CHAPTER 1
The Middle Market
The middle market is at once the most dynamic part of the U.S. economy and the least known. Smaller than the celebrated, multinational enterprises that participate in global markets, trade on public stock exchanges, are the subject of most academic research, and fill the pages of the Wall Street Journal, Fortune, Harvard Business Review, and other publications, middle market companies go about their business relatively undocumented and usually unheralded. The vast majority are privately held, so publications and broadcasts devoted to investment ideas ignore them. Academic studies are relatively rare. Most are too small to merit the interest of strategy consultancies like McKinsey and the Boston Consulting Group, whose publications about superior management practices focus on the multinationals that are their target market.
At the same time, middle market companies get less attention than small business. The U.S. federal government (and states, following the federal lead) tracks small business performance through the Small Business Administration (SBA), the Bureau of the Census, and other entities. The SBA, now a cabinet‐level agency, advocates for small firms in Congress and in the deliberations of other cabinet departments and government agencies. It orchestrates the provision of counseling services that reach over 1 million entrepreneurs and small business owners annually. Because there are so many small businesses—more than 30 million by the SBA's count—they attract the attention of local and regional chambers of commerce and other groups. American Express promotes “Small Business Saturday” after Thanksgiving each year and “Shop Small” programs year‐round. And, of course, the small business that grows into a giant is the stuff of entrepreneurial American mythology. The Palo Alto, California, garage in which David Packard and William Hewlett founded HP was declared a California landmark in 1987 and was listed on the National Registrar of Historic Places in 2007.
The middle? Not so much. Only in the past decade or so has the U.S. middle market been given sustained attention by researchers, notably through the National Center for the Middle Market (NCMM) at The Ohio State University, surveys and analysis produced by RSM, a tax, audit, and advisory firm, an annual private capital markets study by Pepperdine University, and a few other entities. A handful of chambers of commerce, notably in Chicago, Cleveland, and Philadelphia, have created special programs for middle market companies. Several city business journals produce annual rankings and celebrations of local middle market companies. A Congressional Caucus for Middle Market Growth existed for half a dozen years before disbanding. But there is nothing in the American business landscape comparable to the support for and celebration of the German Mittelstand, the cadre of midsized family businesses Germans consider the core of their economy and the reason for its enduring success.
PERFORMANCE AND IMPACT
Yet the American middle market is arguably as important to the U.S. economy as the Mittelstand is to the German. There are different definitions of the middle market (see the section further on) but however one counts, it produces about one‐third of private GDP, more than $6 trillion—half again as much as the entire German economy and more than the economies of France, Italy, and Spain combined.
The critical role of the middle market is not just a matter of its overall size. The resilience of these companies—Dun & Bradstreet data show that almost 70% of middle market companies have been in business for more than 20 years, compared with only 26% of small companies—makes them especially important to the communities in which they operate and the families whose members they employ. So does their growth. Although small businesses are the legendary engine of economic growth, on a net basis the middle market actually produces more growth, partly because fewer midsized companies fail, and partly because many small businesses are not built to scale (a neighborhood restaurant, for example). On average, middle market companies' revenues grew 7.0% between the first quarter of 2012 and the end of 2019, according to the National Center for the Middle Market data, and added employees at a 4.3% annual rate. Both numbers are substantially higher—about one and a half percentage points—than the growth rates for large or small companies. As they grow, many middle market companies become big companies—27% of large U.S. companies in 2010 had been middle market companies five years earlier.
One can make similar observations about the importance of the middle market to employment. During the 2007–2010 “Great Recession,” about 43% of small businesses went under, versus 18% for the middle market and 3% for big business. But the surviving middle market companies added 2 million jobs in 2007–2010, a period during which large companies reduced headcount by nearly 4 million.1
Beyond these economy‐wide effects, the middle market plays a critical role in the industry clusters that, as Professor Michael Porter has shown, are sources of national competitiveness and metropolitan‐area vitality.2 Companies of this size are frequently tier‐one suppliers to global manufacturers, delivering parts and components or offering business services like logistics and distribution. Of particular relevance to readers of this handbook, they are often the source of new intellectual property that makes them acquisition targets for large businesses, a phenomenon widely observed in pharmaceuticals, life sciences, fintech, software, and other industries. A “barbell economy” made up of large and small companies does not fare as well as one with a robust middle market.
The role middle market companies play in business ecosystems parallels the role they play in industry clusters. Middle market companies are rarely the “keystone species” in a business ecosystem, but they give it breadth and sustainability as suppliers to OEMs and providers of intermediary services. A business ecosystem like the tourism economy of Orlando or Las Vegas includes hundreds of middle market firms in the mix along with big companies like Disney and Southwest Airlines. The automotive ecosystem includes a full range of suppliers of parts and components, along with their suppliers, plus a downstream mix of dealerships, a large percentage of which fall into the middle market; a Brookings Institution study of the automotive industry in Tennessee showed that it depends on a supply base of 1,000 companies, all middle market.3
From a strategic point of view, the most successful middle market companies tend to have deep relationships with a few customers or suppliers, rather than shallow, transactional relationships with many. In some cases, this concentration is driven by big companies; for example, encouraged by Bath & Body Works (then part of L Brands), more than 14 suppliers have come together outside Columbus, Ohio, in an International Personal Care and Beauty Campus (inevitably nicknamed “Beauty Park”) that produces bottles, caps, pumps, and packaging—an estimated 50% of the supplies the big company needs.4
DEFINITION
Defining the middle market depends partly on statistics, partly on who is doing the defining, and partly on feel. NCMM defined the middle market as being comprised of companies with annual revenues between $10 million and $1 billion, based on analysis of the U.S. Census Bureau's 2007 Business Census, which showed that about one‐third of private‐sector GDP and employment was produced by companies in that range, with another third coming from smaller firms and another from larger enterprises. That definition has been broadly but not universally adopted. The idea that the middle market should be the middle third of the economy has obvious appeal and utility, but it is a moving target. First, GDP grew nearly 50% between 2007 and 2020, from $14.5 trillion to $20.9, which suggests that the sliders would be set differently today. Second, the definition was created by finding the middle third of the American private sector. In New Zealand, work by NCMM's then‐partner GE Capital found that country's middle market to consist of companies with revenues between $2 million and $50 million, in contrast with the U.S. middle market with its broader revenue range, described later in this chapter.
Other parties have defined the middle market according to how they organize themselves to pursue middle market opportunities. Banks tend to define three market segments—often called something like small business, commercial, and enterprise—roughly according to how the bank believes it can serve them well and profitably. Technology providers and others do the same. At JPMorgan Chase, the middle market thus defined extends from $20 million to $500 million in revenue. Dealmakers such as investment banks, private equity firms, and the like are more likely to segment by transaction size, in part because they often rank themselves in their industries by the number and size of transactions they make.
Some organizations define the middle by number of employees. ADP, whose core business is payroll services, segments its market that way: small (1–49 employees), midsized (50–499), and large (500 or more). Government organizations tend to count noses, too. Not to be outdone in a complex environment, the SBA sets the parameters for small business depending on revenue or headcount, plus industry—so that retail bakers are small if they have fewer than 500 employees, but a small commercial bakery must have fewer than 1,000 employees, and makers of cookies, crackers, and tortillas 1,250.
As shown in Figure 1.1, over 90% of U.S. and Canadian M&A transaction volume is with deals of less than $500 million in value, and about 70% of the volume is with those that are less than $150 million and averaging $47 million in transaction value in 2021.
For us, the middle market for M&A encompasses businesses with revenues from $5 million to $1 billion, often subdividing it further into three segments as discussed in Chapter 2.
FIGURE 1.1 U.S. and Canadian M&A Transactions
Data source: Dealogic 2022.
CHARACTERISTICS OF MIDDLE MARKET COMPANIES
Hence the role of judgment—or art—in defining the middle market. It may be less important to define companies by size than by their characteristics, behavior, organization, and their interactions with customers, competitors, and capital markets.
Ownership
The overwhelming majority of middle market companies are privately held. Within that privately held group, roughly a third are family‐owned businesses, 10 to 15% are substantially or entirely owned by private equity investors, and the balance is “other”—a mix of entrepreneurial owners, family offices, partnerships, sole proprietorships, and so forth.
Companies change hands, of course; that is the reason for this handbook. Thirty‐three percent of middle market companies say they have undergone a major change in ownership (selling all or part of the company, bringing in a new investor, transitioning ownership within a family, etc.) in the previous five years.5 One change in ownership often leads to another; if a private equity group buys a company, it typically sells again within a few years—sometimes to another private equity firm group (thus restarting the process), sometimes to a strategic buyer, and sometimes to management. Private equity holding periods have been rising and averaged 6.9 years in 2018, according to the Cebron Group. These patterns were disrupted by the Covid‐19 pandemic, which made valuation very difficult.
Access to and Use of Capital
Broadly speaking, middle market companies manage their capital conservatively. Individual or family owners, a large part of whose wealth may be concentrated in the company they own, are reluctant to dilute that equity by seeking outside investors and are leery about taking on debt. This is particularly true for lower‐middle market companies whose cash flow may be uncertain and—perhaps more important—where debt is often personally guaranteed by the owner. Personal guarantees mean that debt and equity carry the same risk for the owner, and can have a profound impact on the capital decisions for these companies. When one is investing one's own capital—or one's mother's—prudence often trumps boldness. Smaller companies prefer to fund expansion from retained earnings rather than by borrowing. When they invest in innovation, established lower‐middle market companies are—again, broadly speaking—more likely to prefer “safe,” incremental innovations over risky, disruptive ones. Upper‐middle‐market companies are less likely to guarantee debt personally, more willing and able to use their balance sheets and relationships with capital providers strategically, and more likely to take on innovation risk in pursuit of greater reward.
Organization
As companies grow, they become more complex. A small business may be run by an entrepreneur, their family, and a handful of employees, each of whom wears many hats. When specialized knowledge is required, the small firm goes outside, retaining a lawyer or tax accountant. Small business may have experts, but they rarely have corporate functions—there is no department of human resources, marketing, or even finance. There's a computer guy to maintain the systems, but not an IT department.
The middle market is where functions appear. Somewhere in the lower‐middle market revenue range, a recognizable finance team appears; sales becomes a department, not just a sales leader and a few commission reps; people are put in charge of procurement, operations, and distribution. At first, those functions are skeletal. The Society for Human Resources Management says that as a rule of thumb a company has one dedicated HR staffer for every 75 full‐time employees, which means that even a 300‐person company will have an HR department of four—enough to manage basic tasks of pay and benefits, hiring, and compliance, but not enough to staff expertise in fields such as learning and development, executive compensation, succession planning, performance reviews, or diversity, equity, and inclusion. (Consequently, data show that middle market companies are more likely to fill skills gaps by hiring from outside than by developing from within.) In the core of the middle market, functions are much stronger, though still not deep. A middle market company might employ specialists in financial planning and analysis—but just two or three, not dozens or hundreds as large companies do. However, at the upper end of the middle market, functions are robust and the companies have more business management sophistication.
In the core and upper middle market, divisions appear alongside functions: divisions for different products, services, or geographies, perhaps with separate P&Ls. When functions and divisions meet, the result is a matrix, a complex organization in which different parties each vie for their share (or more than their share) of CEO attention and investment resources.
Management becomes more professional as these companies functionalize and divisionalize. Decisions that were made informally now go through processes. Accounting, which in the lower middle market has been done primarily to prepare tax returns, becomes more descriptive and useful for tracking business performance. People begin to complain about “silos” between departments. Family businesses may bring in outsiders to fill key management roles. Often the first act of a private equity buyer is to upgrade functions—particularly finance—by bringing in an operating partner to push for efficiencies or installing functional leaders from their own talent bank.
Governance, too, matures as companies grow. Small businesses often have no established governance; there's the owner, a kitchen cabinet of friends and family, and a triumvirate of advisors—lawyer, banker, accountant—who offer counsel but have no formal responsibility. Over time and as companies grow, they appoint boards whose role may initially be advisory but that often take on fiduciary duties; they may also create other governance bodies, such as family councils whose powers and duties are explicitly defined; and the roles of outside advisors may be strengthened, for example to include preparing audited financial statements according to GAAP.
These growth inflections—the emergence of functions, divisions, processes, and professional management—are what really describe the middle market landscape. Small businesses have not experienced them yet. For big business, they're old hat. The middle is where they emerge, and the decisions that a company's owners make about them will determine the company's prospects for growth, enduring success, reduction of business specific risks, and ultimately the enterprise value. Management expert Jim Collins likens middle market companies to adolescents, charting directions and making decisions that will define them: “I've always thought that there's a journey and a progression in a company's story. You start with an idea and then turn an idea into a business. Then you turn a business into a company. Then you turn a company into a great company, and a great company into an enduring great company. The midsection of that chain—the shift from a business to a company and then to a great company—that's your mid‐market stage.”6
The special characteristics of the middle market—its relative public obscurity; its dynamism; its ownership, governance, and attitude toward capital; its role in industry structures and economic ecosystems; and its own internal management processes and maturity—all explain why middle market M&A is a discipline of its own. It has a unique body of knowledge and there is a distinctive art to employing it.
NOTES
- 1. National Center for the Middle Market, “The Market That Moves America,” 2011, https://www.middlemarketcenter.org/research-reports/middle-market-insights-perspectives-opportunities; Anil Makhija, presentation to Middle Market Summit, The Ohio State University, 2011.
- 2. Michael E. Porter, “Clusters and the New Economics of Competition,” Harvard Business Review, November–December 1998, https://hbr.org/1998/11/clusters-and-the-new-economics-of-competition.
- 3. Mark Muro, Scott Andes, Kenan Fikri, Martha Ross, Jessica Lee, Neil Ruiz, and Nick Marchio, Drive! Moving Tennessee's Automotive Sector Up the Value Chain, Brookings Advanced Industries Series, 2013, https://www.brookings.edu/research/drive-moving-tennessees-automotive-sector-up-the-value-chain/.
- 4. “Logistics: Production ‘Nirvana' in New Albany,” Columbus CEO, April 4, 2017, https://www.columbusceo.com/business/20170403/logistics-production-nirvana-in-new-albany.
- 5. National Center for the Middle Market, Preparing for Major Business Transition, 2020, https://www.middlemarketcenter.org/research-reports/successful-middle-market-business-transition-planning.
- 6. “Greatness Is a Choice: An Exclusive Conversation with Jim Collins,” National Center for the Middle Market, 2014, https://www.middlemarketcenter.org/middle-market-academic-research-summaries/greatness-is-a-choice-an-exclusive-conversation-with-jim-collins.