The economic power of the middle market is immense. If it were its own country, the US mid-market would be the fifth largest economy in the world. But when private equity (PE) tries to capitalize on the growth potential of the lower middle market, they face a challenge: cultural literacy. The fact is that the cultural world of PE and that of the lower middle market owner are different. First, there may be differences in education. Second, the business owners haunted by PE investors are often new to M&A, and their lack of experience can easily cause misunderstandings. Finally, PE needs to work on overcoming its less-than-stellar reputation. As PE tries to gain value at the lower end of the mid-market, the industry would do well to include cultural literacy as well as a capital stock – PE and owners will mutually benefit, as will the US economy.
Private equity investors looking ahead to another fruitful year of deals are increasingly looking to purchases hidden in the lower middle market: companies valued between $10 million and $100 million. It is not uncommon these days for these investors to pursue strong founder-led or family businesses with annual revenues of $100 million, $50 million, or even $25 million. According to The National Center for the Middle Market, many are “B2B organizations that operate within the supply chains of other larger companies” — solid extensions or platforms that offer innovative product designs, compelling business models, or a valuable stable of employees.
But when private equity (PE) tries to capitalize on the growth potential of the lower middle market, they face a challenge: cultural literacy. And as Peter Drucker is said to have pointed out, “Culture eating strategy for breakfast.” Our years of deals in this part of the market have taught us that without cultural literacy, we cannot build trust with these hard-working owners, close a deal, or even master smooth post-closure integration.
The fact is that the cultural world of PE and that of the lower middle market owner are different. The Economist wryly noted that “there has long been a gentlemen’s club element about the private equity industry,” which lower-middle-market owners may find unrelated. If the PE community wants to move deals to close quickly and create more value throughout the transaction lifecycle, they need to “speak” the language of these business owners, which is easier said than done.
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First, there may be differences in education. Private equity decision-makers often come from top universities. One report found that most of the MBAs PE firms sent to Europe came from just four schools: Harvard, Wharton, INSEAD, and Stanford. Even if they are not educated at the “top” universities, virtually all PE professionals have a college education and usually a graduate degree. In contrast, many successful lower mid-market business owners have millions in the bank, but no college degree or even a bachelor’s degree.
At the auction of a company we represented a few years ago, a procession of PE investors stormed through a hotel conference room near the BWI airport, all eager to take over our client’s business. It brought in nearly $100 million in annual revenue, grew by the day, had always been profitable, had deep customer relationships with financial giants, and provided a national network of trained employees. As each PE group started their pitch, our client stopped them to ask, “How many of you have MBAs?” The visitors, from Los Angeles, Dallas, New York and Philadelphia, all raised their hands. Our client announced that he and his wife had no college degrees. It was his way of inspiring admiration for the value he could have created without higher education. The PE group that got the deal treated the owners and the business they had built with real respect.
Even owners who have higher education and are brilliant subject matter experts are probably not financial experts. In fact, a survey by the National Center for the Middle Market found that as many as 90% of midsize companies selling or merging have “little or no previous experience” with mergers and acquisitions. PE players, on the other hand, are naturally M&A experts.
That’s the second big mismatch: the business owner is an M&A amateur and their lack of experience can easily lead to misunderstandings. Adam Altus, managing partner of Sier Capital, told us: “I really want an investment banker to represent sellers. If a founder-owner is not professionally represented, negotiation is time-consuming and unstable.”
But cultural literacy goes beyond educational differences and M&A speaking. The values a typical founder-owner brings to the conference table, along with their life experience, often differ from PE. Many founder owners have been raising their business as long as they have raised their children. Such companies often have high employee retention rates and deep affection for their employees.
“When my parents, Tim and Jane Bennett, were setting up their production company, the Maiman Company in Springfield, Missouri, my mother personally signed off each employee’s salary. She would write ‘thank you’ on each. It was important to her that every employee knew how much they meant to my parents and the company,” recalls Adam Bennett of Bennett Partners in Alexandria, Virginia.
This deep kinship between owners and employees has often been created through decades of struggle. When we represent founder owners selling a $10 or $15 million EBITDA business, the owner will often care as much about what happens to their old employees as what the cash will be. The PE buyer must understand that the purchase price is only part of the value that owners seek – respect for key employees and the company’s legacy are also extremely important.
Finally, PE has to face the reputation that precedes their reach. That reputation — so toxic that “The Private Equity Council” had to literally rename itself “The American Investment Council” — is making polls devastating. In 2019, for example, Lake Research Partners and Chesapeake Beach Consulting found that majorities across the political spectrum are opposing the “predatory tactics of private equity.” With such a street credo, PE representatives are going into an uphill battle.
Meanwhile, business owners often fail to recognize that there are many different types of PE investors. The classic PE model of cutting costs to the core and jacking up revenues to produce profitable sales in three years is no longer the norm, especially in the lower mid-market. A good question for owners looking to make a culture change is, “How long do you hold your investments?” There are many PE firms that want to hold investments for many years, even decades. In fact, long-hold investments often outperform typical five- to seven-year buy-and-flip strategies.
Mastering enough cultural literacy — on both sides of the fence — so that all parties understand what is important to the other increases the chances of mutual success. Instead of dividing the pie, understanding the other party’s needs opens up the possibility of increasing the pie: the founder-owner-seller may value the speed of closing very highly, for example because of a health risk. The PE buyer may be focused on tax considerations. Properly identifying what each side cares about most and then negotiating a deal that switches gracefully between a myriad of deal points to satisfy both sides takes cultural literacy.
Of course, shutting down is not the end of the road. Post-close integration is essential for a successful acquisition, and the fusion of different corporate cultures can be challenging. Lower mid-market companies may have processes dating back to their founding days that need to be changed. In fact, installing better business practices is part of how PE can turn a $10 million EBIDTA company into a $20 million EBITDA company. But the integration challenge will go better if all parties pay sufficient attention to cultural issues. No investor and no seller today wants to make an acquisition to see an exodus of dedicated, skilled workers.
The economic power of the larger middle market is immense. In terms of size, if it were its own country, the US mid-market would be the fifth largest economy in the world. As private equity looks ahead to extract value from the lower end of that market, the industry would do well to include cultural literacy as well as a capital stock – PE and owners will mutually benefit, as will the US economy.
This post To close deals in the mid-market, private equity needs cultural literacy was original published at “https://hbr.org/2022/03/to-make-deals-in-the-middle-market-private-equity-needs-cultural-literacy”