Back when the largest private equity firms started to rule the waves, many private equity firms moved downstream to the middle market in hopes of finding relief from the high valuations, and the middle market became the darling of the private equity industry. And why not? The middle market, where deal value tops out at $1 billion, provides one of the best ecosystems for private equity investors to create returns. The middle market offers more companies to invest in, greater opportunities to change companies, and lower valuations and barriers to entry. These favorable attributes have made middle-market companies the most sought-after assets, which, over time, has made it difficult for private equity firms to generate high returns for their investors. So, as a new generation of seasoned private equity professionals begins to branch out, they’re opening up shops in the lower middle market, where deals are valued at between $10 billion and $250 million. These new firms are thinking small to grow big.

“The competitive nature of even the lower middle market is intense,” says Eric Bacon, a managing director and co-founder Watervale Equity Partners, a lower middle-market PE firm launched in August. “The sell processes are compressed, offering limited exposure to the seller and management, and multiple teams spend big bucks to distinguish themselves in a race to a quick close. We are trying to escape some of that by moving down lower.”

Bacon launched Watervale with Mike Faremouth and Jim Guddy. Unlike Linsalata Capital Partners—a private equity firm focused solidly on the middle market, from which the three founders hailed —Watervale is focused on the very lower middle market. The Cleveland, Ohio-based firm is hitting the fundraising trail, looking to raise $125 million to make control investments in companies with less than $6 million of Ebitda.

“We see that there is an inflection point somewhere in the $6 million to $7 million Ebitda range,” says Bacon. “Below that the economics simply don’t work for the investment banks to run a full auction process and there is less support from the lending community. Yes, the risks are higher with less infrastructure and management depth. But, we’ve worked there and enjoy rolling up our sleeves.”

The typical transaction value for Watervale will likely be less than $50 million. Limited partners are expected to be a typical mix of pension funds, endowments and family offices.

“We were seeing deal flow at this lower level that didn’t fit LinCap’s criteria,” says Faremouth, who serves as the firm’s president. “We started to realize that the lower middle market is where we belong. We are attracted to these companies and there is a much larger population of companies. We believe it’s also very relationship-based at this level, which we like and can thrive with.”

Like Watervale, most firms entering the lower middle market are attracting by the increased number of opportunities provided by the lower end of the market. The numbers are compelling. There are about 350,000 companies with annual revenues between $5 million and $100 million, compared with 25,000 companies with revenue between $100 million and $500 million and only a few thousand companies with revenue above $500 million, according to Forbes.

The competition in the lower middle market has been intensifying over the last several years. The 10-year average purchase price multiple for leveraged buyouts of businesses with enterprise values below $250 million is currently 7.3 times Ebitda, the highest it’s ever been, according to Preqin.

The Riverside Co. has been investing in the lower end of the middle market for almost 30 years. Stewart Kohl, co-CEO of the firm, says the market keeps expanding. “Private equity keeps expanding its borders—industries, size, flavor, geography—but it keeps finding ways to make money,” he says. “Doing smaller deals is hard and expensive for the general partner, but we’ve built the scale and experience to be able to do it consistently well for our limited partners relative to boutiques, spinoffs or bigger firms going down market.”

Recognizing that the lower end of the middle market will still be competitive, most firms are investing in niche sectors where they have expertise. That makes sense, because all lower middle-market players say being operators is key.

Sector specialization
For example, in addition to focusing on lower middle-market deals, Watervale will invest in manufacturing companies in the industrials and consumer space. “We will typically be interested in manufacturers of engineered products with good branding or a strong reputation that have opportunities for growth. A growth path is very important,” says Guddy, who serves as a managing director.

WM Partners, a Fort Lauderdale, Florida-based PE firm focused on the lower middle market, is targeting companies in the health and wellness sector. In June, the firm closed its first fund, HPH Specialized Fund 1, at $307 million, exceeding its $300 million fundraising target.

The fund is focused on acquiring lower-middle market companies with leading brands in the vitamins, minerals and supplements sector, or VMS, and natural personal care sector, and integrating them into the Wellnext consolidated platform. The fund seeks to make equity investments of between $15 million and $75 million.

“The lower middle market is the sweet spot for our investments, and the vitamins, minerals and supplements and natural personal care sectors in the U.S. is a large market,” says Ernesto Carrizosa, executive managing director of WM Partners. “Altogether it’s a $56 billion industry. VMS is about $39 billion. It’s highly fragmented in the lower end of the market and there are too many brands, which creates an attractive opportunity for consolidation and value creation.”

According to WM Partners, there are less than 10 VMS companies with more than $1 billion in revenues. However, there are more than 75 VMS companies with $100 million to $1 billion in revenues. And below $100 million, there are more than 900 companies that have been in business for more than three years.

“We want to create value through operations,” says Carrizosa. “If you buy larger companies that is harder to do. All the companies we have bought thus far have been for single digit multiples. The VMS and natural personal care sectors will continue to grow. Two out of three consumers take a supplement or vitamin. With the millennials and baby boomers becoming more health conscious, there are strong demographic trends for these types of businesses. To date, VM has closed on three acquisitions, which have been integrated into the Wellnext platform.

“Investment professionals are constantly seeking out niches and areas to achieve excess returns,” says Giles Tucker, a managing director Harris Williams & Co. “It’s widely known in the deal market that there is a finite group of target companies, so those folks that have broken away from more established firms are trying to set up shop in what they perceive as a less efficient market. They hope to buy attractive assets for lower purchase price multiples, but the lower middle market is getting crowded pretty quickly. There’s no question that you are seeing more banks represent $3 million to $8 million Ebitda companies and running more competitive processes than ever before.”

Favorable returns
Interest in the lower middle market has grown substantially, according to Probitas Partners’ Private Equity Institutional Investors Trends for 2017 Survey. In 2017, 63 percent of institutional investors said they are focusing on the U.S. small market buyout sector defined as funds with less that $500 million. That’s compared with 81 percent focusing on middle market buyouts and just 33 percent focused on large buyouts. (Respondents were allowed to choose more than one investment strategy).

Investors are clamoring to get into these niche funds because the returns seem to be there. AUA Private Equity Partners LLC was founded in 2012 by Andy Unanue and focuses on companies that benefit from the growth of the Hispanic population in the U.S. In 2015, AUA bought Raymundos Food Group LLC, a maker of Hispanic branded snack and dessert foods. AUA was able to acquire the family owned company for a significant discount to comparable businesses.

Immediately after closing, AUA went to work, making operational changes and adding new leadership, including CEO Ricardo Alvarez, who previously held chief executive positions at Overhill Farms, Spartan Foods, Busch’s Fresh Food Market and Ruiz Foods; and Jim Taylor, who served previously as chief financial officer of Rupari Food Services Inc. Under AUA’s ownership, Raymundos made an add-on acquisition in Noga Dairies Inc., a maker of drinkable yogurts and ethnic dairy products, expanding Raymundos’ better-for-you offerings. AUA has also improved worker safety, boosting Raymundos’ food safety and quality ratings.

In nearly two years since closing the Noga Dairies deal, the company has approximately doubled revenues, grown Ebitda by more than 40 percent and returned more than 50 percent of invested capital. “We were able to buy the company below market value, increase Ebitda and return capital to our investors in 18 months’ time,” says Unanue. “We are getting inbound calls to sell this company daily.”

AUA closed its first fund in 2014 and is 80 percent invested. The firm is preparing to raise its second fund. Unanue likes the lower end of the market because it gives his firm a chance to make operational changes, which is what his and many other lower middle-market firms believe they are best at. Unanue served previously as chief operating officer of Goya Foods Inc., the largest, Hispanic-owned food company in the U.S. Goya was founded in 1936 by Unanue’s grandparents, who were Spanish immigrants. “I am an operator. AUA has strong focus and we can make a real impact on companies and grow them, creating strong alpha for our companies, investors and ourselves,” says Unanue. “There are not many people looking at deals the sizes we look at and in the Hispanic market. You have to have the experience and background to run these companies. Not many people have that.”

Operational expertise
Watervale’s Guddy agrees operating experience is necessary to have success in the lower end of the market. “You have to build relationships and recognize it’s not just a financial transaction. It’s a partnership. It’s about growing a great business and helping ease the pressure of cycles on these businesses. It’s being ready to step in as the CFO or CEO. It’s being willing to get your hands dirty,” says Guddy.

That doesn’t mean there aren’t challenges. General partners normally are providing an array of services to help companies find success. That is harder to do with smaller funds. Riverside has done it by scaling up companies and using that to its advantage. Not every firm can or wants to grow up to be a Riverside.

The good news for other potential lower-middle market entrants, says Béla Szigethy, Riverside’s co-CEO, is that there’s room for more. “While there is additional capital coming into this end of the market and it always feels competitive as a buyer, there are always new companies being born and growing up and ready for investment. The world continues to generate new companies all the time and there’s room for the best of these new players,” says Szigethy.

Out on their own
The move down market and to new sectors is all part of a larger trend within private equity. The industry is going through structural changes. The first-generation private equity firms have grown up and their founders are of retirement age. It’s put many partners at an inflection point. Some general partners have decided to stay with the firms they grew up at; others have decided to try something new. “Every day we are seeing very talented private equity professionals leave the name-brand shops and start their own first-time funds,” says Tucker. “They have track records and success and it’s usually within a niche so they are really focusing on what they focused on at a larger shop. Smaller shops are popping up all the time now.”

The birth of Watervale came out of the natural progression of Linsalata Capital’s succession planning. With the founder of Linsalata near retirement age, some of the partners decided to stay on at Linsalata while others founded Watervale. “The team at Linsalata gave their full support to the team that wanted to do something different,” says Bacon, who expects to attract some of LinCap’s existing investors, noting that Watervale will be too small for many of them.

The spinoff from LinCap was very coordinated and thorough to ensure a smooth transition. “This is a very amicable process and I’m excited for the Watervale team as they move forward,” said Frank Linsalata, founder and chairman of LinCap.

According to Tucker, the trend of many new firms launching as first generation firms wind down or change hands is just beginning. “Many firms are working through succession planning right now. Private equity is a young industry, and the first generation of founders is at retirement age. There will be a lot of change,” says Tucker.

Mike Faremouth
Watervale Equity Partners