Insights into the Private Equity Lower-Middle Market

00:00 Alex: Welcome back to the Raw Selection Private Equity Podcast. Joining us today is Paul Isaac, Managing Partner of Isaac Management LLC, a private equity firm investing in the lower middle market. Let’s dive in. Paul, could you share a brief insight into your background, please?

Paul: Yeah, sure. I’m currently living in Detroit, which is at the core of the Midwest’s industrial and manufacturing space. 00:28 But I actually grew up in St. Louis, Missouri.

I spent my entire life there and then moved overseas. I come from an Arab background; my mom and dad are both from Iraq. After high school, we moved there for a couple of years. I went to college overseas and started working there.

I was doing private placement deals for the U.S.-led mission in Iraq. This was in 2014.

00:58 Alex: So you’re old enough to remember the war with ISIS. No offence. Paul: Yeah. I was doing consulting and private placement work out there while I was in college.

I studied economics, came back home, started in banking and capital markets, and then transitioned over to the deal side - structured products and private credit. I landed in Detroit after coming back from overseas, spent some time in Chicago, and then returned to Detroit. 01:27 About two years ago, I launched Isaac Management. There are a lot of fluff words out there, but at its core, Isaac is really a holding company of sorts.

We operate in the lower middle market private equity space, but we don’t have a fund or fund investors. We’re not structured like a typical private equity firm. There is no fee structure, fund life cycle or predetermined exit date. 01:55 The thesis was straightforward: buy and hold these companies for as long as we want, with the assumption of cash flow into perpetuity, and build platforms.

We focus on four segments: industrials, manufacturing, financial services and business services. That’s what we’re working on today. Alex: What’s one mistake you see private equity firms or portfolio companies making, and what would you suggest to correct it? 02:24 Paul: Do you want one really big mistake or a few minor ones?

Alex: Let’s go big. Paul: I think the biggest mistake is probably overleveraging and not really knowing the target market of the company you’re buying. You can say that all of that comes out during due diligence, but that’s really where all the bodies are buried. At the end of the day, everything looks good on a spreadsheet.

02:52 You can make just about everything work one way or another, but what you really need to integrate into is the actual culture of the firm and the market it serves. That’s especially important for lower middle market companies because these aren’t multinationals or huge national or regional grocery chains doing one or two billion in top-line revenue. These are effectively small businesses. Some are doing a million in revenue; others are doing five, ten or twenty million.

03:21 These companies are deeply ingrained in their communities. If you come in with the traditional buy-and-flip mindset - which, through no fault of their own, private equity executives often have because they have a structure, mandates and a fund cycle - then, if your fund is set to exit in five years, you have to exit in five years. You’re going to do the best you can for your investors. 03:52 That’s where you see a lot of juicing, financial engineering and that sort of thing.

You don’t see the same connection to the community, where these businesses are often a core lifeline. Call it a cultural disconnect or whatever you want, but I think it’s important to truly understand the company, its employees and the customers it serves in the local or regional community. 04:22 I think that’s a gap because people want the business to be successful, but people don’t like change. If you buy a grocery chain with three or four supermarkets and someone’s grandmother has been shopping there for 50 years, she doesn’t want anything to change.

She wants to go to the same place, see the same people and receive the same service. Understanding that becomes extremely important when you’re dealing with this market segment. 04:50 Alex: This is a broad question, but given your focus on financial services, manufacturing and other sectors, what’s your take on current deal trends in the lower middle market? Paul: I think the lower middle market is in a period of flux right now.

Deal volumes slowed down considerably during the Biden administration. We obviously saw an uptick in interest rates, which priced a lot of investors out of deals or simply made those deals stop making sense. 05:20 That’s going to happen; you’re going to have cycles, and that’s fine. But the lower middle market is highly concentrated, and these companies don’t have the same access to resources as a larger private equity firm acquiring a business or a commercial banking client doing $50 million or more.

05:49 They don’t have access to the same resources or tools. Larger private equity buyers can hedge their interest-rate exposure. If they lose money in one area, they can make it up elsewhere. In the lower middle market, you generally don’t have access to that.

Your options are things such as ABL lending and traditional commercial loans. 06:18 There’s also SBA financing, which has been fairly reasonable, but it’s the government - they extract their pound of flesh. I’m sure you’re familiar with that in the UK. The market is in flux.

Interest rates have pretty much doubled, or even more than doubled, since 2021. When a company goes to market and speaks to a banker or broker, that banker’s job is to sell the company at the best possible price for the client. 06:46 What ended up happening - and I wrote an article about this - is that bankers and companies remained anchored to a price from a particular period. The cycle changed, but the pricing and structure didn’t.

You then had a group of buyers ready to transact. There is something like $2.25 trillion in private markets ready to be deployed. 07:15 That’s a huge number, but it can’t be deployed if the deals don’t make sense.

These deals stopped making sense financially. They became too expensive, the DSCR was too low, banks wouldn’t finance them and nobody would back them. Neither side would back down, so we became caught in a quagmire over the last couple of years. Deal volume has definitely slowed, and interest rates are a major contributing factor.

07:44 When prime plus spread was around 6%, and today prime plus spread is 13%, that deal suddenly makes no sense. That’s where we’ve found ourselves. It changes almost every week with this administration, but they’re now estimating three interest-rate cuts between now and 2027. 08:13 Does it get better?

I think so, but the people actually transacting need to understand what sits beneath everything. People are slowly starting to wake up to it, but I think it will take some time. Alex: With reference to your portfolio, and considering deal flow, rates, ambiguity and uncertainty, how has the current environment affected your portfolio companies, and how are they navigating it? 08:39 Paul: The effect on anybody’s portfolio is that you’re going to take a hit on the bottom line.

When you talk about something like tariffs, it’s effectively a second tax on what you’re already paying. When you’re in manufacturing or industrials, you’re extremely exposed to changes in commodity prices. 09:08 When those commodities go from one dollar to five dollars, things suddenly don’t add up in the same way. Across the private equity industry - not necessarily within every individual company - you’re seeing haircuts across the board.

People are taking losses, repositioning and trying to refinance where they can. 09:36 You’re seeing a lot of pressure on these companies, especially those with debt-heavy balance sheets. I don’t want to say anyone is in trouble per se, or that they can’t come out of it. What I am saying is that it takes more patience and thought than it did before, when you could simply refinance your way out of a situation and almost anybody would pick it up.

Money was basically free and terms were very loose. 10:05 Everything was fine, and everybody wanted to do a deal. Now, people are much more conservative. Underwriting standards have tightened considerably and debt has become more expensive.

The same company that had a DSCR of two last year may now be teetering between one and 1.25. Those deals can become extremely difficult to finance on reasonable terms. 10:35 There will be lenders trying to sell you something that looks like a payday loan, but I don’t think that’s the right thing to do.

Overall, there is definitely compression. I wouldn’t call this a complete bear market, but I would call it a genuine correction and readjustment phase. As I said before, I think we’ll come out of it. It’s really only a matter of time.

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You didn’t come from the typical investment-banking route, if there is such a thing as a typical private equity route. 12:32 Talk us through building the firm from scratch, having no institutional backing and not operating through a fund structure. Give us some insight into your journey so far. Paul: I’d love to sound like a superhero or a pioneer and say we thought about this from the beginning, found a gap and were geniuses, but that simply isn’t true.

You adapt. That’s life - you adapt. The idea of starting Isaac Management came to me when I was about 26, so just a couple of years ago. 13:01 What really spurred it on was going into the private credit business and supporting private equity sponsors with acquisitions.

My thought was: people are doing this at a large scale, but what about the smaller companies? If you look at private markets today, 99% of companies have fewer than 500 employees. 13:30 You could say some of those may still be large revenue-generating companies, and that’s true. But the vast majority within the lower middle market fall into the revenue range I talk about: around one to five million dollars, or sometimes ten or twenty million, depending on the deal.

14:00 I thought there had to be a way to participate on the smaller side, so I did more research and reading, and it turned out there was. When I first thought about starting Isaac, I wanted it to be a hedge fund. Growing up, I watched people such as Ackman and Icahn, and you get that starry-eyed look and think, “That’s who I want to be.” So I thought about starting a hedge fund.

14:30 I put pen to paper, started taking meetings and spoke to people and advisers to understand whether it was possible. They said it was definitely possible, but this was around peak COVID. Investment capital had largely dried up. Everybody was moving to cash or running for the hills, and almost nobody was able to fundraise.

The worst part was that I had to come in without a track record. 14:59 All the work I had done at J.P. Morgan, where I spent several years, belonged to the bank; none of it was my own.

I couldn’t market it in any way. I would take meetings and they would ask, “What does your track record look like? What are your returns?” I had to say, “I can’t really talk about that.

” Those are exactly the words every investor wants to hear. 15:28 I had a difficult time getting everything together, and that idea was more focused on public markets. After that, I started researching the lower middle market. A search fund appeared on my radar, which I had never heard of at the time.

I read more about it and thought, “This sounds like micro private equity.” Then I learned about Shore Capital and had a few exchanges with Justin Ishbia, who is a gentleman. I don’t know him very well - only in passing - but the idea started to take shape. 15:57 I then began seeing more changes in the markets.

Hedge fund managers and active investors were trying to move towards a permanent-capital model, where investors couldn’t withdraw their money whenever they wanted. Otherwise, you effectively have no control over your returns, because somebody can pull the rug out from under you. 16:26 You then have to reposition your entire thesis. I said, “I don’t want that, so what do I do?

” This is going to sound corny, but I looked at the Berkshire Hathaway model, which is permanent capital. You have a company with a balance sheet, and you invest the assets on that balance sheet. I asked myself how I could do that, and Isaac Management was born: no fund, no life cycles, no outside investors, no committees and no outside influence. 16:56 What made the model so attractive was that some larger players were beginning to focus on the lower middle market because the multiples were extremely attractive compared with larger deals, and the margins were good too.

But they were still funds, so they still had to sell. When you speak to somebody who has built a company over 30 or 40 years, perhaps as a second-generation owner, and tell them, “I’m from private equity and I’m on your side,” they wince a little. 17:26 They know you’re coming in to buy the company and eventually flip it, so you’ll try to maximise returns. To them, that raises the question: “How are they going to manipulate our financial statements to extract the most profit possible?

” I’ve had these conversations. I would walk into a meeting and say, “I’m a private equity investor,” and the tone would immediately change. They would become extremely defensive. 17:53 They were polite, but the meeting was effectively over.

So I changed my approach. Instead of calling us a private equity investor, I described us as a principal investment firm, meaning we invest our own money. Long-term permanence is what we’re after: growing these businesses for decades and completing add-on acquisitions. I’ve even considered taking a company public - not on the Nasdaq, but on a market relevant to its size.

18:22 That was the metamorphosis that came from taking a lot of hits in the face. You have to reposition and change, and that’s what I did. What began as an idea for an activist hedge fund focused on nano-cap stocks became a principal investment firm in the lower middle market. Honestly, I couldn’t be happier.

I think this is my niche. 18:51 I’ve done a lot of work in the space, I’ve been in the industry for a long time and I know a lot of great people. This market has historically been very underserved. When you look at the numbers, small businesses account for something like 44% of U.

S. GDP. There are around 35 million small businesses, and roughly 28 million of them are single-employee, owner-operated businesses. 19:20 These numbers are approximate, but this is a huge part of the American economy and it has largely been overlooked.

It’s rewarding to find a place within that gap, which we have. People have been very receptive, and it has been great. 19:48 Alex: Looking at the deals you’ve completed and your communication with sellers, what have been the biggest lessons from your journey so far? Paul: The biggest lesson is authenticity in the way you communicate.

I’ve read stories about HVAC small-business owners receiving five calls a week from search funders trying to buy their companies. 20:18 Everybody comes in with the same playbook: “You’ve done a great job. Hand it over to us, we’ll cash you out, and don’t worry about what happens next.” From what I’ve seen - and I could be wrong - the people who built these companies care deeply about what happens next.

This is their legacy. It’s what they’ve built. 20:48 You can quote me on this: I never want somebody we transact with to call me a year later and say, “What the fuck did you do to my company?” Being as transparent as possible about what you want to do is the most important thing.

Another major lesson is deal structuring. When you introduce certain structures, people can be hesitant because they aren’t familiar with them. Most of the time, people are looking for a cash or stock transaction, which is normal. 21:18 But there are ways for business owners to participate in the upside, such as an equity rollover or an earn-out with a contingency.

Seller financing over time can also allow them to continue earning income for the next few years as they transition into retirement. Alex: Know your stuff before you go into a meeting. Paul: Yeah, knowing your stuff before you go into a meeting is really important. 21:47 You’re going to be asked questions by both the banker and the owner.

If you suggest a structure with a 20% equity injection, 60% financing and a 20% equity rollover, they may ask, “What the hell is an equity rollover?” That’s when you explain how they can participate in the upside and how you plan to complete more acquisitions through the platform. 22:14 Rather than spinning it off into a separate holding company or HoldCo-type legal structure, you can give them the opportunity to participate. Come prepared, know what you’re talking about and be respectful.

These people aren’t necessarily Wall Street-savvy or deal-savvy. 22:42 They don’t complete many transactions. This may be the only transaction they complete in their entire life, so approach it with sincerity and understanding. People who have already contacted an investment bank or business broker generally want to sell, but they don’t necessarily know how to sell.

They may not know exactly what they want or what they can get. It’s up to you to bridge the gap, so be a steward. That’s it. 23:08 Alex: In the lower middle market, which growth lever do you believe moves the needle most - pricing, M&A, operations, talent or something else?

Paul: In the lower middle market, you can pull all of those levers. I think M&A is a little overdone. You complete an acquisition and then add two or three businesses through a roll-up. Yes, that will grow your top and bottom lines.

23:38 Congratulations, but anybody can do that. The real opportunity is in operations, not pricing. Increasing prices is easy; it’s a card trick. Operations is where all the bodies are buried.

It’s where companies live or die. You either have a great back office that knows what it’s doing, operates consistently and works efficiently, or you don’t. 24:05 A lot of lower middle market companies don’t have the budget to build a strong back office, so there is a significant gap. Carl Icahn has said this many times - and I’m paraphrasing - that there isn’t a company in America where he couldn’t walk in and cut 30% in waste.

I think that’s true. It’s especially true for larger companies with big bureaucratic organisations and tens of thousands of employees. 24:34 But in the lower middle market, when you’re dealing with only a few dozen employees, layoffs often don’t make sense. That one person may be a key employee and the subject-matter expert in a particular area.

Employee development therefore becomes extremely important. Systems and procedures become extremely important, as does optimising the technology you use. 25:03 Operations is, bar none, the most powerful lever you can pull. Talent comes second.

I read a study not long ago that found replacing an average employee earning $50,000 a year can cost a company $85,000. Alex: Yep. Okay. 25:32 Paul: That’s a staggering number.

You lose the employee and their productivity, and while you think you’ve saved $50,000, you’ve actually cost yourself an additional $30,000. That backward way of thinking, designed to juice short-term profits, is one of the biggest reasons we stayed out of the fund space and chose permanent capital. If you have a long-term horizon and a long-term view of what you want to do, it doesn’t make sense to allow people to withdraw their money whenever they want. 26:03 That’s especially true in markets that aren’t marked to market every day.

You can’t call a broker and ask, “What’s my price today?” It doesn’t work that way. I’d say the two most important levers are back-office operations and talent development - making people feel that they have skin in the game. 26:31 One exit strategy I’ve considered is an ESOP, giving employees actual shares in the business.

That keeps people highly engaged. Once they feel they can genuinely make an impact, they will. That’s partly psychology, but it matters. Alex: What do you read, watch or listen to that you would recommend others check out?

27:00 Paul: The staples are CNBC and Bloomberg. What I read is a little different. I’m not committed to one particular journal. I like to read a range of articles from different publications.

I’ll have Bloomberg open, search for a subject I want to research and then read everything that comes through the pipeline. 27:28 That could be Barron’s, the Financial Times or even Benzinga, which is based here in Detroit and publishes some good pieces. Crain’s is also a strong publication, especially here in the Midwest. Its Chicago and Detroit editions have great business articles.

Then there are the more typical publications such as MarketWatch and The Wall Street Journal. 27:58 I don’t have a special stack of newspapers that I read exclusively. I stay away from Variety and the gossip columns, though. Alex: If anybody wishes to reach out after the podcast, what’s the best way to get in touch?

Paul: The best way is either through LinkedIn or our website, isaacmanagementllc.com. 28:25 There is a contact form, and all of our information is available there. Our email address, investment criteria, background on the firm, information about me and details of what we look for are all included.

LinkedIn is also great. We have a company page, and you can reach out to me personally. Those are probably the two best options. Alex: Marvellous.

Thank you very much for coming on the Private Equity Podcast and sharing your insights into the lower middle market. Paul: It’s been a pleasure. Thanks for having me on. 28:54 Alex: And thank you to everybody for once again tuning in to the Private Equity Podcast.

Until next time, keep smashing it.