July 24, 2024 - During the United States’ (U.S.) Great Recession of 2007-2009, one specific company classification outperformed its peers. Middle market companies — companies ranging in annual revenue from $10 million to $1 billion per the National Center for the Middle Market (NCMM) added 2.2 million jobs during this time, showing their resiliency during economic downturns and their overall importance to the economy. Based on this resiliency, these companies are highly appealing to investors like private equity and private credit funds as their strength in turbulent times suggests potential returns that could outpace the market.

Specifically, the popularity of business development companies (BDCs), closed-end investment funds that make investments in small and medium-sized companies, grew over the last 15 years as large banks began to acquire small banks and the banking industry reduced their overall lending to middle market companies following the Great Recession. According to FS Investments, the total asset value of both private and public BDCs increased from approximately $30 billion in 2008 to over $200 billion in 2021. That figure has continued to grow over the past two years, and according to S&P Global, the total asset value for BDCs was approximately $300 billion as of Q1 2023.

Market volatility

BDCs use their capital to invest in various types of privately held securities, primarily in secured, variable rate debt. As interest rates were near all-time lows following the Great Recession, the variable nature of debt did not become concerning until Q2 of 2022, when the Federal Reserve began aggressively raising interest rates to combat inflationary pressures on the economy. In addition to rising interest rates, supply chain constraints also began to impact middle market companies in 2022. A Q1 2022 Middle Market Growth article noted that 80% of companies surveyed experienced supply chain disruptions that impacted their business. Additionally, inflation was a major concern during this time for all companies, as inflation rates topped 8% for the first time in over 40 years. Because of these macroeconomic factors, there was significant macro concern about how middle market companies would be able to navigate the changing economic landscape.

Responsiveness of middle market companies

Middle market companies took several measures to adapt to the changing landscape and have been an economic bright spot during challenging times. In the same Middle Market Growth article, 60% of survey responders noted that the supply chain issues caused them to change the way their business operates, and almost 35% of responders mentioned that they hired a specific individual to assist with supply chain constraints. Because of their size, middle market companies must be more aggressive during uncertain times, but they are also more nimble than larger companies. They can leverage price increases for customers to combat inflation or cut costs to stabilize margins. In addition to internal operating decisions, middle market borrowers have also relied on their private equity sponsors and private credit lenders to navigate the current economic climate. Borrowers that have faced tightening liquidity or failed certain covenants have negotiated with lenders to amend the terms of their credit agreements to either deferring amortization payments, removing leverage tests that may result in default interest payments, or converting cash interest payments to payments-in-kind (PIK). Fitch Ratings noted that the percentage of debt issued by BDCs that is accruing PIK was at 3.6% in 2019 and has since increased to 8.3% in 2023. In addition to actions by lenders, private equity sponsors have also provided additional financing to support liquidity. Not only is management invested in the future performance of these companies but so are financial backers who typically move in lockstep trying to spur growth and support portfolio companies through economic downturns.

Market expectations and outlook

It is difficult to predict how major macroeconomic trends will impact middle market companies in the future. What has been seen thus far is resiliency, flexibility, and nimble decision making helping these businesses weather historical storms. The National Center for Middle Market indicated that revenue grew for middle market companies at 12.4% in Q4 of 2023 and has a 12-month projected growth rate of 8.1%. Employment growth for Q4 of 2023 was 9.6% and projected 12-month growth is 8.7%. These statistics suggest that middle market companies have not only been able to stay above water but generate growth during the current high interest rate period and overall market volatility.

From a Blackstone article in Q4 of 2023 on private debt, interest rate coverage ratios, a statistic that represents a company’s earnings capacity to cover its interest expense, have, as expected, declined over the last 18 months for private borrowers. While this metric has declined, the average remains elevated at 1.5x, still enough to cover interest payments. At the start of 2024, market expectations were that the Federal Reserve would begin decreasing interest rates throughout 2024, however, as inflation continues to persist, there remains uncertainty over any changes in interest rates and the overall economy. Despite interest expenses’ increasingly heavy burden on cash flows, middle market companies have shown their ability to adapt through an unprecedented economic landscape and continue to contribute to the growth of the overall economy.

Leveraging sound valuation services

In the ever-evolving economic landscape marked by rising interest rates and complex financial challenges, middle market companies require robust valuation services that not only reflect the current market realities but also anticipate future shifts. Citrin Cooperman’s Valuation Advisory Services Practice assists companies through detailed and defensible valuations that support critical financial activities, including mergers, acquisitions, and compliance requirements. Our approach integrates deep industry knowledge with a strategic understanding of market dynamics, ensuring that your business is well positioned to navigate uncertainties and seize growth opportunities effectively.

Citrin Cooperman is committed to providing the insights and expertise necessary to enhance your company's success. For personalized guidance on how our Valuation Advisory Services Practice can help your business adapt and thrive in a changing economic environment, please reach out to Jordan Birnbaum at jbirnbaum@citrincooperman.com, Reid Worster at rworster@citrincooperman.com, or your Citrin Cooperman advisor.