With M&A poised for a strong finish this year, distributors on either side of a deal should strategically prepare now for the opportunities that will arise. Buyers must carefully examine how a targeted asset fits, and sellers must ensure maximum value before entertaining offers.

This article is part two in our series on M&A in distribution. Part one gauged the current climate for activity across the industry and how countervailing winds have stunted the volume and size of deals.

Midway through 2016, a trio of headwinds – energy, price transparency and the strong U.S. dollar – stunted revenues across distribution and, in turn, slowed the pace of merger and acquisition activity.

Yet a lack of organic growth in many industry verticals has companies seeking acquisitions to boost their top lines. With the economy forecasted to recover in the second half of 2016, M&A is expected to accelerate as strategic buyers scour acquisition pipelines to buy growth while financial buyers look to deploy capital and pad their portfolios.

This projected rise in M&A over the next six months should prompt company executives – no matter what side of a deal they’re on – to consider strategically preparing for this surge of opportunities.

“I think the slowdown in M&A at the beginning of the year is going to be temporary and that M&A will pick up meaningfully for the back half of 2016,” says Reed Anderson, head of Houlihan Lokey’s industrial distribution practice. “Momentum tends to pick up for deals because there’s that time lag on M&A.”

Advice for sellers

For the best results, companies looking to sell to a strategic or private equity buyer must be prepared when a suitor emerges. Just as someone selling a house can’t expect top dollar if they haven’t made some enhancements and upgrades such as a remodeled kitchen, a distributor hoping to get market value or better has to get their business in order, as well.

“M&A is not a flip-the-switch activity,” Anderson says. “It does take a little while to successfully sell a business. So if you’re going to move down that path if you’ve made a strategic decision to sell, it takes a little bit of time to execute that strategy to get a deal done.”

While no company is perfect when it’s put on the market, it is critical to think about removing as many blemishes as possible, or “de-risking your business before taking it to market,” Anderson says.

The first item on any seller’s checklist is deciding how quickly you want out. The timeline will dictate the type of maintenance you need to perform on the business, according to Jim Miller, a principal and founder at Supply Chain Equity Partners.

If you’re looking to exit the business quickly – for example, in one year – the approach should be centered on “cleaning your financials, getting your inventory cleaned up, getting your receivables cleaned up,” Miller says.

But for many businesses, delaying the sale might make more financial sense because it allows time to drive value into the company. Strategically investing in the company now, even if the exit plan is a few years down the road, will yield a larger payday when an offer emerges.

“On a five-year plan, the advice we give distributors is to build your business as if you’re never going to sell it,” Miller says. “Invest in the people, invest in training, invest in IT systems, invest in infrastructure, invest in the product lines.”

A recent example is Airgas. The company in 2011 rejected a $5.8 billion takeover attempt by Air Products, an offer that the company’s founder Peter McCausland said “grossly undervalued” the company and its growth potential. Last year Airgas agreed to a $10.3 billion offer from Air Liquide. In between, Airgas invested heavily in its e-commerce capabilities, among other areas.

But with so many distributors operating as lifestyle businesses, in which the owner is also the chief executive, they tend to make reactive decisions to threats and opportunities and aren’t as good at making intentional, proactive moves when there is no apparent business need to do so, according to Mike Marks, Indian River Consulting Group.

“They add staff or they add IT when the system’s just about to break and everybody’s complaining,” Marks says. “Then they’ll step up to the plate, and they’ll go do it.”

Smart company executives don’t wait for something to force a move that adds shareholder value. They start planning now for the next generation – or next owner – to take over.

“Real shareholder analysis is where you sit down with somebody and say, ‘How do I get out of here? Do I bring somebody in to run it? Do I have offspring to pass it off to? Do I want to sell it? Do I want to keep it in the family?’” Marks says. “Having those discussions before the fact, so people can start to think about what it is they want to do, creates a lot more shareholder value.”

Where to invest?

In today’s M&A landscape, it is critical to invest in your business – especially technology – even when the economy is soft and profit margins are slim. This will help distinguish your company from other targets that buyers might be pursuing, says Jason Kliewer, co-head of Baird’s distribution investment banking group.

“A strong ERP system enabling quick turnaround on diligence questions inspires confidence in a sale process, as does a clearly articulated growth strategy with metrics used to track progress,” Kliewer says. “Each of these factors can have a meaningful impact on valuation.”

Technology isn’t the only area where a company can create a competitive advantage within the acquisition pipeline. Hiring the right talent, especially a superlative sales force, makes a distributor more attractive to suitors.

Forming an industry-leading customer experience also helps you rise above peer companies. While buyers will look at specific metrics when contemplating a deal, those that dig deeper in their due diligence might see how an abstract concept like the “customer experience” manifests itself in top- and bottom-line growth for distributors, says T.J. Monico, head of distribution, investment banking, KeyBanc Capital Markets.

“You see the better metrics with companies that know how to create a better, more progressive customer experience,” Monico says. “You also see it evidenced in their growth rates, as well, so that companies growing above the industry growth rate – implying that they’re taking some share from other companies – they either have a disruptive technology to help them deliver a better customer experience or just a better approach to making their customers happier. Otherwise it’s harder to differentiate themselves.”

No matter where the investment occurs, companies are “typically better off doing what makes the most sense for the business,” Anderson says. “If you’re looking at strategies, if you’re looking at investments, and you think those are the right things to do for the business, those are likely the right things to do for an M&A sale, as well.”

First and foremost, Miller says, companies should ask themselves, “Do I have a bad culture – a ‘scraping dollars out of the business’ culture – or do I have an ‘investing in people’ culture? Do I have a quality management team, quality recruiting and training and retention rates on quality people?”

If a distributor hasn’t been keeping pace on ERP and inventory management, if it hasn’t been hiring top-notch talent or creating a unique user experience, those problems will fall to the new ownership team and stunt future cash flow.

Best practices for buyers

All of those seller considerations are what buyers should be looking for in their new assets. SRS Distribution Inc., McKinney, TX, which has made 45 acquisitions since its founding in 2008, doesn’t buy companies for “proprietary technology or proprietary products or access to anything new to the model,” says President and COO Dan Tinker.

But “we certainly are always looking at the talent,” Tinker says. “The financials are what they are; the key to us is are we acquiring a talented team of people that can grow the business with more resources and a different risk tolerance. Some people can do that, some can’t, regardless of the company.”

SRS looks for “people that can operate under our model, which is an EBITDA growth model rather than a privately owned family company model,” Tinker says. “Can they thrive in that environment? You want them

to come in and be excited about their new environment and really take the business to a new level with unlimited resources because they are now part of a national network and family of companies instead of being a mom and pop.”

Other buyers, such as F.W. Webb Co., Bedford, MA, which has made three acquisitions in the past year, look to either extend the company’s footprint or add a division in hopes of becoming a “complete solution for customers,” says COO Bob Mucciarone.

The HVACR and plumbing distributor is strategic in making sure that the acquisition target will benefit the company in places it is looking to expand. Acquiring geography is often easier than launching a greenfield and trying to build a brand there.

“For example, down in New Jersey, acquisition is the way to go because you’re buying relationships, you’re buying people – and the biggest asset a company has is its people – and when we do an acquisition we keep most, if not all, employees,” Mucciarone says. “And you’re buying a customer list. They already have relationships with customers. That’s significant because you have instant business. It’s like turning on a switch.”

Other considerations

Distributors looking to acquire in hopes of adding product lines, geographies or customer lists must be careful about who they target and why. They must first examine their core business and ask themselves, “What am I really good at? What do I do well and do better than someone else?” said Dave Gabriel, president, Sonepar North America, Charleston, SC, during a panel discussion at the National Association of Electrical Distributors conference this year.

“If you have an alignment … then maybe it makes sense,” he says. “Know yourself first. Chasing volume for the sake of volume, or chasing geography for the sake of geography, I wouldn’t advise that for anyone.”

Gabriel says that during the due diligence process, Sonepar asks specific questions to determine a good fit. These include: How technical are they? What are the systems they have in place? What is the culture of the organization? Is it a good fit?

But as buyers look for a variety of factors that align with their business model, from talent to technology to geography to product line to growth rate, they must not act rashly, according to Marks.

“When you talk about acquisition, the first part is where do you add value? What’s your value proposition?” Marks says. It doesn’t make sense to just buy a company that gets you into a different market where there are no synergies. “There’s a lot of really stupid acquisitions where people buy things and they destroy shareholder value.”

A company also should focus on what it brings to the asset, not solely what the asset brings to the company. When Stellar Industrial Supply, Tacoma, WA, began looking at buying Impact Industrial Supplies, Tampa Bay, FL, last year, Stellar President and CEO John Wiborg said the company saw an opportunity to “bring some resources to Impact – and by that I mean not only financial resources but capabilities such as our vending solutions and also our metalworking capabilities.”

But perhaps the biggest criterion a distributor should consider is culture. As Miller says, a buyer will inherit all the profit-draining traits of a bad culture, which is why Stellar and other savvy companies look to align not only product lines and geographies, but the basic principles of how each company’s leaders run their respective businesses.

“When we’re looking at acquisition possibilities, the first gate that’s got to be overcome is, ‘Is this organization we’re looking at a great organization and are their values and business philosophy compatible with ours?’” Wiborg says. “They’re never going to be exactly the same but they have to be compatible.”