The Merits of Investing in the Lower Middle Market in Northern Europe

At the time of writing, it is difficult to project the magnitude of the damage that the ongoing pandemia will cause to economies globally. From investor’s perspective, instead of forecasting the years ahead, we believe the time is more convenient to focus on the underlying portfolio characteristics and identify the key value drivers. Delineating different scenarios on what might be the impact on the portfolio becomes much more fruitful, when the value drivers have been identified. In this article, we discuss the building blocks of our investment strategies in Northern European lower middle market and why we believe that this strategy will continue to provide strong absolute returns also post-pandemia.

By way of definition, Northern Europe refers to the countries here in the North, i.e. the Nordics, the DACH and Benelux regions, and the UK. We tend to use ‘Beer-drinking Europe’ as the name for our core market, as the consumption of beer per capita in these countries is higher than for wine. Our core focus is on the lower-end of the market. More precisely, companies with an EV of €20 - 100 million. These small and medium-sized enterprises (SMEs) are the backbone of the European economy. In the European Union’s non-financial sector, just under 25 million SMEs accounted for 99.8% of all non-financial enterprises, employed 95 million people (66.4% of total employment), and generated €4.2 trillion in value added (56.8% of total value added).¹ Needless to say, this massive segment of the European economy will face tough times due to the economic shutdown. As noted, the magnitude is yet to be discovered, but we are confident that a few fundamental characteristics of the lower middle market companies will provide some protection from investors’ point of view

Firstly, smaller companies are less efficient and have smaller, more ‘home-grown’ management teams, what’s more, their boards are often staffed by people who are operationally involved. Combined, these characteristics present immense improvement opportunities, but obviously require a lot of heavy lifting, hands-on steering and involvement. Consequently, the valuation of the lower middle market businesses will always be lower than the upper-end of the market as the perceived risk is higher. The historical average entry valuation of lower middle market companies is around 7.5x – 8.5x EBITDA with fairly little volatility between high- and low-cycle marks. In comparison to the broader LBO market, this is 2-3 turns lower.² Valuation multiples are indeed bound to the perceived risk, do not get us wrong, but they do, however, limit the volatility of the company valuations.

Secondly, the growth profile of lower middle market companies mean they consume cash and seldom produce enough cash flow to be highly levered. Moreover, the modest size of these companies means that they do not have access to bank financing the same way the larger companies do. Consequently, the capital structure of lower middle market companies is equity-heavy. On average, the capital structure is made up of two-thirds equity and one-third debt, with absolute leverage levels of 2-4x EBITDA. Again, this is 2-3 turns lower than the broader LBO market, which reduces financial risk and provides more liquidity headroom in the current lock-down.³

Thirdly, value creation models of lower middle market companies predominantly focus on growing their top line, either organically or through acquisitions, and on increasing their margins and bottom line through efficiency improvements. For the managers that focus solely on creating value through acquisitions, the current market environment will most likely provide attractive add-on opportunities that will offset some of the negative impact experienced by the companies acquired pre-crisis.

So what is to be expected from the future? From a primary investor perspective, one can expect that new investments and exits will be reduced for some 6-9 months. By comparison, post-GFC, new investment volume fell by roughly 50% whereas exit volume fell slightly more.⁴ Further, holding periods of companies acquired pre-pandemia will most likely be extended until company valuations have adjusted and buyer / seller price expectation meet again. Consequently, funds’ cash flow profiles will be pushed forward putting pressure on IRRs of existing portfolios. On the other hand, fund raising will slow down as investors become more cautious and have less capital available for new investments. The best lower middle market managers will still have access to capital but many others will not, resulting in less competition for deals. At the larger end of the market, there are still record amounts of dry powder waiting to be deployed providing lower middle market managers with strong exit alternatives once the markets normalize. Turning to secondaries, although company valuations will adjust downwards over the coming quarters, lower middle market valuations tend to correlate relatively little with public markets. Given the recent volatility of public markets, we see many temporary secondary market participants retreating from the market currently. This combined with an expected increasing amount of liquidity-seeking investors coming to market, will provide an interesting supply / demand –balance where buyers are price-setters.

According to a recent study conducted by McKinsey, PE firms that maintained their capital-deployment rate before, during and after the GFC, tended to outperform.⁵ Given that the private equity industry has grown and developed significantly since the GFC, we believe the market could rebound rather quickly in comparison to the last downturn. Historically, the vintages following a market dislocation have always outperformed and we believe that the Northern European lower middle market remains one of the most attractive private equity markets going forward.

Staffan Jåfs Head of Private Equity

Teemu Blomqvist Associate, secondaries

¹ European Commission, Annual Report on European SMEs 2017/2018, 14 November 2018.
² eQ database (covering 200+ European buy-out fund investments since 1994).
³ eQ database (covering 200+ European buy-out fund investments since 1994).
⁴ Bain & Company: The Impact of Covid-19 on Private Equity.
⁵ McKinsey & Company: Lessons for private equity from the last downturn.