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2023 Lower Middle Market Deal Outlook

Heading towards the close of 2023, the economic environment is marked by ambiguity, influencing decisions of both buyers and sellers in the middle market. However, despite these challenges, deal activity is not expected to come to a complete stop. In fact, add-on acquisitions are expected to flourish as larger companies look to “buy and build” in an uncertain environment. Capital is likely to flow down to the lower middle market, defined as businesses with $100 million in enterprise value or less, as these smaller deals are easier for larger companies to finance and integrate. This means that private equity groups will be pursuing smaller bolt-on transactions as demand remains strong.

Outlook for Deal Activity in the Lower Middle Market

The trend of deal activity continuing in the lower middle market is not only driven by demand, but also by the supply of lower middle-market businesses coming to market. Throughout 2023, there’s been a notable increase in sellers eager to exit their businesses, including founders who want to step away or large corporations that need to divest non-performing assets to raise cash. This increased seller motivation, combined with the uncertain economic outlook and the rising cost of capital, may lead to lower valuations. However, it is important to note that valuations will not necessarily be unfair and companies that are in a good position can still receive a fair valuation in this environment.

Analysis of Deal Activity in 2022 and its Implications

It is worth noting that deal activity in 2022 slowed considerably, following a massive peak in 2021. This was due to a variety of factors, including geopolitical issues, inflation, rising interest rates, and supply chain instability. According to GF Data, which provides data on deals from more than 250 active private equity contributors, there were 129 PE-sponsored M&A deals in the first half of 2022, compared with 464 in all of 2021. These figures cover transactions with enterprise values of $10 million to $500 million.

Factors Driving Deal Activity in the Lower Middle Market

A survey* of ACG members conducted in late summer found that 66% of respondents believe deal activity will either slow or stay about the same in 2023. The public stock markets are down, IPOs are down, interest rates are up, leverage levels are down, and banks are being very conservative. All of these factors are making financial sponsors more selective in terms of what they pursue.

Selectivity of Financial Sponsors in Pursuing Deals

It is important to note that top-tier assets with recurring revenues, high margins, and limited cyclicality are still receiving robust interest and valuations from financial sponsors, along with support from lenders and sellers. These deals, which account for 68% of total deals tracked by GF Data and completed in the first half of 2022, are receiving mid-teens to higher EBITDA multiples, similar to 2021.

Focus on Top-Tier Assets in the M&A Landscape

In a volatile market, due diligence takes on increased importance. M&A processes may slow down as buyers take more time to do their due diligence. This further emphasizes the importance of operational excellence and execution for sellers. In 2021, buyers were often buying companies based on projected year-end numbers and taking the sellers’ word for it. During 2023, buyers have steadily grown more skeptical, seeking to rigorously verify incoming results.

At Astria Group, we specialize in providing strategic guidance and expertise in navigating the ever-changing landscape of the lower middle market. Our team of experienced professionals is here to help you seize opportunities and overcome challenges. Contact us today to discuss your specific needs and discover how our tailored solutions can support your business goals.

*ACG stands for Association for Corporate Growth.

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