Author: Gerald O'Dwyer

The private equity (PE) landscape is filled with opportunities, particularly in the lower middle market (LMM). With companies generating between $5M and $100M in revenue, and EBITDA margins typically ranging from 10% to 20%, LMM businesses represent a sweet spot for PE investors. This is because these companies often lack the resources and sophistication of larger enterprises, making them ideal candidates for value creation through operational improvements, cost optimization, and market expansion.

What is the Lower Middle Market?

The LMM encompasses companies with annual revenues between $5M and $100M, with EBITDA typically between $1M and $20M. These companies are often privately held and operate in fragmented markets, which means they face limited competition from larger, more dominant players. For PE firms, this presents a fertile ground for value creation by consolidating smaller companies into larger, more competitive entities.

For example, a family-owned business with $15M in revenue and a 12% EBITDA margin ($1.8M) could see significant value creation by implementing operational efficiencies, improving sales strategies, and expanding into new markets. With the right leadership, that same business could increase its EBITDA to 18%, driving annual EBITDA to $2.7M and boosting its valuation by millions of dollars.

Why Fragmented Markets?

Fragmented markets are particularly attractive to PE investors because they provide opportunities for consolidation and economies of scale. Consider a market where no single company has more than 5% market share. This fragmentation often leads to inefficiencies, such as duplicated costs and underutilized assets. By rolling up multiple smaller companies into a larger entity, PE firms can eliminate redundancies, improve operational performance, and increase market share.

For instance, if a PE firm acquires five companies in a fragmented industry, each with $10M in revenue and 10% EBITDA margins, it could create a consolidated entity with $50M in revenue and potential EBITDA of 15% post-integration, resulting in $7.5M in annual EBITDA—a significant increase from the $5M aggregate EBITDA of the individual companies.

The Importance of Value Creation

Value creation is at the heart of any successful PE strategy. In the lower middle market, this often involves improving cash flow, enhancing operational efficiencies, and driving top-line growth. PE firms target companies where they can improve profitability through strategic initiatives such as cost reduction, supply chain optimization, and sales growth.

For example, let’s say a company with $25M in revenue and 15% EBITDA margin ($3.75M) is acquired by a PE firm. By improving its working capital management, increasing sales by 10%, and reducing costs by 5%, the firm could boost EBITDA to 20% of revenue, driving annual EBITDA to $5M. This increase in profitability could add $12M-$15M to the company’s valuation, assuming a typical LMM multiple of 6x-8x EBITDA.

Using Value Creation to Improve Cash Flow

Cash flow is king in PE. Increasing cash flow not only makes a business more sustainable but also increases its attractiveness to potential buyers. Executives can drive cash flow improvements by optimizing inventory management, renegotiating supplier contracts, and improving customer payment terms.

Consider a business generating $30M in annual revenue with an EBITDA margin of 10% ($3M). By reducing its days sales outstanding (DSO) from 60 days to 45 days and cutting its cost of goods sold (COGS) by 3%, it could free up an additional $1.2M in cash flow annually. This improvement enhances the company’s ability to reinvest in growth or reduce debt, making it more appealing for a future exit.

Why Executives are Better at Contacting Owners Than PE Firms

Lower middle market business owners are often skeptical of PE firms. They fear being seen as just another transaction, losing control of their company, or facing drastic cost-cutting measures. Executives, however, are perceived differently. They’ve walked in the owner’s shoes and understand the day-to-day struggles of running a business.

For example, an executive with experience leading a $50M manufacturing business can empathize with a $20M business owner facing margin pressures due to rising material costs. This connection allows the executive to build rapport and trust, making the owner more willing to discuss potential partnerships or even an exit strategy. PE firms often lack this direct line of communication, which is why executives are more successful in opening doors to potential deals.

How Execs Interacting with Owners Makes Them Better at Value Creation

Executives gain unique insights when they interact directly with business owners. These insights can uncover hidden value drivers that PE firms might overlook. For example, an executive speaking with an owner of a $10M revenue company in the healthcare space might discover inefficiencies in billing practices that, if corrected, could increase EBITDA by 5%.

By understanding the intricacies of the business, executives are better positioned to drive value creation post-acquisition. They can implement targeted initiatives that address the company’s specific pain points, such as improving operational processes, increasing market penetration, or streamlining the supply chain. These improvements can lead to higher profitability and, ultimately, a more valuable company.

A Starting List of Questions Executives Can Ask Owners

To better understand a company’s potential for value creation, executives should ask the following questions:

1. What are your gross margins, and how do you manage costs?
2. What are your primary challenges in scaling the business?
3. How much capital do you need to reach your growth targets?
4. What is your customer retention rate, and how do you measure customer satisfaction?
5. What is your average order value (AOV), and how do you track key performance indicators (KPIs) related to sales and marketing?
6. How are you leveraging technology to improve operational efficiency?
7. What are your plans for succession, and what steps have you taken to prepare for a sale?

These questions help executives identify potential areas for operational improvement, growth opportunities, and succession challenges—key components of a successful value creation strategy.

Monetizing Market Knowledge

Executives with deep market knowledge can monetize their expertise in several ways, including:

• PE Board Roles: Serving on a PE portfolio company board and advising on strategy and operations.
  • Compensation: $50K-$150K annually in fees and equity stakes.
• Operating Partner: Leading the day-to-day operations of a portfolio company.
  • Compensation: $200K-$500K annually, plus equity participation.
• Succession Planning Consultant: Assisting owners in preparing for succession or sale.
  • Compensation: $75K-$200K per engagement.
• Sale Preparation: Helping owners optimize their business for sale, including improving financials and operational performance.
  • Compensation: $50K-$100K for consulting, with potential for equity or a success fee.

By positioning themselves as experts in their field, executives can secure lucrative opportunities with PE firms and business owners, while also driving significant value creation.

Why Lower Middle Market PE Firms Need Executives with Street Knowledge

LMM PE firms need executives with hands-on, “street” knowledge because they are often working with businesses that lack sophisticated systems and processes. Executives with practical experience know how to navigate the challenges of scaling a business, optimizing operations, and improving cash flow.

For example, a PE firm might acquire a $40M revenue business with 8% EBITDA margins ($3.2M). An executive with deep industry knowledge might recognize that by renegotiating supplier contracts and improving salesforce effectiveness, they could increase EBITDA margins to 12%, boosting annual EBITDA to $4.8M and significantly increasing the company’s valuation.

Why Executives are Needed More Than Ever During a Recession

Recessions create uncertainty, and business owners are often looking for ways to take some cash off the table. Executives who can offer value creation strategies or help position a business for sale are in high demand.

For example, a $25M revenue business with 10% EBITDA margins ($2.5M) may be struggling with rising costs and declining sales due to the economic downturn. An executive who can identify cost-saving opportunities, improve sales performance, or secure new financing can provide the owner with the liquidity options they need, while also increasing the company’s value for a potential exit.

The BlackmoreConnects Advantage: Creating Optionality for New Cash Flow Channels

By following the BlackmoreConnects principles, tools, and templates, executives can create optionality for new channels of cash flow. BlackmoreConnects provides a systematic approach to building relationships with PE firms and business owners, helping executives position themselves for board roles, operating partner positions, and consulting engagements.

For example, an executive who follows the BlackmoreConnects system might secure a PE board role, earning $75K annually, while also consulting for two business owners, earning an additional $100K per year. Over the next 12-24 months, this could add hundreds of thousands of dollars to their cash flow.

Without BlackmoreConnects, executives are left to navigate the complex PE landscape on their own, often missing out on lucrative opportunities. By using the system, they can accelerate their success, build wealth, and create new streams of income.

The lower middle market is a goldmine for executives who are willing to step out of their comfort zone, connect with business owners, and create value. By leveraging their expertise and following the BlackmoreConnects system, executives can unlock new channels of cash flow and position themselves for long-term success in private equity.