The Pipeline: M&A and IPO Insights | S.4 Ep. 8 - Bridging the M&A gap in the lower middle market

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Joe Mantone   00:00:04

Welcome to another episode of the Pipeline, an S&P Global Market Intelligence podcast that dives deep into the world of M&A and IPOs. I'm your host, Joe Mantone. And today, I'm speaking with Paren Knadjian, a partner at Eisner Advisory Group and also a member of the firm's Transaction Advisory Services practice. Paren has more than 20 years of experience in M&A and has experience for all different sides of the table, along with being an adviser, Paren has co-founded companies that sold, and he also worked in corporate finance for Thompson. So Karen, thank you for joining us today.

Paren Knadjian   00:00:44

Thank you for having me.

Joe Mantone   00:00:46

On today's conversation, we are going to be talking about the state of deal activity in the lower middle market. But before we get into that, Paren, I wanted to ask you about your background. I see you went to school in the U.K., the University of Bristol and you had an electrical engineering degree. Now you're in Sunny California and Los Angeles and working in the world of M&A. How did you end up in M&A advisory?

Paren Knadjian   00:01:16

Yes. Actually, my high school was even at a naval school. So at the very end of that, I almost signed up and joined the British Navy. But that didn't happen, and I went to university and at University of Bristol in the West Coast of Britain and came up with an engineering degree. I actually started my first job, my first professional job as an engineer, but it didn't -- wasn't something I was that interested in or excited about. And so I was recruited by a startup software company and ended up leading products, sales and marketing and the kind of commercial side of the business. And that's the business that was sold to Thompson Financial, and that's how I got into corporate M&A through Thompson Financial. So it was a little bit of an accidental move into M&A. But since then, I've been doing it. As you said, through Thompson Financial, I was a founder of a boutique investment bank, and I've been working for Isa Ramp and its predecessor company for over 10 years in transaction advising.

Joe Mantone   00:02:17

Do you still use any of your engineering background...

Paren Knadjian   00:02:21

I still think I have a pretty analytical mind, very comfortable with numbers and analyzing numbers. So I guess that's the closest thing I come to engineering background, but not -- I don't -- I'm not building turbine airplane engines anymore.

Joe Mantone   00:02:35

That's long gone. engineering can help you with problem solving, though, right?

Paren Knadjian   00:02:39

Yes. Yes, I think that it does sequence.

Joe Mantone   00:02:42

Having said on different side of the table from an M&A perspective, I'm kind of curious, I know you do a lot of working with entrepreneurs now. What is kind of the biggest blind spot that founder-led businesses have when entering a sales process? -- setting their expectations typically is one of the first things we have to do. Most entrepreneurs have not experienced multiple M&A transactions. Most of them have started the firm, grown it. There might even be a multigenerational families, so they've been involved in the business. So when it comes to when they're thinking about selling when they perhaps don't have a succession plan, which is quite often or the triggers that result in the sale. I think the first thing we have to do is talk to them about their expectations. Their experience of M&A is maybe what they read in the Wall Street Journal or maybe what their friends and their golf club perhaps told them. And so they tend to have an expectation that's very much headline driven. And so we have to explain to them that the way things like valuations work, particularly in the lower middle market, which is where we focus on, is not based on the headlines. It's not the highest multiple that anyone's ever got. in a particular transaction isn't the one that necessarily you're going to get. So explain to the market as a whole, actually talking them through market data that we have to hand as well that's specific to their industry, to their size, maybe even to their geography, that helps a lot because it puts it in context for them. So -- and then making sure that the company is ready for a sale. You don't want to take the company to market if it doesn't have the necessary things ready, the paperwork, the legal documentation, but also having good books and records, making sure the financials are in good state of play. We actually go through a kind of a readiness program with them to make sure that they have the necessary things in place before going and talking to potential investors. So that's kind of the first -- certainly the first phase...

Paren Knadjian   00:04:43

Of any transaction that we work with. Yes. And you mentioned the headlines. I mean, it's probably a little tricky right now because I know we've been seeing these blockbuster deals kind of skew the total value of deals, but the number -- the volume of M&A has kind of been subdued for a while. I think that value versus volume, it's where the statistics fall, right? So the value of M&A deals as a whole, certainly in the first half of 2026 is higher than the equivalent of 2025, but the volume of deals is lower, then that suggests that the mega deals are pushing that total volume up. And it's that classic kind of K-shape that you talk about K-shape economy. I think the M&A market is K-shape itself. So the mega deals, which especially if you include IPs, of course, things like SpaceX are already pushing that up. But even in the traditional M&A market, there's some mega deals. And then the upper middle market is a little bit down in volumes. Lower middle market is still active. There's a lot of activity still in that space. And one of the reasons, one of the tailwinds of that one is that private equity is much more -- proportionally much more involved in lower middle market deals than they are in the large cap deals. They are involved all the way up and down the value spectrum. But lower middle market, they are disproportionately involved, I think, in terms of activity. And that's definitely one of the tailwinds of the deal world.

Joe Mantone   00:06:14

Okay. And then so when you say lower middle market, how do you define lower middle market?

Paren Knadjian   00:06:19

We value it in 2 different ways, and they're linked. So the one methodology is the EBITDA of a company. We believe that company is doing between $2 million and $25 million of EBITDA is lower middle market, and that typically equates to $20 million to $250 million in enterprise value. Anything $250 million to $1 billion is what we consider upper middle market, $1 billion plus is large cap. So it's sort of $20 million to $250 million enterprise value. That's kind of the area we consider lower middle market. It varies from depending on who you ask. There's no bright line, I would say about that, but that's how we define it.

Joe Mantone   00:07:03

Right. Okay. But you're saying so in that lower middle market, that part of the upper part of the can, not the lower part right now?

Paren Knadjian   00:07:10

Definitely because deal volume of that one is high. But because they're smaller deals, the value is not as much as a few mega deals, right? So there's still quite a lot of volume in the lower middle market, but each deal is not as much as worth as much as the large cap deals. So that's why you tend to get that cape.

Joe Mantone   00:07:27

Right.

Joe Mantone   00:07:28

And are you seeing any particular sectors more active than others in your?

Paren Knadjian   00:07:34

Yes. There are definitely some hot sectors. The one we're seeing a lot of activity in is blue-collar business services. And the rationale for that one is that AI is not so much of a threat to their business model. We're talking HVAC, electrical, plumbing, these type of services, maybe robots will replace those in 10 years' time or something, but it's certainly not seen as much of a business threat to their current business than, for example, white collar business services. So I think we're seeing a lot of activity in that space. And again, private equity is definitely chasing that space. But there's still plenty of activity in the other verticals. Manufacturing and distribution is still going. It's been a little bit more volatile there. Tariffs, market volatility, things like that have affected that sector more. But that's still -- there's still a lot of activity in that space. We still do health care deals, including physician-owned kind of businesses, still a lot of activity and roll up going up in that space. Is Ramp is organized by service line, but we go to market by industry verticals. So we have a manufacturing distribution group. We have a health care group. We have a financial services group. We have a lot of expertise in each of these verticals. And so we can apply the expertise to transactions as well.

Joe Mantone   00:09:01

So the blue collar services that would be manufacturing just blue-ollar business services. So...

Paren Knadjian   00:09:05

I didn't mention that. It's one of the verticals we business services is a big sector. And white collar is still popular. We're working on a multi-hundred million dollar transaction that fits in our white cog space right now as well. So it's not going away. It's just that the blue collar one, as I said, is less -- is more opportunistic at the moment until maybe we understand the true effect of AI is going to have on all these various different businesses. Right...

Joe Mantone   00:09:32

And that might be considered industrials and other firms, right?

Paren Knadjian   00:09:36

Yes. Yes. I think do we distinguish between manufacturing. So industrials when they manufacture, they make products versus companies that do services. You could be an HVAC manufacturer, but the majority of the business we're doing with our HVAC the support and maintenance companies, right? So that's the service side.

Joe Mantone   00:09:55

Yes. And then I know when we're talking about smaller businesses, sometimes macroeconomic factors can play a role. Obviously, oil prices are -- have been higher. Have you seen that come into play in M&A?

Paren Knadjian   00:10:08

I think the #1 factor is still the cost of capital, by the way. So interest rates are still high. They haven't been going down as most economists expected. As the cost of capital, as the cost of debt in a deal goes up, that increased return is going to the lender, not the equity investor. And so to get the same level of return in an exit, the equity investors either have to get a higher exit price than they perhaps might have or to come in with a lower entry price, right, to get the same level of equity return for their investors. Lower entry price means lower valuations. And so the cost of debt actually affects valuation prices. So I think we've definitely seen that. This valuation gap between buyers and sellers is definitely a headwind. We're talking about private equity money being a tailwind. This is definitely a headwind in the M&A markets and definitely affects lower middle market. That's one factor. I think the general market volatility is there, and that affects prices and volume of activity. I think tariffs, for example, have had a -- and it's not so much the actual tariff value, but the unknown value of tariffs because they've gone up and down, left and right as it were, puts a buyer that's looking at an industrial company doing due diligence on an industrial company asking the question, what's going to happen to the cost of sales? What's going to happen to the cost of? Is it going to go up? Is it going to go down? That puts unknowns into a transaction going to make it more difficult to close. That's definitely a factor. And then the oil price, obviously, if you're in the energy market, that affects it directly, but also so many things are made from oil, plastics, adhesives, paints, et cetera, are derived from oil. So it actually affects many other industrial products as well. So that's been another factor in the market.

Joe Mantone   00:12:09

Yes. And so that valuation gap, I've talked a lot about that with others just about private equities, 2020 vintage, that's still a big factor...

Joe Mantone   00:12:18

Right and exits.

Paren Knadjian   00:12:21

Yes, because private equity entered those years, 2020, 2021, even 2022, valuations were high. It's now part of their portfolio companies, they wanted to exit, and they're not getting again the returns. Remember, private equity, the private equity managers essentially report to the limited partners or the investors in order to get the higher returns. they have to either exit and not get the higher returns or some of the things we've seen, we've seen the secondary markets, continuation vehicles. These are vehicles that you can use to essentially put off the exit date to a later stage. The only trouble with those vehicles is they only really work at your high-performing portfolio companies. So the lower performing portfolio companies, it's more difficult to do a secondary transaction in those because they're not performing as well. So -- but for your high-performing portcos, that is definitely an option. secondary market transactions, continuation vehicles, we're seeing quite a lot of that. Actually, secondary markets volumes are up, Sharon.

Joe Mantone   00:13:30

Why is it that the lower performing companies aren't really a good candidate...

Paren Knadjian   00:13:34

The secondary market, you're still selling some proportion of that portfolio company's equity to another or new set of investors, right? So again, that valuation gap still exists. But instead of doing a final exit where you are returning the money completely to all of your investors, you're doing a kind of intermediate transaction with some new investors. Typically, current investors also roll the secondary vehicle as well. So you're doing an intermediate transaction, you can return some capital to your investors, but it's not the final exit. It's not like the end of project. It's like an extension of the project. And the lower-performing portfolio companies are not getting the valuations that a secondary buyer might want to pay for. So that's the issue there. It is a good vehicle, but it doesn't apply to everything. But there are definitely a kind of an overhang of 2020, '21, '22 vintage portfolio companies that would typically be exiting at this point, but are not so much because they're not getting the value they want to get. And that cost of capital thing, by the way, that I was talking about earlier, applies equally in the other direction in 2020, when the cost of debt was very low, that meant that they could afford to pay for higher valuations because the return on -- they were expecting a higher return on equity.

Joe Mantone   00:14:55

Yes. The lower price of capital certainly helped drive up valuations.

Paren Knadjian   00:14:58

Yes, absolutely.

Joe Mantone   00:15:00

But what's the advice to private equity firms that have those B and C properties that they want to exit and they have investors who want their capital or want some capital return?

Paren Knadjian   00:15:11

It's the best way to get better value out of any company, whether it's a portfolio company or private equity, whether it's a private family-owned business or whatever is to improve financial performance. That's the other thing back to your original question is what advice did we give to our clients when they first think of coming to market. Financial performance is the biggest indicator of value. maybe many people think that I've got a bunch of intangible assets and I've got brand value and all that kind of stuff. All of that is true, but how well you perform and particularly how your EBITDA is doing is the biggest indicator of value and a typical multiple applied to that, that is the value. So portfolio companies, privately owned businesses, any business that is thinking of going to market focus on trying to improve your financial performance if value is the thing you're going after. Interestingly enough, many of our clients don't sell to highest bidders because to them, these are the private owned businesses. To them, the legacy of a business that might be a multigenerational business, what a buyer is thinking of doing to their employees and senior staff, that's as important to them often as value. So still not everyone cares about the value. However, private equity funds, their job is to buy at a certain price and sell at a higher price. So they care more about that, I would say.

Joe Mantone   00:16:39

So all it sounds like we're seeing elongated time lines with holding, right? So...

Paren Knadjian   00:16:46

Yes, deals are getting -- it's taking longer to close and the due diligence phase is extending, particularly, as I said, as things change during the due diligence phase, tariffs, for example, change cost of goods, that delays a transaction. The thing that we found that really distinguishes between a deal that's going to close that's not is conviction. That's the #1 criteria. If the buyers are very interested and motivated to buy a business, they will be flexible about things like price and other structural elements of a deal. So highly convicted buyers get deals done. Others who are just kind of splashing the money around and seeing what kind of sticks, they tend to fall out of due diligence phases when things get a little bit tough. So we very much see that correlation happening in this market.

Joe Mantone   00:17:45

And what are some other structural elements? I mean like earn-outs? Is that kind of what you're thinking about?

Paren Knadjian   00:17:50

I think definitely where the seller is sort of projecting great years ahead and so on. I mean the buyer's response to that is fine. We'll pay you for that when you achieve it kind of thing, which is obviously what an earnout an earnout is supposed to do. So absolutely, we see earn-out. We see other things like structured equity is another option of getting around some of these equity value questions. So there are a number of different ways of doing it. Seller notes sometimes come into play where the exiting party doesn't necessarily care about -- doesn't necessarily need or want cash all at once. In fact, they might want to earn the cash over time to reduce their annual tax payments. So seller notes are also popular as well deferred payments. There's all sorts of different ways of putting off some of the immediate cash needs of a transaction.

Joe Mantone   00:18:50

Yes. And there's still a good amount of private equity dry powder out there, right?

Paren Knadjian   00:18:55

$1 trillion by most people's calculation.

Paren Knadjian   00:18:58

Right. In fact, it's always been a conversation for a long time now, the amount of dry powder out there. It remains the same because even though money is being invested, new money is being raised.

Joe Mantone   00:19:07

So given the extended hold times, we're not seeing any decrease in the momentum in fundraising, investors are still willing to go out there and back private equity firms.

Paren Knadjian   00:19:18

It varies. It's not a simple formula, but it varies. The trend tends to be if you've done well for your previous fund, if you've got the kind of returns, IRRs, MOICs, these are the kind of calculations that are used to put in front of investors, you'll be able to raise another round. I mean what you've done recently is a big predictor of what investors think you're going to do in the future. So much more difficult if you've had a bad couple of funds or you're maybe a new player want to come in and raise money, that's a much higher threshold to overcome. But you've done well and you've returned -- made a good return to your investors, you'll be able to continue to raise and most funds are upping the value of their fund every time they raise a new one. There are some that I think smartly are staying in their space and not trying to become a multibillion-dollar fund because that puts you in a different category. You can't -- if you raised $1 billion fund, you can't manage 50, 60, 70 portfolio companies. You really want to manage no more than 20 or something like that, which means that each deal has to be a higher value. There's less of those around, and they tend to be much more competitive. So I think some private equity managers are smartly staying in their lane in terms of the value or the amount they're raising and therefore, the type of deals they continue to do. I think that's a smart play because once you get up to that multibillion dollar kind of category, you are now competing with the mega funds, the Blackstones and the BlackRock as well. That's a whole different.

Joe Mantone   00:21:04

I noticed that you put out a paper recently talking about AI and how that's impacted due diligence. Any thoughts on that?

Paren Knadjian   00:21:13

Yes. We're using AI in the transaction process, 100%. Everything from helping us -- for example, I'll give you a simple example. We're running a transaction right now where we received 14 indications of interest, okay? They were all in PDF. They weren't -- they did not follow the same format. So some of them had the purchase price in Paragraph 3. Some of them had in Paragraph IV, some of them use different terms to describe it. In the old days, we would have read all 14 documents and manually entered them into maybe a spreadsheet or some other thing. I mean now there's tools that allow you to scan all those and immediately come up with not only a comparison of the offers, but you can calculate the percentile that each offer is in what their Z score is, what the standard deviation from the median is, all that kind of stuff can be done very quickly. So just in that phase alone, it cuts the time and the analytical ability goes up very quickly. Now that doesn't mean that the human element shouldn't be applied. In fact, we're very much believers that in the transaction world, in the M&A world, I talked earlier on about how the M&A world is partly analytical, partly numbers driven, but it's also psychological and emotional. And so the human element still comes into when it comes to actually negotiating transactions, helping customers through a transaction. All these things are based on knowledge and experience. And they're very much kind of a psychological play. So that part of it isn't -- the AI doesn't help in that part. But certainly, data analytics due diligence, buyers, they're doing legal due diligence and the seller uploads 120 legal documents. Again, unstructured, you can use AI to help you with that. So it's definitely affecting those elements of a process. But I want to emphasize how the human element is still very important because it's such a game of psychology. It's such a -- it is very emotional, particularly for the sellers and being able to manage that is an important part of a successful transaction.

Joe Mantone   00:23:28

Okay. Well, I think this has been a really interesting conversation, Parent. So I appreciate you taking all this time with me here.

Joe Mantone   00:23:38

Not at all. A pleasure.

Joe Mantone   00:23:40

Okay. Great. It's a good spot to end it, I think. Well, again, thanks for joining us, and thank you, everyone, for listening.