After setting records in 2016, lower-middle-market (LMM) investors have taken a backseat in 2017, while upper middle market investors chase larger deals, according to PitchBook's 3Q US PE Middle Market Report.

U.S. middle-market private equity transactions totaled $233 billion across 1,652 deals though the first three quarters of the year, representing a 13% increase in deal value from the same period last year. 2017 has seen the two strongest quarters for mid-market capital invested since 2015, and activity for the remainder of the year is expected to remain robust. The increase in deal value is primarily a result of a spike in upper-middle-market (UMM) activity (between $500 million and $1 billion in EV), which is driven by the ongoing shift within PE and VC asset classes towards larger deals. What's more, the restaurant and bar industry is experiencing a revival of sorts, already surpassing last year's total deal count and value after years of declines. Private equity's long-term outperformance of most asset classes is a key driver behind middle-market PE's impressive fundraising. Through 3Q 2017, LPs have committed $84.3 billion across 131 funds – a 2.5% increase in capital commitments, over the same period last year. 

"US middle-market deal flow remains strong," said Dylan Cox, analyst at PitchBook. "Despite the unabated rise in prices, PE firms are finding ways to deploy capital. On the other hand, exit flow has been slower than expected. Sponsor-to-sponsor deals and dividend recapitalizations have become more prominent sources of liquidity."

Pricing Pressures and Dry Powder Propel Upper-Middle-Market Activity

Following a record setting year in terms of lower-middle-market (LMM) activity, this segment is on pace for the slowest year since 2011. With an abundance of dry powder and fierce competition for limited targets, median mid-market M&A EBITDA multiples have risen to their highest level on record, at 10.7x. Rising EV/EBITDA levels and larger deal sizes are contributing to the surge in UMM activity. In fact, 25% of deals and 58% of capital invested in the MM comes from the UMM, up from just 14% and 44%, respectively, last year. As the asset class continues to garner significant interest from LPs, successful managers have raised larger pools of capital, enabling them to move up the chain towards larger deals.

PE Investors Return to Main Street

What once was middle-market PE's bread and butter, US PE investments into restaurant and bars decreased nearly every year from 2006-2015. Yet through 3Q 2017, overall PE activity in the industry has already surpassed last year's totals in both deal count and value. A few examples of notable transactions include; Golden Gate Capital's $565 million carveout of Bob Evans Restaurants, as well as Oak Hill Capital Partners' $525 million secondary buyout of Checkers & Rally's. Many of these brands rely on the franchise model to grow operations, but this has not discouraged PE firms from completing deals in the industry. Since the beginning of 2016, at least five of the 32 mid-market restaurant and bar deals involved a portfolio of store locations versus a parent company or licensor/franchisor.

Forecast Calls for Continued Strength in Fundraising

Private equity's consistent outperformance of most other asset classes combined with its positive net cash flows globally to LPs every year since 2012 allows LPs to recycle capital back into the asset class. Middle-market PE funds are on pace to see another notable year for fundraising, with $83.4 billion committed to 131 funds through 3Q 2017. Meanwhile, public equities are also experiencing a surge in valuations, enabling LPs to contribute more, in dollar terms, to alternatives. One potential challenge to PE fundraising for next year, however, is that the net cash flows to LPs are likely to turn negative because of the downturn in exits. If overall PE fundraising does continue at its rapid pace, we expect to see an increase in funds raised by first-time managers, who garnered $8.6 billion in total commitments in 2016, the highest count since 2009.

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