News Column

Growing From The Middle

July/August 2004, HISPANIC BUSINESS Magazine

Joel Russell

Dennis Gilbert, CEO of Tesoro Corp.
Dennis Gilbert, CEO of Tesoro Corp.

Big or small: That's the conventional thinking about businesses in the U.S. economy. But there is a third category. Medium-size companies occupy center stage in the development of emerging markets, and they account for 69 of this year's Hispanic Business Fastest-Growing100 companies.

Definitions vary for this so-called "middle market." Grant Thornton, an international accounting firm specializing in the middle market, defines it as companies with revenues between $50 million and $2 billion. Microsoft once pegged the middle market as enterprises with revenues between $1 million and $1 billion. MergerStat, a tracking service for mergers and acquisitions, calls the middle market any deal between $25 million to $250 million. Business brokers and investment bankers often base their definition on a company's transaction value rather than revenues, with ranges from $1 million up to $2 billion. In the U.S. Hispanic economy, Hispanic Business defines the middle market as firms with revenues from $5 million to $50 million, a range often used by consulting and investment firms.

"In reality, size is a remote thing," says James Stancill, a professor at the University of Southern California's (USC) Marshall School of Business and an expert on middle-market development. "A distributor might have high [revenue] volume and few people, while a manufacturer or a service company would have lower revenues and more employees."

Instead of a size standard, Mr. Stancill believes middle-market firms are characterized more by the problems and transitions faced by managers. "You get to a certain stage in running a company and it takes on a life of its own," he explains. "At that point, sales becomes the number one priority, and cash-flow management number two. Growth in sales isn't the answer to everything, because it takes money to grow. ... But there is an optimum growth rate that allows for self-financing."

Middle-market CEOs constantly balance their desire for growth against their financial resources. "The biggest challenge for a small business transitioning to the middle market is to cope with operational necessities, and at the same time be strategic in its thinking," says Antonio Grijalva, CEO of G&A Partners Inc., a human resource outsourcing company and the top-growth middle-market company on this year's Fastest-Growing 100 directory. "This requires new layers of middle and upper management, which small businesses because of financial constraints are usually not ready to embrace."

Dennis Gilbert, CEO of construction firm Tesoro Corp., acknowledges the financial tension between growth and safety. "We started out taking all of my retirement money from the government TSP [a kind of a 401(k) plan] along with a small business loan and tapping my personal credit cards," he says. "We self-finance all investments, trying to keep the equity in the company growing to allow our bonding capability to grow."

When accessing capital, middle-market companies often fall into a gap between the standard business loan and public equity markets. "Although these firms typically have access to bank loans, or even to private [bond] placements, they often cannot meet their financing needs entirely through such debt instruments," the Federal Reserve Bank states in a report titled "The Economics of the Private Equity Market." Moreover, the need for money in the middle market usually doesn't arise from a lack of working capital, but rather "to achieve one of two objectives: to effect a change in ownership or capital structure, or to finance an expansion," according to the report. Mr. Grijalva confirms that in the case of G&A Partners, "access to capital is a secondary issue unless we decide to grow through acquisitions or decide to expand geographically."

David Perez and Marcos Rodriguez of Palladium Equity Partners, a New York-based investment bank for middle-market firms, see three common motives for CEOs to seek money: a transition of ownership, an acquisition, or a situation ill suited for bank financing.

Ownership transfers usually combine bank financing with equity because lenders "want to see the new owners put up a meaningful amount of capital to ensure a healthy alignment of interests," Mr. Rodriguez says. "Said another way, the banks want to make sure the new owners or the existing owners if they want to take some money off the table have some 'skin in the game.'"

Equity financing works better for acquisitions because of the longer-term investment horizon. In addition, besides money, the new equity partner can bring operational or strategic assets to the deal. In the final category of money-seekers are underperforming companies that need big investments to reach their potential.

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