After a period of slower deal activity, middle market mergers and acquisitions (M&A) are showing signs of resurgence, with data from PitchBook’s Q2 US PE Middle Market Report indicating a 12% increase in the first half of 2024 compared to the same period in 2023.
This momentum is likely to continue — following a change in administration after the U.S. presidential election and the Federal Reserve’s November decision to lower the benchmark federal funds rate another quarter point to a range of 4.50 – 4.75%.
Lower interest rates are already impacting the broader market. In its Q3 US PE Breakdown, which covers all US PE deal activity, PitchBook reported its highest level of estimated exits (394) since Q1 2022. The Russell 2000 Index — often viewed as a bellwether for private company valuations — rose 1.8% immediately following the rate cut and is up nearly 9% year-to-date.
These tailwinds should ripple into the portfolio companies of private equity (PE) firms, as these funds look to increase exit activity, which has remained flat year-over-year.
Middle Market Dealmaking: What We’re Seeing
Although deal activity is expected to increase, PE exits in the middle-market have stabilized as noted below but not meaningfully improved.
Exit backlog should inspire more M&A
Due to the exit backlog, many PE funds are facing increasing pressure to sell portfolio companies (portcos) after historically long holding periods. U.S. general partners (GPs) have been waiting for more favorable exit market conditions, extending the median holding period for middle-market PE investments to a record 6.4 years in 2023, according to PitchBook.
Given the recent increase in the Russell 2000 Index noted previously, as well as the rise in middle-market deal multiples, which have recovered to 12.9x EV/ EBITDA from a bottom of 11.0x in 2023, we believe the exit market conditions have become more favorable. Anecdotally, we’ve seen earnings of private companies steadily improve which should also help bolster their valuations.
These two factors should set the stage for renewed deal activity. We expect that a rebound in exits will power PE M&A activity in the middle market, as more funds kick off sales processes for the portcos they have been holding onto for an extended period of time.
Strategics play important role in middle market exit activity
As they kick off their expected sales processes, PE funds operating in the middle market are likely to look at other sponsors and strategic buyers.
Since Q1 2023, sponsor-to-sponsor exits have consistently outpaced exits to corporate strategics, making up over 55% of exit activity in Q1 and Q2 of 2024, excluding public listings according to PitchBook.
But strategic buyers remain highly competitive in the middle market. In fact, 69% of fund managers and operating partners in BDO’s 2024 Private Equity Survey reported strategic investors as their top competition for deals, indicating that strategics are still highly engaged and poised to capitalize on opportunities. Moreover, 57% of respondents said they will pursue a sale to a strategic for their exits compared with 37% who cited a sale to a financial sponsor.
Driven by the substantial dry powder accumulated over recent years ($499.4 billion for US middle market funds according to the American Investment Council and PitchBook PE firms are moving more quickly on deals—which is something we’re already seeing play out among our current client base.
Sell-Side Due Diligence: How to Prepare for An Exit
Poor strategic planning, non-disclosure of material changes or events, inconsistent internal controls, and cultural disparities between the buyer and the target — can all derail M&A transactions. With sell-side due diligence, PE firms can address these issues before the sale process begins. While deals can fall apart due to factors outside of the sellers’ control (e.g., political changes or economic turbulence), PE firms should prepare their portfolio companies for exit by managing what they can control with a sell-side due diligence process.
Sell-side due diligence helps GPs maximize the value of portfolio companies and minimize transaction risk during the deal evaluation, negotiation, and closing processes.
When executed effectively, sell-side due diligence offers three key benefits for sellers:
Maintain Control
By identifying potential issues early in the transaction, sellers can take the necessary time to resolve these issues before commencing a sell-side process.
Streamline the Process
Sell-side due diligence reduces the need for extensive—and often repetitive—interactions between management, potential buyers, and their advisors, while also accelerating the winning buyer’s own due diligence process, as they can leverage the seller’s findings.
Enhance Value
By organizing and optimizing information ahead of the transaction, sellers can facilitate negotiations for the highest possible price, positioning the portco favorably in the eyes of potential buyers