Perspectives:

What It Will Take to Make Private Equity Great Again?

The Economy, Among Other Things

Michael Painter, Managing Partner at Plexus Capital and Member of SBIA Board of Governors
The economy, stupid, that famous reminder coined
by Clinton strategist James Carville, can explain much
of what weve been seeing in the lower middle
market.* What is the Lower Middle Market?
The lower middle market is a subset of the
Since 2013, the lower middle market has remained US economy that represents small to
incredibly active. With plenty of debt and equity capital medium sized businesses. For purposes of
readily available, giving buyers the ability to pay higher this newsletter, we define the lower middle
multiples, mounting demand, and a competitive, more market as:
discerning market, managers continue the move
toward smaller portfolio companies. Businesses that earn between $10mm
and $100mm in annual revenues
And why not? The political uncertainty and broader Deals for businesses with between
macroeconomic factors like lagging GDP growth and $10mm and $100mm in total enterprise
anemic employment that have dragged on the S&P value
dont have the same effect on smaller middle-market Private Equity Funds that raise up to
activity. This is a much more resilient space, and its $500mm in capital
what makes it so attractive in the current economy.
With plenty of confidence in the market right now and the availability of debt capital, we can expect this
end of the market to be just as active in 2017. Consider how we ended 2016: revenue and employment
growth exceed that of the S&P, lower middle market companies are pursing growth strategies, reinvesting
capital back into their own businesses, and valuations hit a record high. This is a market primed for
continued investment.

Now some things to consider: Volume is not nearly as high as it could be. Deal value in the lower middle
market increased over 21 percent last year across fewer transactions. Deal volume for 2016 was at 209,
down from 235 last year. While theres plenty of capital thats ready to be put to work and a fair amount of
opportunities for transactions, deal sourcing will remain difficult. It will take creativity and persistence to
thrive in this increasingly competitive market.

So what will make private equity great, especially within the lower middle market? Its the economy! and
no change in policy would have a more immediate effect than tax reform. Already, it looks like replacing
the Affordable Care Act will delay tax reform. Still, tax reform tends to hit the LMM harder than the rest of
PE, and two main concerns are the elimination of the deductibility of interest, which the administration
supports, and changes to carried interest from capital gains. Eliminating the deductibility of interest would
make it more expensive for businesses to borrow money to finance operating costs and other
investments, hurting small businesses.

There are plenty of challenges ahead, but theres even more room for opportunity. With hard work and
focus, while being cautiously optimistic, we may just see a more robust market as we move ahead.

*The full sign hung in Clinton 92 campaign headquarters meant to keep staff on message read: 1. Change vs. more of the same, 2. The economy, stupid, 2.
Dont Forget health careand there you have the makings of a President Trump.
Small Business Investor Alliance | Lower Middle Market Investment Insights | Volume 4, Issue 1 2
 Lower Middle Market Business Indicators
The National Center for the Middle Market (NCMM) conducts a quarterly survey of middle market businesses and provides us
with data for lower middle market companies with $10 100 million in annual revenues. The data and our commentary below
indicates how these businesses compare to larger firms on standard metrics like revenue and employment growth. We also
feature the SBIA/NCMM Lower Middle Market Business Confidence Index, which combines revenue and employment growth in
the preceding year, and expectations for revenue and employment growth in the following year.

Revenue Growth (Last Twelve Months) Employment Growth (Last Twelve Months)
Lower Middle Market vs. S&P 500 Lower Middle Market vs. Large Corp. (ADP)
10.00% 6.00%
8.00%
6.00% 5.00%
4.00%
2.00% 4.00%
0.00%
-2.00% 3.00%
-4.00%
-6.00% 2.00%
-8.00%
-10.00% 1.00%

1Q13

4Q15
1Q12
2Q12
3Q12
4Q12

2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15

1Q16
2Q16
3Q16
4Q16
2Q14

1Q15

4Q15
1Q12
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14

3Q14
4Q14

2Q15
3Q15

1Q16
2Q16
3Q16
4Q16

Lower Middle Market Large Corp.

Lower Middle Market S&P 500
Source: National Center for the Middle Market Source: National Center for the Middle Market, SBIA Estimates

Revenue growth in the lower middle market continues to
remain consistent, trending back upward from the slight dip
in 2015. At the same time S&P 500 revenue growth
continues to grow. Macroeconomic changes do not affect the
lower middle market in the same way they do the S&P,
which is encouraging considering the uncertainty around the
economy.
The lower middle market has seen much more consistent
employment growth over the past five years when compared
to the S&P 500. Lower middle market businesses ended
2016 with a growth rate of 4.5 percent, compared to the S&P
500's rate of 2.4 percent, up from 2 percent the previous
year. A third of survey respondents expect employment will
continue to grow.

Incremental Investment Allocation SBIA/NCMM Lower Middle Market Business Confidence

Where would an extra dollar be allocated? Companies with Revenues between $10-100mm
120.00
118.00
116.00
114.00
112.00
58 66 61 64 110.00
62 65 67 62 63 62 67
64 108.00
106.00
104.00
102.00
100.00
29 25 27 26 98.00
24 23 22 21 24 22 24 21
2Q12
3Q12
4Q12
1Q13
2Q13
3Q13
4Q13
1Q14
2Q14
3Q14
4Q14
1Q15
2Q15
3Q15
4Q15
1Q16
2Q16
3Q16
4Q16

1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 3Q15 4Q15 1Q16 2Q16 3Q16 4Q16
Source: SBIA Estimates and NCMM Survey
Hold Cash Reinvest in Business Spend on Acquisition Other
Source: National Center for the Middle Market

More lower middle market businesses say they would rather
reinvest capital in their own businesses than at any other time
in the past two years. 67 percent of survey respondents say
they would rather invest in new equipment and IT, facility
expansion, and additional staff rather than hold cash. Only 21
percent said they would hold cash, compared to 27 percent
last year.
While confidence has not returned to its 4Q14 high, lower
middle market executive are overall optimistic about the
economy and expect revenue growth to continue its upward
trend. 59 percent expect revenue to grow over the next
twelve months,up 11 pointsfrom 2015.

Small Business Investor Alliance | Lower Middle Market Investment Insights | Volume 4, Issue 1 3
 Lower Middle Market Deal Trends
Average Multiples and Deal Volume Based on completed deal activity in the GF Data universe, middle market
valuations achieved a peak in 2016. Overall valuations for the year
Deals between $10-250mm in Enterprise Value averaged 6.9x Trailing Twelve Months (TTM) Adjusted EBITDA, a record
7.0X 160 high in a data set that goes back to 2003. Whether this activity represents
the peak in this extended sellers market is a more complicated question.
140
6.8X
120 The 206 private equity firms and other deal sponsors that are active
6.6X contributors reported on 84 transactions closed in the second half of
100 2016 meeting GF Datas parameters (TEV $10-250 million, TEV/Adjusted
6.4X 80 EBITDA 3-15x). This brings completed deal volume for the year to 209,
down from 235 in 2015. This is about in line with declines reported by
60
6.2X data services that have the ability to track broader market trends without
40 offering the granularity of our reports.
6.0X
20
Have valuations at long last begun to crest? It is too early to say, but if
5.8X 0 there is some retrenchment in 2017, these hallmarks of 2016 activity will
1H12 1H13 1H14 1H15 1H16
TEV/Adj. EBITDA (L)
stand out in retrospect:
Source: GF Data
Not to be copied, distributed, or reproduced A preponderance of completed deals involving selling businesses
offering above-average financial characteristics (as defined in our full
Valuation Multiples by Deal Size reports). Fifty nine percent of completed deals in 16 involved these
Total Enterprise Value/EBITDA for all Industries better performers. The historic average is 57 percent.

The reassertion of the traditional premium applied to platform

9.0
acquisitions over add-ons. In 2016, platforms traded at an average of
8.5 7.0x, while add-ons were valued at an average of 6.3x. In 2013-2015,
there was virtually no pricing differential between the two groups.
8.0

7.5 A retreat in debt levels on transactions not featuring junior capital

provided separately from the senior debt. Average debt on senior-only
7.0
transactions declined from 3.8x to 3.4x, while average leverage on
6.5 unitranche transactions declined 4.0x to 3.7x.
6.0
Average equity contribution rose to nearly 47% in the second half of
5.5 2016, up from 43-45% in the prior 18 months, an arithmetic
consequence of valuations continuing to tick upward while debt loads
5.0
1H 12 2H 12 1H 13 2H 13 1H 14 2H 14 1H 15 2H 15 1H 16 remained steady. However, this is a reversal of a pattern of declines in
average equity share over the past several years.
$10-25mm $25-50mm $50-250mm
Source: GF Data
Not to be copied, distributed, or reproduced Flight to quality. Reemergence of platform value. Greater reliance on junior
capital. Buyers able to hold the line in equity share. If deal pricing holds,
See page 5 for more information on how to access these will have turned out to be passing trends. If it retreats, though, these
GF Datas full reports and searchable valuation will have been harbingers of the onset of a more discriminating market.
database.
Equity and Debt Contributions Smaller Equity and Debt Contributions Larger
Deals between $10-50mm in Enterprise Value Deals between $50-250mm in Enterprise Value
100% 100%
90% 90%
34%
35%

35%

37%
37%

38%
38%

39%
39%

40%

40%

40%

41%
43%
43%
43%
43%

44%

80% 80%
45%
46%

70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
51%
51%

51%

50%
49%

48%
48%

48%
47%
47%

47%

47%

47%
47%
45%

44%
44%

44%
42%
41%

20% 20%
10% 10%
0% 0%
1H12 2H12 1H13 2H13 1H14 2H14 1H15 2H15 1H16 2H16 1H12 2H12 1H13 2H13 1H14 2H14 1H15 2H15 1H16 2H16
Source: GF Data Equity Sub Debt Senior Debt Source: GF Data Equity Sub Debt Senior Debt
Not to be copied, distributed, or reproduced Not to be copied, distributed, or reproduced

Small Business Investor Alliance | Lower Middle Market Investment Insights | Volume 4, Issue 1 4
 Disclaimers, Definitions, and Access to Data
Disclaimer
This newsletter is intended only for informational, educational, and research purposes, and should not be distributed or disseminated
for commercial purposes without the permission of the Small Business Investor Alliance (SBIA). The information, facts, figures, data,
and analysis included in this newsletter are believed to be accurate, reliable, and credible, however SBIA is not liable for any
inaccuracies or errors in the information contained within. The newsletter does not, nor could it, take into account the needs,
objectives, and financial situation of its subscribers and should not be considered as investment advice by the recipient. SBIA retains
ownership of the contents of this newsletter and reserves the right to alter or make changes to the information retained within
without notice to subscribers.

Definitions
1. The SBIA/NCMM Lower Middle Market Business Confidence Index is an equal-weighted index based on four survey responses
from the National Center for the Middle Markets Middle Market Indicator. The survey includes over 600 C-Suite executives of
companies with annual revenues between $10mm and $100mm. The contributions to the index are: Revenue Growth,
Employment Growth, Revenue Growth Expectations, and Employment Growth Expectations.

GF Data
To subscribe to GF Datas full reports and searchable valuation database, visit www.gfdataresources.com, or contact Bob Wegbreit at
bw@gfdataresources.com or (610) 616-4607.

National Center for the Middle Market

More information about the Quarterly Middle Market Indicator survey, Benchmarking tools, and the Center can be found on their
website: www.middlemarketcenter.org

Small Business Investor Alliance | Lower Middle Market Investment Insights | Volume 4, Issue 1 6