Why You Should Be Talking About Middle-Market Businesses (and it’s not the reason you think)
Private businesses are a critical part of the U.S. economy, yet they can’t always get the capital they need to grow. For investors, this demand could represent a new opportunity.
April 20, 2022 - Middle-market businesses—defined by the National Center for the Middle Market as those with revenues of $10 million to $1 billion—have a big impact on the economy. There are nearly 200,000 U.S. middle-market businesses that represent one-third of private sector GDP, employing approximately 48 million people.1 Moreover, because they’re small, these businesses tend to grow faster than large, established companies. More than three-quarters of middle market companies reported positive revenue growth in 2021 compared to 2020. With year-over-year growth rates reaching an all-time high of 12.3%.1
Relying on Non-Traditional Sources of Capital
In the past, many private businesses struggled to get the capital they needed to open a new factory, expand into new territory, or bring on more workers. Today, that’s less true, though these companies still can’t turn to traditional sources of capital.
Let’s look at the primary ways a private business can obtain capital:
Bank Debt
After the financial crisis of 2008, many banks faced new regulations that limited their ability to lend. These regulations—including the Dodd-Frank Act, the Volker Rule, and Basel III—all led to higher costs and stricter requirements on bank loans.
Consolidation in the financial sector is a factor as well. Since 1990, the number of banks in the U.S. has declined from 12,229 to 4,239 as of 2021.2 Those two factors, regulation, and consolidation, mean that there are simply fewer banks making fewer loans.
Public Equity
Private businesses can list themselves on public stock exchanges—essentially selling a slice of equity to public shareholders. However, many of these businesses are too small to go public. Listing on public exchanges carries significant costs, along with reporting and compliance requirements.3
Private Equity
Traditional private equity is another option. Yet a lot of activity in the sector is focused on leveraged buyouts of businesses that are distressed or businesses with management teams that do not want to retain any ownership. Private equity firms typically take over operational control with the goal of taking dramatic steps to improve performance so that the business can be sold again. That makes private equity an unrealistic option for healthy businesses that simply need an infusion of capital to get bigger.
Demand Meets Supply
What is a healthy, growing business to do? One option is to seek out private capital (private equity and debt investment alongside the existing management team). In addition to the business’s capital needs being met, this option provides some additional benefits by allowing the owner or management team to retain operational involvement as well as some level of ownership.
How do businesses access this type of investment? One way is through investment vehicles that combine the funds of individual investors to create a pool of debt and equity that middle-market businesses can access in the hopes of growing the business. Investors potentially benefit from income (through the debt component) and long-term growth (through the equity component). In this unique structure, investors own shares of the complete capital stack (a debt and equity investment) and have aligned interests with current management. As with any investment, investors should review the fees and expenses associated with investing in private businesses, as there are substantial costs.
As long as private businesses need capital, some market entity will fill that need, creating a potential opportunity. For investors in your client base, providing private capital to these businesses could be an interesting option.
Represents CNL’s view of the current market environment as of the date appearing in this material only. There can be no assurance that any CNL investment will achieve its objectives or avoid substantial losses.
1 Year-End 2021 Middle Market Indicator, National Center for the Middle Market.
2 Historical Bank Data, FDIC.com, accessed April 6, 2022.
3 Patrick Galleher, "Why More Businesses Are Choosing to Stay Private," Forbes.com, February 2020.
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