In the most recent five years,
the headlines for distribution markets were chock full of news regarding
Private Equity Funds and their consolidation of old-line distribution
companies. There was seemingly no end to the purchase of another distributor by
a Private Equity Fund and the multiples for firms went from the common range of
6x to 8x EBITDA to well over 10x for many high profile deals. Private Equity
was, in the parlance of the day, “good for business” including the ability of
the funds to provide capital for expansion, direct the acquired firms with
superior strategic management, and take the long-term view for investment
versus the quarterly view of the public markets. Our research and work with
Private Equity Firms, however, has garnered a different view of the
“value-added” from these entities and what lies in store for the next several
years because of their entry into the business-to-business (B2B) distribution
space.
Private Equity is, as the name
implies, a collection of private investors who invest in businesses for profit.
The equity portion is comprised of any number of wealthy individuals, pension
funds, financial institutions and other unclassified lenders who are interested
in buying companies for their investment potential. The investments are managed
by a group of advisors who set up the financial structure of the fund, buy the
companies and manage the portfolio. The fund advisors are typically paid in
management fees from the portfolio companies, as a percentage of the value of
the fund, and from the sale of portfolio companies.
On paper and in theory, the
positives of Private Equity make sense. Far too many businesses were managed
for the short-term, mismanaged under current ownership, or underfunded in
relation to their profit making potential. Hence, Private Equity could step in,
right these issues, and create a better environment for profit generation of portfolio
companies. Private Equity advisors made a lot of money and in a very short
time. Unfortunately, news of this great and quick wealth spread about the
financial world and a “gold rush” of financial advisors and new funds entered
the market in the last five years.
The flood of interested investors
was greatly enhanced by historically low borrowing rates, relaxed lending
standards, and an overall optimism for Private Equity investments churned up by
growing success stories of firms who were new to the game but outrageously
profitable in a short time. Fund managers were high profile Type “A”
personalities stereotyped with vacation homes, trophy wives, and uber-expensive
lifestyles. They were much touted in the financial trade as “Wunderkinds, Masters
of the Universe” or other titles that expressed both envy and enmity from the
meat and potatoes business owners and managers who could never quite get
sanguine with their growth strategies or lifestyles.
Today, the meat and potato
managers have a chance to feast at the expense of yesterday’s “Masters of the
Universe.” The outlandish growth of Private Equity funds is largely over. The
factors that led to the frenzy of funds entering the market five years ago have
retracted. First, market growth has slowed considerably and there is limited
appetite to buy in an uncertain sales environment. Second, while interest rates
have remained low, the poor investments by financial institutions and high
leverage of most businesses and individuals has created an environment where
there are limited lenders. Third, the remaining investors in Private Equity
firms are becoming nervous and are working to withdraw their funds. In some
instances, the withdrawals are being limited as the funds aren’t available or are
being capped to avoid a run on assets.
And finally, the double digit
multiples paid by the firms as early as a year ago can’t be supported in
today’s low growth/low profit environment. As a whole, Private Equity is in for
a rough 2009 and 2010 and those distribution companies acquired by Private
Equity are likely in for a tough time. A
recent
study by Boston Consulting Group and business school IESE found that
20 to 40 percent of “large buyout”
firms could go under in the next several years and upwards of 60 percent of
smaller firms will share the same fate.
Our own experience in working
with Private Equity clients would confirm the study but our conclusions were
gathered from our work in the trenches. In numerous projects with Private
Equity firms, we have found that some two-thirds had scant experience in
distribution and their interests were based solely on their ability to purchase
the company, ruthlessly cut costs, saddle the firm with exorbitant management
fees, and sell or “flip” the entity to an unsuspecting buyer before the company
began to hemorrhage from mismanagement. Much of the Private Equity model was
about slashing costs, cutting investment, driving up management fees, and
timing the sale before the market went into a down-cycle. This, of course, was
abetted by low borrowing rates and greatly relaxed borrowing standards. Of
course the fund managers pronounced they didn’t adhere to the strip-and-flip
strategy, but in reality, many did.
Only one-third of the Private
Equity clients we dealt with purchased distribution as a strategic investment
and applied a long-term view including hiring better talent to run the
business, investing in infrastructure and service quality, and looked at the
distribution space as a unique business with specialized needs. Our prediction,
perhaps naïve, is that these firms are those in the Boston Consulting Group
study who won’t belly up in the next several years. Our experience that
one-third of these firms add long-run value is close to the study’s prediction
that all but 30 to 40 percent of these firms will fail in coming years. There
will be, however, plenty of opportunity for distribution firms not owned by
Private Equity. The opportunity will come about because of the massive
mismanagement and debt loads piled on distribution firms by the “Masters of the
Universe” or the buy, strip-and-flip set of Fund Advisors.
Taking Advantage of the Private Equity Collapse
The extreme leverage of Private
Equity Funds and the market reversal have created an environment where many
distribution-based holdings will be strapped for necessary investment. This
means that proper inventory, systems, and people may not be upgraded or
replaced for some time. The outcome of this is, of course, a reduced service
platform that precedes dissatisfied customers and an eventual loss of revenues.
The ability of the independent distributor to take advantage of the Private
Equity malaise depends greatly on the signals produced from the market and
competitive strategies employed.
Most problems with distributors
owned by Private Equity firms will start long before the issues are widely
known. Look for departure of key salespeople including applicants who work for
companies owned by Private Equity. Be on the lookout for new credit
applications from substantial end users who have, in times past, done the
majority of their business with the Private Equity competition. And, scan the
business news for problems with other portfolio companies that are owned by
Private Equity Funds. All of these events are market-based signals that the
Private Equity Fund is having problems and, if the current research is
accurate, these problems will be much more pronounced in the next several
years. Once you are certain of the vulnerability of a Private Equity
competitor, it’s time to spring into action.
Most substantial customer
defections in distribution markets are done for two primary reasons, which are
a reduction in service quality or a loss in a key relationship. To profit from
these events, you will need to act swiftly. In the event of a key relationship
loss, look to hire the seller(s) responsible for the relationship as long as
they are potential employees of sufficient quality. Several distribution firms
have created significant growth streams by hiring away brokers for key
relationships. You may overtly solicit competitor’s employees if they can bring
key customers to your portfolio.
If the defection is service
related, it is advisable to approach the dissatisfied customer and understand
what their service and pricing requirements are. Carefully put together a
pro-forma for the customer to understand if you can service them profitably. If
you have activity costs or some other service costing methodology, use that in
evaluating the financial opportunities. There will be, based on our estimates,
plenty of large customers who will defect or come available from the Private
Equity bubble collapse.
Finally, if you want to generate
a winning offensive strategy against weak Private Equity-owned competitors,
consider the new field of
Transaction
Management. Transaction Management and Transaction Based Selling is a
method of managing transaction economics of order size in margin dollars, order
type, and mix of orders. The thrust of the discipline is to drive transaction
economics and give the customer a better price while making better profits for
the distributor. The work is a combination of reducing channel waste and
switching transactions to allow for better profit making. Transaction
strategies can lower prices in the double digits and give better profits than
full service distribution can offer.
The time is ripe for
independently owned distributors to be on the offensive. There will be plenty
of collapses or near collapses in Private Equity-owned distribution holdings in
the next several years. A well-managed strategy, by independently owned
distributors, can take advantage of the situation and add new customers.
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here to read the actual White Paper.
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