A little more than 30 years ago, when the late Jerome Kohlberg Jr. announced he was leaving KKR, he told The New York Times that at his new firm, Kohlberg & Co., he’d be focusing on “deals where reason still prevails.” This was a period, observers may recall, when billion-dollar buyouts were still quite rare for private equity firms not named KKR. In fact, the very concept of the “middle market” didn’t yet exist in 1987 and the need to further subdivide the category – adding a boundary between the middle and lower-middle market – wasn’t necessary until at least a decade later. The question that faces sponsors active in these segments today, however, is whether reason still prevails.

The answer, based on recent deal pricing may seem cut and dried. The median M&A multiple for acquisitions between $100 million and $500 million in size reached 11.3x Ebitda, according to Murray Devine’s 2018 Valuation Report. The larger end of the middle market, representing deals between $500 million and $1 billion in size, were just a shade higher, at 11.6x Ebitda. And large-market transactions, for deals valued $1 billion and above, weren’t even a full turn higher at 12.5x Ebitda.

The challenge for middle market investors today isn’t simply that they’ll be hard-pressed to incorporate multiple expansion into their investment thesis; it’s that the prospect of multiple contraction is perhaps more pronounced than any time since the early 1990s. And given the paper-thin spreads between deal sizes, the contraction threat will linger even in cases when portfolio company growth meets or exceeds underwriting assumptions.

The appeal of the middle market has traditionally been attributable to certain key characteristics. The larger universe of available assets generally provides a steady pace of deal flow. Target companies – at earlier stages in their growth curve – also tend to be more impressionable to operational initiatives, whether it’s to improve the top- or bottom-lines. But while growth catalysts abound, the middle market has always been billed chiefly as a value play, particularly in the lower middle market.

Deal multiples in the middle and lower-middle market didn’t eclipse double digits in a vacuum and the pressures driving pricing have been well told over the past few years. More funds, more capital, readily available debt and, simply, a more efficient marketplace have each contributed to record valuations. And to think that not too long ago, the lower middle market used to be an area where sponsors could transact outside of a formal auction. The length of the recovery has instilled even more confidence in the trajectory of company performance, which was further helped along by last year’s tax cut.

To be sure, many investors active two years ago have indeed seen their portfolio companies grow into what probably seemed to be rich multiples at the time. And a greater proportion of the middle market activity this year has gravitated toward healthcare and technology deals, two sectors that tend to attract higher multiples.

Still, the level of competition has exerted new pressures that are only made more pronounced by a bifurcating market, increasingly defined by the haves and the have nots. For instance, in July, Platinum Equity closed on a $1.5 billion fund dedicated exclusively to deals in the lower-middle market. A fund of this size, competing against funds 10x smaller or even the growing population of fundless sponsors, will have a distinct advantage in terms of resources and available bandwidth.

While behavioral economists, such as Nobel Prize winner Richard Thaler, usually focus on the biases that influence investment activity in the public markets, behavioral factors can be just as persuasive in private equity. Similar to the sunk cost fallacy, commitment bias can motivate smaller funds to see a deal process through – even as multiples extend past traditional comfort levels – to avoid dead deal costs or justify the time spent pursuing a transaction.

An Evolving Thesis
Given the pace of activity in the first half of 2018, it’s clear middle market sponsors have adapted their strategies to accommodate higher prices. Data provider PitchBook quantified that in the first half of the year, U.S. middle-market sponsors closed a total of 1,358 deals worth a combined $178.5 billion. PitchBook also noted that based on the total value, the middle market, alone, accounted for almost 70% of all private equity activity.

This speaks to the role of the middle market within the larger private equity ecosystem, particularly as sponsor-to-sponsor sales, or secondary buyouts, represent roughly a quarter of all PE-led deals.

The July sale of Hearthside Foods, for instance, highlights the prevailing “food chain” within the asset class, as smaller firms increasingly seek exits through secondary sales to larger peers. It also underscores the foundational role of the middle market to set portfolio companies on a course for larger buyouts.

Wind Point Partners acquired Hearthside in 2009, installing Ralcorp and ConAgra veteran Rich Scalise as CEO. Since then, the company has traded hands twice, through a roughly $1.1 billion sale to Goldman Sachs and Vestar and, earlier this summer, to Charlesbank Capital Partners and Partners Group for a reported $2.4 billion. It simply speaks to the value proposition of mid- and lower middle market investors to create scalable enterprises through professionalizing operations and installing management teams who can facilitate rapid growth.

The role of add-ons, too, should not be overlooked. This represents another way middle market investors have been able to remain active in the face of high valuations. Ten years ago, add-on acquisitions or strategic tuck-in deals may have accounted for slightly more than 50% of the total activity, according to PitchBook. Today, it’s closer to 65%.

Again, the Hearthside investment provides a telling case study. Wind Point was able to accelerate the company’s growth through combining it with another portfolio company, Ryt-way. That transaction, in addition to three additional tuck-ins, provided scale and diversification to support added leverage and attract bigger buyers. Goldman and Vestar, meanwhile, built upon this strategy through securing four additional acquisitions to grow Hearthside’s business overseas and expand into new categories.

In the persistent hunt for value, too, add-ons have become critical and may speak to why middle market investors are so willing to pay up for a platform that can support an aggressive rollup strategy. The median Ebitda multiple for M&A deals below $100 million in size was 6.7x, according to Murray Devine’s 2018 valuation report. The relatively wide spread between small-market and lower-middle-market M&A valuations reflects how investors are incorporating highly accretive tuck-ins as a way to lower their effective multiple.

The takeaway, however, is that while valuations are soaring in the middle market, investors have been able to modify their investment thesis to accommodate higher prices. It’s just that investors may have to travel even further downstream to find pockets of value where reason still prevails.