company as a result of the private equity transaction.
The use of leverage allows a private equity firm to pay a higher price for a company and can ultimately drive higher returns on their investment.
As the future owner of the business, the private equity firm has every incentive to make sure that it is an appropriate amount of leverage that the company can support.
The significant number of private equity transactions and the relatively low number of defaults on transaction debt demonstrates that, for the most part, private equity firms have been prudent in their use of leverage. In fact, the U.S. leveraged loan default rate ended 2007 at a 10-year low of 0.1 percent for Moody’s-rated issuers, down from 0.6 percent in 2006. (Reuters, Jan. 30, 2008)
A private equity owned business must learn to live with leverage. In a positive economic environment, the use of leverage can be a great tool to accelerate growth and drive equity returns to the shareholders. However, in a slowing economic environment, a private equity-owned company may need to be more conservative in pursuing its strategic initiatives in order to support the debt on its balance sheet.
This defensive approach in a softening economy creates a clear opportunity for strategic, entrepreneur, or family-owned businesses.
Rise of Strategic Buyers
Until mid-2007, strategic buyers were losing out in auction after auction, as multiples were pushed to new heights by private equity with fresh capital and access to credit.
To ensure survival, strategic/family-owned industrial distributors focused on core competencies: executing their business plans, tightening operating expenses and maintaining customer relationships. However, we have entered a period of slow economic growth, punctuated by a slowdown in private equity transactions.
The record nine-month 2007 M&A volumes were deceptively buoyed by an extraordinary first half of the year. In the third quarter, the credit crunch left a noticeable impact on worldwide deal volumes, which were off 42% to $1 trillion compared to $1.7 trillion in the second quarter.
With debt not readily available for any transaction, private equity firms have moved more cautiously, protecting their cash flows, cutting company operating costs and fully integrating companies already in their portfolios.
In this environment, strategic buyers have a distinct advantage as their PE-backed competitors employ a more conservative operating strategy.
On the acquisition front, less competition for deals and the ability to use cash and/or stock with no financing contingency translates into a very favorable acquisition environment for strategic buyers. Strategic buyers can take an offensive approach to entering new markets.
Pursue acquisitions that generate additional growth and profitability. Consider opportunities to enter adjacent product and geographic markets.
Focus on deals where there is the ability to generate meaningful cost and revenue synergies by eliminating redundant expenses and leveraging product and service opportunities into the acquired company.
The opportunity is ripe for larger distribution companies to acquire smaller competitors that may be more susceptible to a worsening business environment.
Private equity involvement has been a boon to the industrial distribution industry, with increased transaction activity, enhanced valuations and attention by the broader market.
Private equity has played a prominent role in many successful distribution companies including Interline Brands, Wesco, Houston Wire &Cable, Rexel, and Edgen Murray. An improved credit environment and strengthening economy will renew private equity appetite.
In the meantime, traditional strategic, entrepreneurial or family-owned companies should consider the current environment as a unique window of opportunity to pursue both organic and acquisition growth strategies.
Brad Yates is a managing director at Stephens Inc., where he provides expertise in middle-market investment banking to the industrial distribution market. Stephens Inc. is a full-service investment banking firm headquartered in Little Rock, AK. For further information, contact Yates in the firm’s Atlanta, GA office at 404-461-5100 via e-mail at email@example.com.
This article looks at the impact of private equity on the industrial distribution market. The impact can be seen in other distribution sectors, as well. The author says that increased private equity ownership has fundamentally changed the corporate and strategic landscape of the distribution industry.
Worldwide M&A activity reached a record $3.8 trillion over the first nine months of 2007, according to Dealogic.
Much of the activity was directly attributed to private equity firms, which raised nearly $200 billion worldwide during the year. In particular, industrial distribution experienced unprecedented private equity investment.
Over the last two years, 21 private equity firms have made 46 platform and add-on investments in numerous sub-sectors of industrial distribution including general mill supply, tool shop/construction supply, electrical, industrial rubber, industrial gases, industrial lubricants, safety, fluid power, wire &cable, integrated supply, waterworks/utility, and industrial PVF.
Today, nearly every sub-sector of industrial distribution has at least one private equity-owned competitor.
Increased private equity ownership in industrial distribution has fundamentally changed the corporate and strategic landscape of our industry. Traditional strategic, entrepreneurial or family-owned companies will need to adapt to successfully compete with the resources and capital available to PE-backed businesses.
Addressing this uneven playing field will be essential for continued viability in this increasingly competitive environment, especially as the industry approaches a period of less robust growth in 2008 and 2009.
Development Under PE Ownership
Like all owners, private equity firms seek to maximize value for the shareholders of a company.
However, their relatively short investment time horizon of three to five years and their portfolio approach to investing creates a company dynamic that can be very different from a traditional strategic, entrepreneur, or family-owned business.
Perhaps the biggest change that occurs when a company is acquired by a private equity firm is the immediate focus on growth, both organic and through acquisitions.
A private equity firm with a five-year investment horizon will want to optimize a company’s growth strategy, readily pursuing new market opportunities and acquisitions.
Whereas a family owned business may be more risk averse with a focus on protecting the family’s net worth, a private equity-owned business can be more proactive in pursuing a comprehensive growth strategy. It is not uncommon to see a company significantly increase its growth rate and profitability after being acquired by a private equity firm.
Backed by the experience of working with and succeeding with other portfolio companies, in many ways, PE-backed businesses are better equipped to evaluate and take advantage of business opportunities.
On the acquisition front, it is not uncommon for a private equity firm to assist a portfolio company in reviewing and executing acquisitions so as to increase the company’s activity level.
In some cases, private equity owners will be more willing to consider key acquisitions because they recognize the strategic value that comes from quickly adding size and scale to a business.
This is particularly true in a positive economic environment where there is ready access to capital to execute these add-on”acquisitions and where a strong M&A environment can justify a buy and build strategy.
Picking up a key acquisition may allow the private equity firm to significantly increase the value of the combined company in a future liquidity event.
Living with Leverage
Another change that occurs when a company comes under private equity ownership is the increased amount of debt that is placed on the