April 1, 2013
Interviewed by: David Snow
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Driving Growth in Manufacturing

A Renaissance in U.S. manufacturing is underway and private equity firms are preparing to help industrial companies take full advantage. In the first of a multi-segment thought-leadership series, experts from Castle Harlan; Argosy Private Equity; and RSM discuss how private equity firms are trying to drive growth in their manufacturing portfolio companies. Topics include how labor prices in China and U.S. energy have changed the game; what small and mid-sized manufacturing companies need to thrive in a new environment; and why generational change and healthcare uncertainty spell opportunity.


A Renaissance in U.S. manufacturing is underway and private equity firms are preparing to help industrial companies take full advantage. In the first of a multi-segment thought-leadership series, experts from Castle Harlan; Argosy Private Equity; and RSM discuss how private equity firms are trying to drive growth in their manufacturing portfolio companies. Topics include how labor prices in China and U.S. energy have changed the game; what small and mid-sized manufacturing companies need to thrive in a new environment; and why generational change and healthcare uncertainty spell opportunity.


Driving Growth in Manufacturing: The New US Manufacturing Opportunity

David Snow, Privcap: We are talking about a fascinating topic, the manufacturing sector in the United States and the private equity opportunity that that sector now represents. Things have changed dramatically with regard to manufacturing around the world and all of you see this first hand in investing and working with clients. I’m fascinated to hear your perspective. Why don’t we sort of set the stage in U.S. manufacturing and talk about what some of the most important trends are that are going on around the world that are impacting the sector that you all work in. Maybe starting with Anand, what do you think are some of the biggest drivers of the changes in the space that you invest in?

Anand Philip, Castle Harlan: So Castle Harlan has been an investor in the industrial sector and manufacturing broadly for a very long time. We are on almost a weekly basis, walking plant floors of portfolio companies we own and in addition, companies we’re looking to acquire. One of the big changes we’ve seen over the last 15 years is in relative cost positions. So 15 years ago, manufacturing wages in China, for example, were significantly lower than what they are in the United States. They were, order of magnitude, 33 times lower. You then take wage inflation in China, combined with a lack of wage inflation here in the U.S. and today that delta is more like a five to six times difference. So what you’ve got is a scenario where you don’t have China being as cost effective as it was then. You, in addition, throw in the hidden costs of offshoring which are, for example, a longer lead time, tying up your inventory costs as your products flowed across the ocean, and effectively, the U.S. is much more competitive relative to China today. You also have a scenario where jobs that could have been off-shored are generally gone, by and large. And we’re seeing, to some extent, a resurgence of manufacturing in the United States and our estimates, and we’ve seen reports that there’s 10 to 30% of jobs that have gone away that could come back to the U.S.

Snow: Don, I see you nodding. Do you agree with what Anand has been saying, and you know, what can you sort of add to trends that are really changing the game?

Don Charlton, Argosy Capital: Well, I would add that, you know, the U.S. energy market is going to greatly enhance the resurgence of U.S. manufacturing with, you know,

the shale gas plays that are out there and the cost of natural gas coming down so significantly. I think that changes the equation with China. You know, I think most companies in the U.S. that were looking to offshore, you know, looked at China first. We’re certainly seeing a resurgence of other low-cost countries starting to make an impact like Turkey, India, Vietnam, Hungary, the Czech Republic. I think there used to be the notion that there was a low cost, low quality, poor quality and they’ve greatly improved over the years. And I think those are areas to watch for continued offshore.

Snow: How about you, Steve? What are you seeing as some of the biggest and most important trends that are changing the manufacturing space?

Steve Menaker, RSM: Ultimately, the United States is the most productive labor force in the manufacturing sector. So as a result of increased investment, we’ve seen some tax laws that have clearly encouraged companies to invest in equipment and as such they’re becoming more productive. Then I think you have the balance of the costs to bring product in. You have the quality issues that need to be in place and I think, also the U.S. dollar in relation to other currencies has been at a level that is allowing us to compete a little bit more favorably. And we still are the biggest economy in the world. So we’re the biggest consumers. We’re the place to sell to.

Snow: So the dynamic around the world is changing and there is now more manufacturing activity coming to America, how does that change the private equity opportunity? What are some important ways that private equity firms can partner with manufacturing companies to grow value? What are you seeing?

Charlton: A lot of the companies that we’re looking at are in the lower middle market so these are companies that have enterprise value from say 15 million up to 50 million. Most times that’s an owner succession issue and many of them have gone through the recession of ’08, ’09 and have really, really got burned, really had to cut costs, fire people. Those businesses are starting to rebound right now but they conserved capital. So I think there’s a really good opportunity in the manufacturing sector, especially in that lower middle market to handle those controlled costs. But also those owners can provide new capital by which to take advantage of some of the trends we’ve been talking about here today.

Philip: The other factor that’s very interesting is you’ve got corporates that are sitting with a record amount of cash on their balance sheets, which, as we all know, are earning next to nothing. You combine that with very anemic, organic growth rates and it’s a formula to do a lot of M&A. So the question is why hasn’t that trickle of deals that they’re doing expand into a flood of deals. And the reason we think there hasn’t been a feeding frenzy is because on the other side, there still is a significant amount of uncertainty out there. The economy does appear to be on the mend, but

that being said, there’s uncertainty around tax rates, there’s uncertainty around future growth, there’s uncertainty around Europe, and as a result, you’ve got these corporates that want to keep a higher margin of safety and more cash on their balance sheets. They also, as you mentioned, cut a lot of costs of the downturn. So if you’ve already cut your cost structure one time, if there happens to be another slow down, there’s nothing else you can cut. You’ve already maxed out your profit margins. And so you’ve got to keep more cash than you otherwise might just to protect yourself. So what you’re left with is this battle between wanting to do more deals and a need to be more conservative. And so it’s the traditional and historic investor debate of greed versus fear that we’ve come back to.

Menaker: I think with this Renaissance of manufacturing – you’ve seen the politicians speaking  about it  – companies  are  speaking about  driving more manufacturing into the United States. One of the other activities we’ve seen is really about large corporations taking non-core businesses and putting them into the market. And we’ve really seen quite a lot of equity activity around that space where they know who the buyers are, it’s not trying to encourage the family business to sell it when he wants to hold onto it as his medal of honor. And so I think that transaction seems to happen a little bit more but I think it does become, as we’ve seen, a little bit more active and a little bit more aggressive.

Charlton: In terms of the uncertainty, I think the healthcare costs and the new changes that are coming down the line is also creating a lot of uncertainty with some of our portfolio companies. Not really know what the true cost is going to be. I know we have a portfolio company that’s facing a $5 million ticket to embed Obamacare across their workforce, which is a significant item.

Philip: And what percent of their overall cost would that represent?

Charlton:    It’s, you know, this is probably a seven to $10 million EBITDA company so it’s a huge–

Philip: It’s eating profits.

Charlton: –it is and it’s going to, you know, change the way they hire. It’s going to change the number of hours people work and so it’s a significant-, you know, you look at some of the low cost countries and they don’t operate under the same regulatory environment that our business owners do. So, I was hoping, in the next couple years we’ll see something that will help some of these owners be able to hire more people and do it more cost effectively. But they’re competing against low cost countries – where typically that isn’t the case.

Menaker: And made a great point about all companies really have driven their costs down, taken the last two or three years to do that so it’s really

about creating an opportunity to drive revenue. And I think ultimately, that is the opportunity perhaps, that private equity can bring to some companies, is driving the top line. I think most people know what to do with the bottom line.

Snow: Well, that’s a good segue into the topic of, you know, private equity firms like to talk about they bring a lot more than just capital to their investments. And so, what do a lot of these manufacturing companies that you’re in touch with and that you own, need to get to the next level of growth? Do they need technology? Do they need better management? What can a private equity firm bring to improve the value of these manufacturing companies?

Menaker: All the above, I mean everything you just mentioned. I think really it is depending on each of those companies but in a situation that I’ve seen is that you’ve had companies that have been mature, they’ve nurtured themselves, and these owners really don’t know what to do next because they’re only doing what they’ve known forever. The market’s changed the way the world communicates, the speed at which you have to react into the marketplace. So they’re not really capable or experienced in making that change, and I think there are significant resources that private equity or other investors really bring to the mix.

Philip: And business as  usual hasn’t  worked for  a little bit  of time  and it’s definitely not going work going forward. So all the things you talked about, implementing new systems that allow you to take the data that you have as a company and be able to make actionable decisions based on it, those types of things are going to be critical going forward. And so we see companies all the time that have information that they don’t use or utilize and part of what we do is try to be able to help them analyze that information in much more effective ways. A very simple example is a company that has a good understanding of its business down to a gross profit line. And certainly might have through its manufacturing costs. But when you take its fully cost structure, they absolutely don’t understand how the business works. And if you can help analyze the business in those manners, you can make better decisions in terms of which customers you should be targeting, which customers you maybe want to fire to some extent, and other types of appropriate business decisions.

Charlton: Yeah, they say one of the most undermanaged resources in all of business is pricing. So a lot of times when we come into a company, a company spends so much time and resources and team members focused on cost control, but the level of pricing, really has a much bigger impact on the bottom line. So we typically bring in experts who do this for a living and have done it, you know, for hundreds of companies. And I think it really opens the owners’ eyes that there’s real opportunity to-, just like you said, some customers may be actually costing you money and you have to fire them. And, you know, the certain way to implement a price increase may not be an across-the-board price increase but it’s

stratifying all your products and figuring out where you can gain the most ground.

Philip: And one of the things on the pricing topic I think is interesting is that many management teams in the manufacturing sector especially are scared to take their prices up.

Charlton: Absolutely, absolutely.

Philip: They are still playing a market share game as opposed to a highest profitability game. And so they say-, the moment you bring up the pricing issue they say hey, if we take prices up, so-and-so is going to take all that business. And part of what we do is, as you mentioned, try to do it on a very selective basis with rationale, with explanations you can justify to customers because of the way your business works, because of the value you add to the products you then sell onto them. And as a result, you can end up in many of these cases, taking prices up quite dramatically and quite interestingly based on the specific customer.

Charlton: Totally. Many times they think their customer’s going to leave. When in actuality, rarely do they leave.

Philip: I have almost never seen that example.

Menaker: Let’s talk about geography because that’s one of the opportunities that I’ve seen with some of my clients where private equity has created that push to expand beyond the U.S. geography, to go international, and that’s something we clearly have identified with our clients that perform better in a lot of cases, or operating on a worldwide basis. There is a bigger economy than just the U.S. and so then it’s either the experience of Don maybe you had referenced yet – some experience with helping companies expand beyond that marketplace so that they do participate and open up new doors. Because private equity clearly needs the top line to grow, too, right? You can’t just create value. You can’t just create value-cutting expenses in the long-term. One client I’m working with now is looking to establish potentially there or another location either in Europe or in China, simply because there’s a market there and they need to find that opportunity. Never would have done that had they been on their own.

Snow: What is the mood like now for the future, compare it to maybe, you know, 10 years ago? Is there a big difference?

Menaker:     There’s clearly a lot more talk about manufacturing being the right place to be in this market. I think there has always been a push. We continue to be the largest manufacturing country in the world. We are the largest economy in the world. So we shouldn’t surely discount that. I think there just needs to be a focus back on where we hare. We have strengths. We are the most productive of any employment force in the world. We

absolutely sell more and so we just have to find that opportunity where people look and you have to grow. So without that growth and that push to growth, it’s really going to be impossible to get there.

Charlton:  Yeah, I think-, we had talked about this earlier, I think the lack, we see that a lot of owners struggle with finding talent ‘cause manufacturing technology has increased. You know, a lot of our college graduates aren’t going into these programs and I think we’re losing somewhat of an edge internationally by not getting our best and brightest in the manufacturing field.

Menaker: I saw a study that showed that 80% of the people in the United States support manufacturing and when they asked whether they wanted their children to go into manufacturing, less than 20% said yes. And so I think that talked maybe a little bit about the dirtiness of that field. But there are clearly opportunities. Many of our companies we work with are having a difficult time finding skilled laborers. I don’t know whether you’ve found that with your investments, but finding that skilled person who wants to work in manufacturing is tough.

Charlton: We’ve seen the ones that have been successful are actually small manufacturing companies who take it on their own. They say I’m going to go to a local technical school, I’m going to set up my own program, I’m going to fund it and it provides a great source of highly skilled labor and they can cater the curriculum to the type of worker that they want.

Philip: We actually had one instance where we had a bus service that would bus in workers from nearby towns because a lot of them wouldn’t necessarily want to otherwise commute and come in over here. And at certain levels, you’re absolutely right; it’s very hard to find the talent. So you want to find a technical position, like a CNC machinist. There are not a lot of guys out there who are willing to fill a position like that, partly because as you said, they don’t have the expertise and the guys who did it are from generations ago. And once they phase out, there’s a huge gap sitting in between there.

Charlton: Absolutely. Yeah, you wonder how that transition is going to occur. I think 55% of businesses in the U.S. today have owners that are 55 and older. And I think 35% of those are 65 and older. And a lot of them I don’t think have done a really great job of transferring that knowledge they had growing up on the factory floor and passing it to the next generation. So I think these types of programs really need to feel the gap if we’re going to compete globally in the manufacturing environment, which I think we can, based on all the factors we talked about. You know, energy. There are a lot of positives. I just think we need a little bit of help.

How does a RSM engagement with a private equity client typically begin and evolve?

Menaker: So naturally the first phase that we might engage in with somebody is really around the transaction; where they’re interested in making a purchase, they want to kick the tires, they want to have a deeper understanding of the numbers. And so we’d involve our transaction advisory group specialists where they spend all their time focusing to really come in. And it’s using people that have experience working on manufacturing companies with that specialization so that when we get inside, we can identify some of the issues, weaknesses, and/or potential opportunities so that the private equity groups have a real deeper understanding of what they’re looking at. We then can evolve from, if the transaction proceeds, depending on the size, sometimes they need help with integration, how do they bring together, whether they have to put in new systems. Sometimes that has happened as we’ve seen it from carve out situations. We’ve also seen where they need some help just in transitioning to a better structure, different reporting, private equity groups. Depending on the size, larger deals might look to us for some of that integration assistance. And then ultimately we roll into what it looks like on the backside of auditing, tax returns, tax structuring, all those things that really have to take place. And those are just critical as the upfront costs because you’ve got to make sure that it’s properly structured and that the financial statements really can ultimately be audited and issued the right way.

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