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The perception that lower middle-market deals are riskier than other segments of direct lending has been the subject of much debate, but now these very companies are leading a revival in leveraged buyouts and acquisition activity.

There鈥檚 been 鈥渁 ton鈥� of activity in the sub-$50mn total enterprise value (TEV) segment of the market over the last six quarters, because of increased add-on activity and a decrease in platform investing, says Bob Dunn, a managing director at GF Data. Deal volume has improved at the lower end of the middle market, and it鈥檚 likely to continue in the next two quarters.

Given their smaller size, a common belief is that lower middle-market borrowers are more vulnerable to macroeconomic shocks than larger corporations. But according to lenders in the sector, most of the transactions in this segment of the market have tightly structured deals with covenants and operate with less leverage, both of which play an integral role in their resilience.

鈥淩isk is in the eye of the beholder,鈥� said Kevin Prunty, senior managing director of LongWater Capital Solutions. 鈥淭he data doesn鈥檛 support the notion that the lower middle market is riskier than the upper middle market. There are structural protections that lower middle-market lenders can get to help mitigate the perceived risk and offer significant level of credit enhancement.鈥�

While upper middle-market companies often are viewed as a safer bet because they have diversified revenue streams, access to more financing options and can better withstand economic volatility, leverage 鈥� a proxy for a company鈥檚 financial resilience 鈥� is higher.

Lincoln International noted that new deals for larger companies are closing with higher leverage because of a supply/demand imbalance, decrease in base rates and increase in enterprise value multiples for larger deals. As such, Lincoln increased its leverage for the $40mn to $100mn EBITDA and greater than $100mn EBITDA size categories by 0.50x as of Oct. 15.

Indeed, leverage tends to be lower in companies with less than $50mn of total enterprise value, per GF Data. Companies with $10mn to $25mn of TEV have senior debt to EBTIDA YTD of 1.5x, and those in the $25mn to $50mn band have 2.0x senior debt to EBITDA. Borrowers with $100mn to $250mn have senior debt to EBITDA at 4.1x YTD.

Meanwhile, covenants are often a safeguard for lower middle-market lenders that incorporate these tools in their credit agreements. Only 5% of lower middle-market companies have loans that were covenant-lite at Sept. 30, according to聽Covenant Review. That compares with 17% and 26% of loan in the upper middle market and traditional middle market, respectively, that have no financial maintenance covenants.

According to Bill Sacher, partner and head of private credit at Adams Street, which plays in the core and upper middle markets, 鈥渓ower mid-market is a little bit more dependent on the strength of the economy. During periods of economic strength, those underlying companies tend to perform a little bit better. But in periods of economic downturn, those businesses tend to default more and have lower recoveries.”

Brian Garfield of Lincoln says defaults are rising, and it鈥檚 in the lower middle market, but it鈥檚 idiosyncratic and not widespread.

Whether the lower middle-market deals are risky, they are leading the way in buyout activity. Add-on transactions continued to play a central role in sustaining deal activity, accounting for 40% of acquisitions tracked year to date, according to GF data.

鈥淭he lower middle market represents a lot of important deals that drive the backbone of our economy,鈥� said John Koeppel, a partner at Lippes Mathias and team leader of the firm’s private-equity and independent sponsor practices.

In the lower middle market, aging boomers looking to retire can drive a lot of deal flow.

Another advantage of lower middle-market deals emerged with the signing of the One Big Beautiful Bill in July. Under the bill, qualified small businesses are not required to pay federal tax or capital-gains tax. The law may incentivize further buyout activity in the sector.

鈥淲ith so many business owners looking to transition out in the coming years, and a strong ecosystem of private equity, independent sponsors and other buyers active in this space, these lower middle-market deals will continue to play a key driver in the overall LBO / M&A ecosystem,鈥� Koeppel said.

Particularly attractive are businesses with recurring revenue streams, noted LongWater鈥檚 Prunty. Home-services businesses such as landscaping, insect abatement and others that operate in fragmented markets that can be rolled up present interesting opportunities.

鈥淲ith interest rates not going up materially from here, it鈥檚 giving people a sense of calm,鈥� Prunty said.