There's a hidden crisis hurting mid-sized companies

• Many smaller private companies are experiencing financial peril.
• Performance is down overall for these middle-market companies, which are struggling to repay debt.
• Meanwhile, large public companies on the whole are doing better than they were pre-pandemic.

Many of America's smaller private companies are struggling financially, but you may not have realized.

Many large public companies successfully navigated the pandemic and ended up larger and wealthier. But a new study suggests that for some privately-held middle-market companies, or those with revenues between about $100 million and $750 million, the impact of high inflation and increasing capital costs has been devastating.

And as the financial health of these smaller, private companies declines, US supply chains could be threatened, which could negatively impact the economy and larger publicly traded companies.

A new paper from Marblegate Asset Management, in partnership with supply chain leader RapidRatings, found that many middle-market companies are under major distress as their margins fall and their ability to pay their debts weakens.

Many of these companies — which typically rely on traditional bank financing rather than public bond markets that bigger companies can use to borrow — don't have the resources and flexibility to recover fully, leading to a growing separation in performance between public and private companies. The authors call this an example of a "rip tide" economy.

Though individual middle-market companies don't have as much pull on Wall Street, these companies collectively employ about 50 million people and account for a third of private sector GDP, according to Marblegate. However, economic forecasts often omit performance data for private companies, as their financial data is harder to access than for public companies that must publish their results regularly.

"These companies are still trying to work their way through the myriad of unresolved operating issues in the pandemic's wake," the authors wrote. "As such, they are both unprepared and likely incapable of dealing with the ongoing threat of inflation and the hardening impact of the Fed's policy response."

Larger companies have greater access to different forms of credit and equity markets, allowing many to maintain high levels of capital.

RapidRatings supplied anonymized financial data on about 1,200 middle-market companies. Marblegate Asset Management then compared these findings to public companies in the Russell 3000 index — the broadest measure of American public companies. The firm looked at earnings before interest, taxes, depreciation, and amortization — or EBITDA, a standard financial measure that evaluates a company's operating performance.

The firm's analysis found that EBITDA fell over 24% for middle-market companies between 2019 and 2022, whereas EBITDA grew 18% at large public companies. This discrepancy was also notable for EBITDA margins — which measure a company's operating profit as a percentage of revenue. EBITDA margins fell 25% during the time period for middle-market companies, while it only declined 2% for public companies.

Whereas large public companies can charge more for increases in raw material and labor costs, middle-market companies on the whole struggled to pass on these costs to customers.

Additionally, when looking at net profit after tax as a measure of profitability, middle-market companies saw declines of nearly 80%, compared to growth of 33% at large public companies. Meanwhile, liabilities rose over 20% for middle-market companies and stayed flat for large public companies, which is especially problematic during periods of high interest rates. This shows companies struggling to make a profit are at risk of failing to meet their long-term financial obligations.

The debt to EBITDA ratio — deemed financial leverage — increased 62% for middle-market companies, while large public companies saw that leverage ratio fall 14%.

While Marblegate's analysis is based on data from 2022, these trends appear to have continued into 2023 for smaller private companies that borrow from regional banks and thus face greater financial distress when interest rates are high. In fact, according to the authors, middle-market companies made up most of 2023's corporate failures, and more bankruptcies and defaults will likely occur as interest rates remain elevated, Axios reported.

"Capital will predominantly flow to the strong companies while the average middle market business unable to manage surging labor and borrowing costs will have few options as their solvency deteriorates," the authors wrote.

Still, it's unclear how the pain points at these middle-market companies will impact the labor market — which still reports under 4% unemployment— or the chances of the long-anticipated soft landing.