigate this restricted access and capacity issue. Third party allocators often implement rigid allocation policies which determine which clients and mandates will ultimately receive access. Some allocators are not motivated to grant pro-rata access in respect of constrained opportunities to newer clients, or clients that are not using that advisor for multiple mandates/services or products. The deck therefore may be stacked in favor of existing investors, with new clients left unable to get the most sought-after fund opportunities. Allocation policies using subjective criteria (such as limiting allocation in a constrained opportunity to only a subset of their largest clients), or on a first come – first served basis (constrained capital allocated to existing clients only with newer clients receiving access only to funds that have larger capacity) over a simple pro-rata approach can further exacerbate the challenges associated with gaining access to the top tier LMM managers.

conclusion

Investing in U.S. lower mid-market private equity funds can be beneficial for portfolio construction and return enhancement due to their ability to target underappreciated and overlooked companies that have significant potential for growth.  These smaller companies often benefit from the expertise and resources that a LMM fund manager can bring to bear, which can help them professionalize and scale rapidly. Sourcing, selecting, and accessing those managers with expertise and focus is key to capitalizing on the rising demand, potential for compelling performance, and advantageous diversification of the LMM market segment.

FOOTNOTES AND IMPORTANT INFORMATION

¹Data source: Preqin, Jan 28 2025
²Pitchbook fundraising for U.S. buyout funds as of January 27, 2025.  Lower Middle Market (“LMM”) funds defined as U.S. buyout funds $2 billion or below in fund size.  Large and mega funds defined as U.S. buyout funds greater than $2 billion in fund size.
³https://www.spglobal.com/market-intelligence/en/news-insights/articles/2024/7/private-equity-dry-powder-growth-accelerated-in-h1-2024-82385822

SOURCES

Unless otherwise noted, fundraising data sourced through Pitchbook on January 27, 2025. 

Benchmarks or other measures of relative market performance are provided for information only and do not imply that an Abbott Client will achieve, or should expect, similar returns, volatility or results, or that these are appropriate benchmarks to be used for comparison.  The market volatility, liquidity and other characteristics of private equity investments are materially different from publicly‐traded securities and the composition of these indices does not reflect the manner in which any Abbott Client portfolio is constructed with respect to expected or actual returns, portfolio guidelines/restrictions, investment strategies/sectors, or volatility, all of which change. Index returns will generally reflect the reinvestment of dividends, if any, but do not reflect the deduction of any fees or expenses which would reduce returns.  An investor cannot invest directly in the indices.

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Past performance is not a guide to future results and is not indicative of expected realized returns.

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