For years, private equity firms treated the middle market, firms with $50 to $500 million in revenue, as a goldmine.
Smaller, family-owned businesses were easier to understand, had less competition from mega-funds, and required relatively simple operational changes to generate outsized returns. It seemed like an ideal formula.
Then reality hit.
Middle-market PE deals are increasingly underperforming. Exits are dragging on. Management teams are burning out. The playbook that worked a decade ago appears to be broken, and experienced PE operators are quietly admitting they don’t have an answer just yet.
The Scale Problem
The fundamental issue is one of economics. As debt costs soared from 2022 onwards, larger PE deals could absorb higher financing costs through scale, diversification, and favourable financing terms. A 200-basis-point (2%) increase in borrowing costs can devastate the returns on a $100 million acquisition far more than on a $2 billion deal.
Why does this happen? Three reasons.
Firstly, scale allows larger deals to more easily cover fixed costs. Things like legal, management, and accounting fees tend to be roughly the same whether you do a $100 million or $2 billion deal. As a result, fees eat into the profits of a smaller deal much more rapidly.
Secondly, larger PE firms tend to be more diversified. By owning multiple companies they can spread risk and maybe raise prices elsewhere to offset higher interest payments.
Thirdly, since larger PE firms tend to be viewed as ‘lower risk’ they often have access to cheaper credit. As such, larger deals can borrow at lower rates and for longer maturities, meaning that a 2% rise may not fully hit, or may only kick in after an extended time lag.
This explains why the capital structure of middle-market deals has shifted dramatically. Debt-to-equity ratios have compressed since late 2022, with equity contributions on middle-market LBOs rising markedly along with interest rates. In other words, as the cost of debt has risen, PE firms have been forced to put up more of their own cash to make the numbers work.
But here’s the problem: PE returns are built on leverage. When you can’t lever a deal effectively, your return profile deteriorates. Suddenly, that comfortable 4x return target becomes 2.5x. At some point, it becomes barely worth the risk and effort.
The Exit Maze
The real pain isn’t in the entry; it’s in the exit.
Private equity distributions to investors exceeded capital contributions in 2024. This hasn’t happened since 2015, signaling a long-awaited shift in the exit environment. But dig deeper and the picture darkens for middle-market managers.
Mega-funds are able to exit through strategic sales to larger corporations or via IPOs. Middle-market companies can’t access IPOs easily, with IPOs accounting for just 6% of exits by value in 2024.
Strategic buyers for smaller platforms are also rare. The result?
For the 2019 vintage of deals, only 20% of portfolio companies achieved fully completed sales, versus 44% in the 2014-2016 cohort. The remainder exited through partial sales, minority stake monetization, or rolling the companies into continuation funds, all of which leave companies in PE portfolios longer and so return capital to investors more slowly.
Holding companies for up to 10 years, which is common now for middle-market PE funds, creates its own catastrophe. Management teams that were promised exits become demoralized. Key talent leaves. The businesses lose momentum just when they need it most.
The Operational Mirage
The theory for making money in middle-market PE was clean and fool proof: acquire a fragmented, under-managed business, install professional management, apply cost controls, and drive significant margin expansion. It worked in the 2010s when interest rates were low and acquisition multiples were reasonable.
That arbitrage is now gone. Middle-market businesses aren’t undermanaged anymore, especially the strong ones that PE firms actually want to buy. A typical founder-led business with $200 million in revenue already tends to have competent managers and efficient operations. The cost-cutting playbook yields another 3-5% of EBITDA if you’re lucky. That’s not enough to overcome the higher debt costs and longer hold times.
Several PE operators I spoke with noted that the “add-on strategy”, which involves buying a platform and then acquiring smaller competitors to bolt on, has become far more difficult. In the lower middle market, where roll-ups accounted for over 80% of all deals, PE firms drove deal volumes by consolidating fragmented markets. But these fragmented markets are fragmenting again as the synergies from consolidation haven’t materialized and integration costs have exploded. The math has stopped working.
Rising Competition from Unexpected Corners
PE firms aren’t the only players anymore. Sovereign wealth funds, pension plans, and family offices are increasingly adopting an investment strategy that favours direct investment. This means taking a significant stake and seeking greater operational oversight. This offers these investors more control, reduced fees by cutting PE firms out of deals, and thereby the potential for greater returns on invested capital.
These investors also bring superior patience and lower return hurdle rates. They’re willing to hold middle-market businesses for longer because distributions aren’t their primary concern. As a result, they’re winning the best deals, and PE firms are forced to fight for the remainder.
What Comes Next
The reality is that middle-market PE hasn’t failed, it has matured.
It is no longer easy money. Returns are lower, hold times are becoming longer, and thus the PE firms that go on to succeed in the space will be able to add operational value, not just financial engineering.
Zuhair Imaduddin is a Senior Product Manager at Wells Fargo. He previously worked at JPMorgan Chase and graduated from Cornell University.
Image: DALL-E
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