Business, Mid-Market & Industrial

How to Underwrite a Mid-Market Company Acquisition

Underwrite a mid-market company by validating adjusted EBITDA through a quality of earnings review, then testing free cash flow after capex, working capital and taxes against the proposed debt. The metrics that matter most are total leverage to adjusted EBITDA, fixed charge coverage, free cash flow conversion, and customer concentration.

What makes mid-market company underwriting different

Mid-market companies, generally with revenue from about $5 million to $500 million, have professional management but are still exposed to concentrated customers, key leaders and limited diversification. Valuation is based on adjusted EBITDA, and the central underwriting task is deciding which add-backs to accept: owner compensation, one-time costs, run-rate savings and pro forma acquisitions all inflate EBITDA if not scrutinized. Working capital needs, capex intensity and tax structure determine how much EBITDA converts to free cash flow. Management depth, systems and reporting quality vary widely in this segment and affect both risk and the ability to integrate add-on acquisitions.

Senior lenders size debt on validated EBITDA and free cash flow, set leverage and coverage covenants, and spend most of their time on the downside case: what happens if the largest customer leaves or margins compress. Private credit lenders may provide unitranche financing at higher leverage with lighter amortization in exchange for higher pricing. Private equity sponsors underwrite to IRR and MOIC targets, emphasizing organic growth, margin improvement, add-on acquisitions and exit multiple. Equity accepts more risk for upside, while lenders seek protection through covenants, collateral and a conservative view of EBITDA. Both lean heavily on the quality of earnings report and on management interviews.

Key metrics

Adjusted EBITDA

The basis for valuation and debt sizing, so each add-back must be supported.

Total leverage

Debt to adjusted EBITDA measures the burden relative to earnings.

Middle market senior and unitranche lenders often lend in the range of roughly 3x to 5x EBITDA, depending on sector and size.

Fixed charge coverage ratio

Shows ability to cover interest, scheduled principal, capex and taxes.

Lenders commonly set minimum fixed charge coverage around 1.1x to 1.25x.

Free cash flow conversion

The share of EBITDA that becomes cash after capex and working capital shows true debt service capacity.

Customer concentration

Losing a major customer can sharply cut EBITDA.

Underwriters often scrutinize any customer above about 10 percent of revenue.

Net working capital

Seasonality and growth affect cash needs and the purchase price adjustment.

How to underwrite it, step by step

Commission a quality of earnings review to validate adjusted EBITDA and add-backs.
Analyze revenue by customer, product and geography, and assess concentration.
Evaluate gross margin trends and pricing power.
Determine normalized working capital and set the working capital peg.
Assess capex needs and free cash flow conversion.
Evaluate management team, systems and reporting quality.
Build base, downside and upside cases and test leverage and coverage.
Structure debt, equity and covenants to match risk profile.

Due diligence checklist

Audited or reviewed financial statements
Quality of earnings report
Monthly management accounts
Customer and product revenue reports
Working capital analysis
Capex history and plan
Management team bios and organization chart
Material contracts with customers and suppliers
Tax returns and structure review
Legal and compliance diligence reports
Management presentation and budget

Key risks and mitigants

Aggressive add-backs and run-rate adjustments inflate EBITDA.

Rely on the quality of earnings report, accept only supported adjustments and cap pro forma synergies in the credit agreement EBITDA definition.

A top customer reduces volume or rebids the contract after closing.

Review contract terms and renewal dates, conduct customer calls and stress the loss of the largest account.

Founder-led company lacks a finance function or second-tier management.

Budget for a CFO and key hires, and use rollover equity and management incentive plans to retain leaders.

Working capital consumes cash as the company grows.

Set the working capital peg on a trailing average and size the revolver for seasonal and growth needs.

Add-on acquisitions underperform or strain integration.

Condition delayed draw funding on leverage tests and review integration capacity before each add-on.

Rising interest rates squeeze coverage on floating rate debt.

Stress coverage at higher base rates and require partial interest rate hedging.

Typical financing and deal structure

Mid-market buyouts are typically financed with senior term loans and revolvers from banks or private credit funds, often as a unitranche facility that combines senior and junior risk in one loan with one set of documents. Mezzanine debt or preferred equity may fill the gap between senior debt and sponsor equity. Sellers frequently roll equity and sometimes provide seller notes or earnouts to bridge valuation gaps. Representations and warranties insurance is widely used to cover breaches of seller representations in place of large escrows. Covenants usually include maximum total leverage and minimum fixed charge coverage, with negotiated EBITDA add-backs, equity cure rights and delayed draw facilities for add-ons.

Red flags

Large unsupported add-backs or pro forma adjustments.
Declining margins or revenue concentrated in a few customers.
Weak financial reporting or late closes.
Key management departing after closing.
High capex needs not reflected in EBITDA.

Frequently asked questions

What is a quality of earnings report?

A quality of earnings report is an independent accounting analysis of a company's historical results. It tests whether reported EBITDA is accurate and sustainable, evaluates each proposed add-back, analyzes working capital and flags one-time items. Buyers and lenders in mid-market transactions rely on it to agree on the earnings base used for price and debt sizing.

How much leverage can a mid-market company support?

It depends on the stability of cash flow, sector, size and lender type. Lenders commonly finance mid-market companies at a few times EBITDA, with more leverage available for recurring revenue businesses with low capex and less for cyclical or concentrated companies. Free cash flow after capex and taxes ultimately determines how much debt can be repaid.

What is a working capital peg?

A working capital peg is the normal level of net working capital agreed in the purchase agreement, usually based on a trailing twelve month average. If working capital delivered at closing is above or below the peg, the purchase price is adjusted. This stops a seller from pulling cash out by collecting receivables or stretching payables just before closing.

What is unitranche financing?

Unitranche financing combines what would otherwise be senior and subordinated debt into a single term loan with one blended interest rate and one credit agreement. Private credit funds commonly provide it in mid-market buyouts because it closes quickly, offers higher leverage than a bank senior loan, and often has lighter amortization, at a higher cost.

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Educational content, not investment, credit, legal or tax advice. Benchmarks are common practitioner rules of thumb and vary by lender, market and cycle.