Raising capital for a lower-middle market business is tricky and always has been. Not quite large enough to grab institutional lenders’ attention, yet not small enough to not need a good chunk of capital to grow or retool.
About a decade ago, Jeff Schwartz, then ten years into a career in large-cap private equity investment after the previous ten years spent in investment banking, came to the conclusion that in order for him to be a true entrepreneur, he would have to stop working for someone else and start his own investment firm.
But there were no shortage of investment firms. There were, however, shortages of investment firms that have workable ideas on how to differentiate themselves from the market and offer consistently strong returns based on those ideas.
As fate would have it, the two seemingly independent situations above found themselves intertwined when Schwartz founded Corbel Capital Partners, a private equity firm that specializes in the lower middle market, specifically on how to utilize structured investment products to help lower middle market companies gain access to financial vehicles previously only allotted to much larger entities.
Structured Investment Products
While evolutions in financial products created options for many larger companies, and even those that qualified as mid-size companies, that wasn’t really the case for the lower middle market.
Products like unitranche debt offerings, where senior debt and subordinated debt are tranched together instead of prioritizing senior debt over subordinated debt, for example, took off in the early 2010s and private equity firms started acting as lenders for middle-market businesses.
Private equity created larger funds in order to do this, with those middle-market businesses using the debt to finance acquisitions.
This was largely due to the fallout from the Great Recession and the increased scrutiny put on bank lending practices. When the institutional lenders moved out, the private debt market moved in.
But, Schwartz said in an interview in early 2023, those products weren’t necessarily designed for the lower middle market.
“The unitranche was a structure that made a lot of sense for buyouts in the middle market, but there still was a real lack of capital for small businesses that were looking to either make acquisitions on their own without a sponsor present or to take on growth capital or recapitalize their businesses,” Schwartz said. “Banks were fundamentally not comfortable with a shareholder dividend or buyout as a use of proceeds, so there was a void in that marketplace, which is one that we feel like we’ve been able to fill.”
Schwartz and Corbel Capital Partners have been able to do this because of their ability to navigate a program called the Small Business Administration’s (SBA) Small Business Investment Company (SBIC) program, which is designed to “enhance small business access to venture capital by stimulating and supplementing the flow of private equity capital and long-term funds which small business concerns need for sound financing of their business operations and growth.”
Schwartz said Corbel Capital Partners uses a dual strategy, both on the equity side and the debt side, to provide options for its clients.
“The Small Business Investment Company program lends money to us (vetted and certified financial advisors) to enhance our profile for our investors and allow us to make investments into small business under potentially more attractive terms to them,” he said.
Schwartz further said it has “created a dynamic marketplace for small businesses to raise capital and allowed these businesses to grow without necessarily selling control of their businesses to more traditional private equity buyers.”
Equity and Debt
And that is where some change has occurred. Schwartz references debt and equity as separate solutions for lower middle market businesses, one he is seeing tilt less toward the equity side and more toward debt.
“There were many, many, many small businesses looking for what we at the time called structured equity,” Schwartz said of the capital raising vehicles available to lower middle market businesses. “Now, it’s turned into more structured debt and a structured investment product that provided them capital to either grow or recapitalize their businesses and also a level of private equity support and sponsorship that certainly doesn’t exist from a normal lending institution.”
Structured equity occupies a unique position within the capital structure of a company, bridging the gap between traditional debt and equity. It embodies elements of both, offering investors a combination of fixed-income payments, potential upside participation, and priority in liquidation over common stockholders. This hybrid nature makes structured equity an attractive option for companies seeking flexible financing solutions that balance risk and return potential.
But that involves giving up control, either in part or in the whole, of a company, something that many smaller business owners are reluctant to do.
That is where structured debt comes into play. While there are several similarities between structured debt and structured equity vehicles, there are also important differences that play well for smaller businesses.
The first, as mentioned above, is the retention of an ownership stake in the company. Structured equity has it, while structured debt holders are essentially creditors and are treated as such.
The returns for structured debt are also more consistent, if not as potentially lucrative. While structured equity holders will receive fixed income payments and potentially some upside from a company’s growth, debt holders receive a fixed income stream in the form of interest payments.
Each can be useful individually for the lower middle market, but Schwartz sees them as interconnected, using each as it most benefits the companies they work with.
“Some of those investments are structured as equity and some of those investments are structured as debt,” Schwartz said. “Those are the two sister strategies that can work well simultaneously within the Small Business Investment program.”
Due to the aforementioned inefficiencies in the market, Schwartz said Corbel Capital Partners has been able to generate “outsized returns” for their clients using this strategy, and it is one he feels can prove strong for some time.
“We could take our debt fund and we could split that into a senior debt fund and a mezzanine fund,” he said. “Or we could take our equity fund and split it into two different funds: a growth buyout fund and a growth-equity fund. There are a lot of options while still playing in this marketplace we feel is so attractive.”
