An M&A Guide for the Middle Market

A new report from the National Center for the Middle Market singles out mergers and acquisitions as a powerful and even predictable force behind sector success. “Middle Market M&A: What Executives and Advisors Need to Know to Make the Most of Mergers & Acquisitions” uses data from Thompson Reuters to determine that approximately 2,000 middle market deals are struck every quarter. 2017 was no different, despite 60% of middle market companies reporting they perceive an uptick in merger and acquisition activity.

“It feels up, but it’s not,” explains NCMM executive director Thomas Stewart, who points to historical Middle Market Indicator data showing a definite cadence in the transactions. “Those charts are as predictable as a marathon runner’s heartbeat. Just constant rhythm. … What’s different is there is [now] a lot of money out there looking to make deals. That means two things: Price is going up and the structure of the deal has changed a little bit. Less banks, more equity.”

Regardless of the cyclical evolution, NCMM research shows that 1 in 5 middle market companies makes an acquisition every year, while 1 in 20 sells outright or divests a portion of the company. 

Though less frequent, sellers often have stronger impetus to act. Many times a middle market business is a family operation. If there is no apparent succession plan, and the owner decides to exit while the getting’s good, often the decision to divest partial ownership is tied to an owner’s desire to liquidate a portion of the long-term investment they’ve made in a business over time. Whatever the motivations, a sale can rise abruptly. In many cases people don’t sell until they’re propositioned, Stewart says.

Common reasons to buy include acquiring new customers or capabilities. Interestingly, many respondents view expansion not as a luxury available solely to businesses enjoying an abundance of cash flow in the best of times, but as a necessary component of survival. Stewart says there’s an acute fear of being overshadowed and boxed out by growing competitors if businesses stand pat. “A lot of people told us that they felt that they had to get bigger to compete with consolidation,” Stewart says.

If fear defines the beginning of the purchase cycle, exuberance colors its final stages. Of companies that do participate in the acquisition phase, 60% report buying is vital to their growth strategy and signal they expect a deal to account for 26% of future growth, which Stewart says comes from a mixture of “data and hope.”

“That suggests that [respondents] are hoping for more than bolt-on sales, that they’re hoping for positive synergies. One and one is going to make 2.3,” he says.

The eye-popping growth numbers paired with an appetite for expansion in the sector might suggest that middle market execs are old hands at deal-making, but their responses say otherwise. Forty-one percent of companies that reported completing a purchase within the past three years say they had limited experience in acquisitions, and almost a third (29%) were participating in the M&A process for the first time. This inexperience can cause missteps that cut into the value of the deal, says Ed Kleinguetl, a transaction services partner at Grant Thornton LLP, which contributed to the report.

“There are a number of novice mistakes,” Kleinguetl says, such as the misconception that the acquirer and acquired businesses are functionally similar. “Even if it is a common business, there are many dynamics that can create differences,” he says. “First among these is the overall cultural alignment, which is often a reflection of the owner-operator.” Further, some businesses are highly disciplined with strong systems and controls. However, many middle market companies are run by gut feel and intuition. 

Overcoming these obstacles begins with a checklist. Employees, health plans and operations all need methodical synchronization. Even more important is prioritizing plans to retain top talent and customers post-acquisition and developing a communications plan.

“Communication to customers must be proactive to thwart nimble competitors who see an acquired company as distracted and its customers as prime targets for poaching,” Kleinguetl says. “The same holds true for key employees. The old adage is true: In the absence of communication, people create their own realities. It’s better to proactively communicate to each key stakeholder group.” 

Of course, all this maneuvering presupposes middle market buyers and sellers have identified a target. Yet, here too, amateurs operate. The report finds that middle market sales searches are helmed most often by internal advisers. Only a third of buyers consult outside law firms, and fewer request help from investment bankers. Sellers are even less likely to make use of external experts. Though logic would dictate an experienced guide gives a buyer or seller an advantage during the search and negotiation process, Kleinguetl says would-be dealmakers often operate illogically and are less likely to accept help even if an expert is consulted.

“In likely half the cases where an owner is involved, there is a gut feel or intuitive decision to go forward with the deal,” he says. “Sometimes it is hard to overcome these types of decisions, which have emotionally already been made. ‘Buyer beware,’ is always sage advice.”

Expertise is particularly valuable when considering valuation, which can be difficult to assess and laden with emotional baggage, yet paramount to any deal being struck. Forty-one percent of buyers report they find it very difficult to value a business they are purchasing, and 43% of sellers say the same thing about their own business.

“In many cases, the valuations can be off because of optimistic estimates of synergies or deal value to the acquirer or unforeseen market conditions,” Kleinguetl says. “There is a correlation between the depth of initial diligence and the ability for a deal to deliver the anticipated results. … As an example, one client closed a transaction, and a few weeks later discovered the roof in a distribution center had to be repaired—an unforeseen $1 million expenditure. The problem is that just looking at financial statements and tax returns in a data room will not find the leaking roof, unless the target discloses it.”

Finally, motivated buyers and sellers might encounter a longer process than they had anticipated. Most deals can be completed in under a year, but becoming “deal-ready” is a multiyear process.

“Deal readiness is an interesting concept,” Kleinguetl says. “The reality is that most buyers do not like to see ‘lumpy’ results in a target’s history. They like the proverbial upward growth history and implied trajectory. If the plan is to sell a company, it is important to focus on performance quickly and maintain a continuous improvement mindset.”