How cultural fluency can help private equity tap into the middle market

While private equity investors have traditionally focused on large, mature companies with at least $100 million in revenue, which are perceived as offering higher returns with lower risk, the situation is very different in today’s market.

Founder-led or family-owned businesses in the $10 million to $100 million (or even lesser) annual revenue size are growing targets for many PE investors.

Despite not having attained the status of a multibillion-dollar behemoth, these midsize companies — operating within the supply chains of bigger established organizations and offering innovative solutions and compelling business models — are increasingly attractive to PE investors. Midsize companies, these investors believe, can fetch good returns, albeit with more risk and under the right circumstances.

That said, when attempting to tap into the growth potential of the middle market, most PE investors face the challenge of cultural equity, a topic whose growing importance was recently covered by the Harvard Business Review. 

In a nutshell, cultural fluency refers to an individual’s ability to understand basic norms and perspectives of people from other cultures, including picking up on nonverbal information and giving genuine reactions.

How the cultures of PE and the middle market differ

The cultural milieu of PE can be starkly different from that of many middle market business owners. Among the cultural differences that contribute to a disconnect between the PE community and middle market business owners are:

Education.

While PE professionals often hold an MBA degree from a top business school or at least hold a college degree, many successful founders and leaders of portfolio companies have no undergraduate degree, let alone a graduate degree.

Expertise.

PE managers are by nature M&A experts, but even the most educated and adept middle-market business owners are unlikely to possess comparable financial skills. Compounding the divide is the fact that middle-market business owners pursued by PE investors are often new to M&A. 

According to a study from the National Center for the Middle Market, 90% of middle-market companies that sold or merged within the previous three years had either very limited or no experience in M&A transactions. This lack of experience in the PE industry and transactions can easily beget disagreements and friction. 

Mindset.

The values and beliefs that a typical middle market founder-owner brings, along with their life experience, are very different from that of PE professionals. Decades of struggle to build the business from scratch often creates deep kinship between owners and employees, many of whom have worked with them from the start. However, most PE investors do not share this perspective and fail to recognize the owners’ views in this regard when valuing portfolio companies. 

How cultural fluency can help PE thrive in the middle market

As PE investors focus on deals in the middle market, paying attention to cultural nuances will foster trust with business owners. Cultural literacy can also pave the way for:

Mutually beneficial deals.

Mastering cultural fluency can help both parties — the PE community and portfolio company owners — to correctly ascertain the other side’s needs and priorities, potentially enlarging the pie and improving the chances of mutual success.

For instance, when negotiating a deal, the PE buyer may be focused on tax considerations while the business owner is preoccupied with a health crisis and seeking a quick closure. Cultural fluency, in the form of considering the other person’s perspective, could help both parties negotiate a deal that gracefully embraces these priorities. 

More successful post-close integration.

Post-close integration is crucial to a successful PE acquisition, but integrating different business cultures can be daunting. If not properly addressed, these differences can lead to frustration among employees, hamper productivity and increase the risk of turnover among top talent. No business owner or investor, particularly in this era of the Great Resignation and looming recession, would want to close an acquisition only to see an exodus of committed, skilled employees.

Middle-market companies may have practices and processes that trace back to their founding days and that are in dire need of an update. Implementing better business tools and systems is one way PE can drive EBIDTA optimization at portfolio companies. Cultural fluency — by putting everyone on the same page — can make business integration easier.

Improving PE’s less-than-stellar reputation.

PE generates a fair amount of negative sentiment over allegations of predatory practices. Many middle-market business owners are of the opinion that PE investors siphon profits from portfolio companies and leave them vulnerable to collapse. Dealing with this uphill battle of fixing PE’s reputation and building rapport with middle-market businesses requires cultural literacy. 

Takeaway

The U.S. middle market has immense economic power. In fact, it would manifest into the world’s fifth-largest economy if it were its own country. But seizing on this market’s growth potential necessitates looking beyond just the capital stack.

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