Four trends in the US mid-market

Dealmaking and capital raising continue to gain momentum in a robust mid-market, with emerging managers and ESG making progress.

1 Confidence rises among mid-market firms    

After a tough 2020, things are looking up for the US mid-market. According to the latest data from the National Center for the Middle Market, which defines the segment as companies with annual revenues of $10 million to $1 billion, year-on-year revenue growth reached 8 percent in Q2 2021. While that growth remains uneven, the overall outlook for the US mid-market is positive. More than half of companies (58 percent) surveyed by the NCMM in June plan to enter new markets in the next 12 months, compared with 43 percent in December and 37 percent in June last year.

Furthermore, economic confidence among mid-market companies has exceeded pre-pandemic levels. Per the NCMM’s Middle Market Indicator for Q2 2021, 89 percent of mid-market business leaders express confidence in the national economy, up from 82 percent in Q2 2019. And while confidence in the global economy is slightly more muted at 81 percent, this is still far above the 69 percent recorded two years ago.

The outlook is also brighter for private equity funds targeting the mid-market, with investor appetite on the up. After capital raising fell from $159 billion in 2019 to $111 billion in 2020 – which, indicative of the mid-market’s resiliency, was still above 2018 levels – PitchBook data suggests growing fundraising momentum going into 2021. In the first quarter, 40 US mid-market funds closed on a total of $37 billion.

2 LPs regain appetite for emerging managers

Some emerging managers are also benefitting from the more hospitable fundraising environment. According to PitchBook, funds raised by emerging managers represented almost 73 percent of the number of mid-market funds closed in Q1, the greatest proportion since 2013. First-time funds accounted for 12.5 percent of first-quarter fund closes in the US mid-market, up from 11 percent in full-year 2020.

After a flight to familiarity last year, which hampered fundraising efforts among first-time managers, LPs appear to be more open to forging relationships with new GPs. So far, the firms that have had the most fundraising success tend to be those founded by individuals with existing LP networks and who have established a name for themselves while working at previous managers.

“The market is split between the haves and the have-nots,” says Natalie Walker, a partner at StepStone. “Emerging managers with relationships with LPs and strong track records are raising more quickly than usual because of the virtual due diligence process, while those without are taking much longer to raise.”

However, building relationships with new funds can offer some advantages to LPs, such as access to co-investment opportunities.

Eric Deyle, managing director at Eaton Partners, says: “Once a firm is raising fund III or IV, it’s really difficult to establish a key role with a sponsor or become a strategic investor. The trend for co-investments is playing into this – LPs need to come in at the right inflection point if they are to establish themselves as a first-look co-investor.”

Investors’ efforts to back new talent and diverse teams could also play in emerging managers’ favour, alongside targeted strategies that focus on supporting next-generation managers. “We’re seeing the creation of dedicated funding platforms and a broadening of the type of investor targeting newer managers,” notes Deyle. “Foundations, family offices and endowments have long been supporters of new firms, but now we are seeing pension funds and insurance companies step in, too.”

3 Dealmaking gathers pace

Dealmaking in the mid-market has certainly been picking up speed. Some 1,140 deals were executed in the final quarter of last year, according to PitchBook, totalling $160 billion, and that continued into Q1 2021 when more than 770 deals were closed at almost $120 billion combined. These quarterly deal values are the two highest on record. By way of comparison, pre-pandemic, 719 deals closed in Q4 2019 at a total deal value of $105 billion.

With plenty of dry powder chasing deals, competition has ramped up as mid-market firms seek out the most attractive targets. This means managers are having to get in front of deals quickly and be selective about the targets they want to pursue. “Even though there are a lot of firms and a lot of competition, there are actually a lot of deals in the market,” Dave Tayeh, head of private equity, North America at Investcorp, tells Private Equity International. “If it’s not something we feel great about, we’re not going to spend a ton of time [on it], because we know others will.”

This dealmaking frenzy is also putting extra pressure on service providers. Lucas Group founder Jay Lucas tells PEI that the system is overloaded with more demand for deals than there is capacity.

And it is not just providers of services such as market mapping and due diligence that are feeling the heat in the mid-market. Elsewhere, robust fund finance activity has led to pent-up demand for new recruits at US banks, according to Rory Smith, founder of fund finance-focused talent search company Brickfield Recruitment.

After pandemic-related hiring pauses, the hunt is now on for experienced professionals that can support future growth.

“Given that fund finance has been one of the star performers for many banks, they are now being more open-handed with budgets when it comes to those who delivered during the tough times of 2020,” says Smith.

4 GPs make progress on ESG

Pressure can come in many forms, and one area where US mid-market managers are coming under scrutiny from investors is on ESG. “Eighteen months ago, I would say the US firms were behind on ESG, but they have been catching up quickly and making more noise,” says Cristina Alcaide, managing director of the private funds group at PineBridge Investments, adding that “one of the main motivators has been the influence of LPs”.

While US mid-market GPs are generally perceived as lagging behind their European counterparts and larger firms when it comes to addressing environmental, governance and social concerns, they are now working to quickly catch up. “Initially some managers viewed ESG as a burden and there wasn’t too much clarity around good practice; now they are dedicating resources to it and don’t want to be left behind,” says Helen Lais, managing director and head of US primaries at Capital Dynamics.

A proactive approach to ESG can present a value creation opportunity and equip managers in the crowded mid-market with a competitive edge. As Lais notes: “Even small managers with $300 million AUM on their first fund, if the leadership believes in ESG, it’s tremendous what they can accomplish. They can insist on diversity in their management teams, because they have leverage with those companies and the companies are malleable, and they can quickly make a real difference.”

When developing ESG or diversity, equity and inclusion strategies, however, there are some pitfalls to watch out for. According to FMG Leading CEO Matt Brubaker and managing director of growth strategies at the firm, Will Busch, III, these include pursuing initiatives with the sole objective of minimising reputational risk, or trying to address every issue at once. “Private equity firms’ DE&I and ESG initiatives should simply be about creating value, just like the work they do every day, but intentionally touching on the needs of a broader group of stakeholders,” note Brubaker and Busch.