Supply House Times

Opportunity in the New Year:<br>The Pending Collapse of Private Equity and the Effect on B2B Distribution

January 5, 2009

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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