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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.

Private businesses are critical to the U.S. economy, but right now, many are starved of the capital they need to grow. As a result, there could be a potential opportunity for your clients to invest in vehicles that provide capital to these businesses.

Middle-market businesses—defined as those with revenue of $10 million to $1 billion by the National Center for the Middle Market —have a big impact on the economy. There are nearly 200,000 such businesses in the U.S., making up about a third of the U.S. private sector GDP and employing almost 47.9 million people.1

Given the importance of these private businesses, you might think banks would be lining up to lend to them. Yet that’s not the case. Many private businesses can’t get the capital they need to open a new factory, expand into a new territory, or bring on more workers. To understand why, you need to look at the various options that these businesses have—or often don’t have—for accessing capital.

Why Are These Businesses Cash Starved?

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 Volcker Rule, and Basel III—led to higher costs and stricter requirements on bank loans. Some of the rules are still being hashed out, but the uncertainty itself can make banks hesitant to lend.

Consolidation in the financial sector is a factor as well. The four largest banks today were formed through mergers and acquisitions among 37 different banks since 1990.2 Those two factors—regulation and consolidation—mean that there are simply fewer banks making fewer loans these days.

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. One recent study found that just 3 percent of small and mid-sized businesses are publicly traded, and only another 3 percent have considered it.3

Private Equity

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 a goal of taking dramatic steps to improve performance so that the business can be sold again. It’s not a realistic 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 private capital (a private equity and debt investment alongside the existing management team). In addition to meeting the business’s capital needs, 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 to keep growing. Investors potentially benefit from income (through the debt component) and long-term growth (through the equity component). In this unique structure, investors own the full capital stack (a controlling debt and equity investment) and have aligning 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 capital is constrained for private businesses, there will be an unmet need in the market. And as with any unmet need, a potential opportunity is created. For investors in your client base, providing private capital to these businesses could be an interesting option.

1 3Q 2017 Middle Market Indicator, National Center for the Middle Market.
2 “The Making of the 'Big Four' Banking Oligopoly in One Chart,” Visual Capitalist, Jan. 25, 2016.
3 Access to Capital: How Small and Mid-Sized Businesses Are Funding Their Futures, Milken Institute and the National Center for the Middle Market, April 30, 2015.

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