The mid-market M&A opportunity for investors

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The lower middle market has seen a surge in deal activity in recent years, according to firms that track mergers and acquisitions (M&A) activity.

And one M&A veteran in the mid-market would like to see more Canadian family offices seize on the potential profitability of small- to medium-sized enterprises.

Mark Borkowski, president of Mercantile Mergers & Acquisitions Corp. in Toronto, says many family offices tend to focus on private real estate, which now have capitalization rates topping 9 per cent in some cases.

Yet successful mid-market private businesses can offer a much better return, he notes.

“With a well-run private company, the owners can get on their equity 20 to 25 per cent returns.”

Private equity funds – including from the United States – are already focusing on the opportunity, says Borkowski, who brokers deals for the funds, and a few for family offices.

“Private equity firms are crawling all over the mid-market.”

Demand for mid-market companies – enterprises generating $1 million or more annually of earnings before interest, taxes, depreciation or amortization (EBITDA) – is building to a fever pitch again, as investors look beyond public markets and higher-risk venture capital, Borkowski says, noting the aforementioned valuation is the most widely used for mid-market deals.

A recent PWC report supports this view of the market, stating larger deals – those exceeding $1 billion – have declined significantly from record activity in 2021. Yet mid-market remains more active and is forecast to grow faster in this higher-financing-cost environment, it forecasts.

The prospects in Canada are palpable, given that more than 80 per cent of enterprises are mid-market, Borkowski says.

Even multi-nationals like PepsiCo and IBM are buyers, he adds.

“Smart money is looking for investments that make more money than real estate, or stocks, and that’s what private businesses can offer.”

Demand is high, but supply is low

A recent McKinsey report estimates about $3 trillion is on the sidelines globally, seeking to invest in a limited number of opportunities.

Like elsewhere, Canada’s mid-market has a dearth of sellers, even though it has an abundance of highly profitable businesses with aging owners who need to transition, Borkowski says. “There are these guys who started 40 years ago, nearing the end.”

Indeed, their businesses can be profitable with best ones generating $10 million annually in sales with 20 per cent EBITDA, he adds.

Canadian family offices and family businesses uniquely positioned

Canadian family offices are uniquely positioned to excel on either side of these deals. On the hand, family offices may be sellers, able to select from several private equity suitors flush with capital. On the other, they can be buyers in their own right or in partnership with private equity.

At Kismet Wealth Group, a multi-family office in Etobicoke, many of its business-owner clients have been doing mid-market acquisitions on their own.

“We’ve had [medical professional] clients purchase clinics to scale up and diversify beyond one location,” says Victor Godhino, managing partner at Kismet.

It’s not only medical professionals. Many second-generation business owners, often in manufacturing, seek to acquire new businesses.

“Younger generation owners want to take over existing businesses versus trying to be founders.” Often under age 45, these clients recognize they do not have to create and bring to market a new app, for instance, to see strong capital growth, he adds.

“They can instead buy an existing business and take it to the next level.”

Leveraging the heft of private funds

One challenge, however, is clients are being outbid by private equity, Godhino says.

Then again if you can’t outbid them, join them, he adds. “Partnership are even more preferable, involving less leverage and generally without the back-and-forth to close deals.”

Private funds are also the preferred exposure for clients at Northland Wealth Management, a multi-family office in Toronto.

“Private equity has been an area our families have invested in since 2011,” says Arthur Salzer, chief investment officer with Northland, adding the asset class represents about 12 per cent of client assets today.

Northland’s strategy has been recently more focused in the U.S. mid-market through private credit funds, he adds.

“If you have a good manager, you typically get equity kickers like warrants for additional upside” in addition to the high-yields in the credit space.

And family firms with experience running businesses are ideal partners with private equity, which typically do not have experience on that front, Borkowski says.

Smooth transitions key to retaining goodwill

However, too often, family offices go about it the wrong way, seeking asset-purchase deals, Borkowski says.

“If that’s what you’re proposing, you are likely not going to see anything good.”

Buying an equity stake with the previous owners staying on for a set timeframe is preferable for many reasons. Notably, owners can use the lifetime business capital gains exemption – now $913,630 per owner – when selling shares.

With asset deals, the exemption is unavailable.

“As well, you’ve got to go to every employee and sever them – guys that have been there for 30 years.” Existing owners recognize the problems, he adds.

Kismet sees this risk, as well. “The biggest risk is the owner had 30 years of handshake deals, and then 25 per cent of the revenue is gone because the person customers are used to dealing with is no longer there,” Godhino says.

In turn, Kismet generally wants owners to stay for about two years for a smooth transition, he adds.

Valuations high, but upside remains

The structuring of deals aside, the challenge today is finding them.

Given their scarcity, mid-market valuations remain high, even as they have fallen from the 2021 peak.

Even still, the mid-market is fertile ground, particularly as many investors become more cautious, Salzer says.

“You can still pay a big multiple on a small client-base of a good company,” and with additional investment, a good operator can grow that customer base substantially, he adds.

“You can end up generating so much extra revenue, the higher up-front cost doesn’t really matter.”

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