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Inefficiencies in regards to what exactly?
Price / value
Inefficient market, illiquid equity, higher variability in risk, less professionalized processes, less human capital variability
It depends.
Multiples do generally increase/decrease at a close rate to the MM/UMM. So multiples (pre-COVID) were very elevated, just like the rest of the market.
Some inefficiencies do arise, and its mainly due to lack of sophistication from the seller. A lot of companies sold in the LMM are founder owned businesses who are looking to retire. That owner might not hire an investment bank/broker to help them sell. They might hire one who is very low quality (example: I had a partner at a small broker once ask me (an analyst) what a cap table was and why we were requesting it for diligence). Not using a IB/broker can also lead to less competitive bidding processes, or none at all. The owner might not hire an accountant to help them with the sale process besides the person who does their taxes every year to do some very basic analysis on that front. They will often hire a law firm they have no relationship with (because they haven't needed to use one in the past), and they do not know how to best structure the transaction so we (buyer) can structure the deal more favorably for us (buyer).
Above represents some broad, and maybe extreme cases where inefficiencies lie in the LMM. Lack of seller sophistication and willingness/ability to spend lots of $ on advice during a sale is where the main price dislocations arise IMO.
Great comment. Agree that a lack of seller sophistication is a leading cause of inefficiencies.
Size matters with some business models as well. Contract manufacturers to medical / aerospace end markets have been PE staples since at least the early 2000s. The vast majority of contract manufacturers are single site operators that serve ~5-20 customers. Top customer concentration is often 50-85% of annual sales. The synergies of acquiring 5+ of these single site operators are pretty obvious, but the undertaking is not be appealing to MF/UMM funds that need to put large checks to work. On day 1, customer and product concentration is no longer an issue. Over the medium term, the combined entity can better serve all of its existing customers with additional services / capabilities. Over the long term, the company may become large enough to garner attention from UMM platforms. There is considerable multiple arbitrage between single site operators and a viable platform investment for a UMM fund.
You might be thinking, "why don't single site operators buy each other?" They do try but often make a mess of it given their only experience is as business operators.
Agree with the comments above. Inefficiencies typically occur in the LMM due to a lack of sophistication, illiquid assets with few buyers, and sometimes opaque businesses which require a significant amount of heavy-lifting in the diligence phase (i.e. poor financial visibility, lack of operating systems, commercial risks, etc.)
In addition to the above, you might see different multiples purely based on size. A perfectly well run business doing $10M of EBITDA will probably trade for a lower multiple than a very similar business doing $100M of EBITDA.
Not really an "inefficiency" but may help to explain the price to value differences you see in the LMM vs MM.
More often than not, very good businesses that are run poorly.
Does this mean quite often returns can be higher in the LMM? If you replace the owners with more competent management, I imagine the business could thrive.
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