Business assets will be transferred to a new generation by 2025. What does this mean for investors?

Not to be overly dramatic, but the next 15 years will see the largest intergenerational transfer of private businesses in the history of the world.

For years now, investors and business owners have been positioning themselves to profit from the unstoppable demographic trend that is already reshaping American consumerism.

A Generational Shift

Baby Boomers began turning 65 years old in 2011 at a rate of about 10,000 people per day and will continue passing that age milestone through 2029.

While the consumer spending impact of Baby Boomer retirement has been widely discussed, the small business acquisition opportunity has not received a similar spotlight in the popular press. This opportunity may just remain a quiet one.

The year 2012 marked the first time that “Baby Boomer retirement” was the primary driver of the sale of private businesses. Still, Silicon Valley dominates the business press. All the while, “boring” business opportunities remain hidden in plain sight.

Baby Boomers own 70 percent of the country’s small businesses. More than $10 trillion in business assets is set to be transferred by 2025. From the classical economics perspective of supply and demand, supply is poised to spike.

Dimensions Of a Marketplace

Industry insiders report that the increase in supply has not been met with a corresponding increase in demand in the lower middle market (defined as businesses generating revenue between $5 and $50 million). Companies on this segment’s lower end are not large enough to attract the attention of private equity firms.

What’s more, the increase in supply may not be met with an equal increase in demand. That is bad news for the sell side because the lower middle market has demonstrated a historical oversupply of businesses for sale. In fact, less than 30 percent of businesses that net between $300,000 and $700,000 and are listed for sale are ever successfully sold. What that means is a whopping 70 percent of such businesses are never sold. They are closed.

Of course, that 70 percent delta is not all opportunity. A pervasive problem with lower middle market companies is that many are simply unsaleable because nothing of value exists to transfer. These businesses are often merely extensions of their owners. Their success is over-reliant on the owner’s expertise, relationships and personality, none of which transfer with a sale, no matter how much the seller promises he or she ensures the relationships will stay in place.

Where Is The Value?

The only small businesses worth buying are those that have an identifiable chance to survive ownership transition. Some factors to look for include: companies with a repeatable process in place, an experienced management layer ready to ascend to leadership, and a defensible moat. Geographic dominance is the most common lower middle market moat, as those firms generally do not have significant IP, network effects or economies of scale.

Small businesses that exhibit a combination of those factors can provide attractive returns on invested capital. Generally, most lower middle market businesses receive valuations of between 2 and 5 times EBITDA (EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, is a potentially misleading metric for business valuation for several reasons, not least of which is that although depreciation technically is a non-cash expense, it represents the inverse of capital expenditures, an important cash expense necessary to support a business’s future operations).

If a $10 million business generating EBITDA of $1 million is purchased at a 4x multiple, the investor will receive a 25 percent return on invested capital. To put a ROIC of 25 percent in context, since 1965, Berkshire Hathaway has generated an annual average stock price gain of 20 percent, making Warren Buffett an investing superstar in the process.

This Is Not Investing Advice

I am merely shining a light on an overlooked market segment in which I once operated. I am definitely not saying small business acquisitions are the secret, silver bullet for everyone that will transform you into the next Warren Buffett.

In fact, small business operations and investing is difficult, requires knowledge and experience and, above all, is risky. Acquiring a small business requires significant resources that become tied up in the investment.

These factors greatly winnow the number of potential buyers to a relatively low number.  The small number of actors in the field is surely a significant reason why the coming Baby Boomer sell-off has not made popular headlines.

Perhaps another reason is that these businesses are not the tech darlings that are disrupting old business models. These businesses are boring. These businesses are your local landscaping company, electrical contractor, or specialty manufacturer.

But I find beauty in boring. Boring is steadier and more reliable. Boring industries struggle to attract top talent. Therefore, developing competence in such a field presents you with a lower hurdle to clear and therefore a higher likelihood of success.

One small business investor puts it this way: “I search for the smallest hurdle out there and then learn how to pole vault.”

The funny thing about competition in the world of small business is that markets are so large that space exists for many multiple competing businesses. Consider the sheer volume of HVAC or building contractors in your city. While some are undoubtedly more profitable than others, it is not often the business’s competitors that cause small businesses to fail. The cause is much more likely to be the owner’s own underperformance. As a small business, your biggest competitor is yourself.

When you think about it, the same can be said of so many activities. Your biggest competitor is yourself.

Video Recommendation

If you are interested in small businesses as a public market alternative or diversification opportunity, this video interview with reclusive investor Anthony Deden is smart, well-informed and attention-grabbing: https://www.youtube.com/watch?v=a4_U6bS-cU4

Best Of Twitter

95% of due diligence is analyzing if customers and employees are happy and why. Your edge is that 95% of investors will not do this. If you want above average returns, you need to do what average investors aren’t willing to do. @iancassel

There’s more to learn from people who endured risk than those who seemingly conquered it, because the kind of skills you need to endure risk are more likely repeatable and relevant to tomorrow’s risks. – Morgan Housel

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