April 22, 2013
Interviewed by: David Snow
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Manufacturing-Sector Deal Dynamics

What drives private equity deal flow in the changing U.S. manufacturing space? How are GPs helping entrepreneurs take their companies to the next level and realize the opportunities in this long-overlooked space? From volatile commodity prices to delicate succession issues, Donald Charlton of Argosy Private Equity; Anand Philip of Castle Harlan; and Steven Menaker of RSM discuss deal dynamics. Part two of Privcap’s series on the U.S. manufacturing resurgence’s impact on private equity.

What drives private equity deal flow in the changing U.S. manufacturing space? How are GPs helping entrepreneurs take their companies to the next level and realize the opportunities in this long-overlooked space? From volatile commodity prices to delicate succession issues, Donald Charlton of Argosy Private Equity; Anand Philip of Castle Harlan; and Steven Menaker of RSM discuss deal dynamics. Part two of Privcap’s series on the U.S. manufacturing resurgence’s impact on private equity.

Manufacturing Sector Deal Dynamics
New US Manufacturing Opportunity

David Snow, Privcap: We are joined today by Don Charlton of Argosy Private Equity, Anand Phillip of Castle Harlan, and Steven Menaker of RSM.

We’re talking about the private equity opportunity in manufacturing. It is a transforming opportunity. I’m really interested in hearing from all of you about your deal flow. What is driving deal flow in manufacturing, given the many changes around the world that are affecting the  space?  Maybe  starting  with Don.  As you  source opportunities, as  your firm  is out  there looking  for new opportunities, what tends to be some recurring themes as far as the reason the opportunity came to you?

Don Charlton, Arogsy Private Equity: In many instances, it could be add‐on opportunities. So, you know, we have a portfolio of about 50 companies, so a lot of the investment bankers or business brokers will look at our website and see similar companies, you know. So one area I’ve been looking at recently is machining, and you know, there’s a plethora of machining companies out there, and some people say the U.S. is kind of going through a renaissance and machining is undervalued. They tend to—the owners that are kind of getting up in age—have no succession plan. But machining is tough. The multiples are fairly low, unless you’re kind of in a hot area, you know. Like the South Carolina area is a very hot area right now, Boeing just built a big manufacturing plant right there, so the multiples for companies down there that have invested in technology to compete in machining, and that is going to require CapEx every year to kind of maintain the edge so they can be price-­‐ competitive, and they have to continue to invest in the newest technologies. So those types of companies command higher multiples. But ones that, you know, have some customer concentration, kind of relied on the old way to do things, trade at a much lower multiple.

Anand Philip, Castle Harlan: And I think the manufacturing sector is so broad that, as you said, it really depends on the subsector within that you’re looking at.So if you’re looking at a company that has very advanced technology embedded in it, is low CapEx, high cash generative, and did well through the recession, that’s probably going to go for a very high multiple. Whereas if you’ve got a company that has a few major customers dominating it, has issues passing through its commodity costs—which, by the way, is a very critical factor right now, because we’ve seen a lot more volatility in commodity cost—and you’ve got some businesses that have an ability to pass that through on a contractual basis and other folks who will go through and negotiate on an individual basis with each customer, which can be both a positive and a negative, it can potentially be a positive, because you can get more than the contracted price change with the customer. And by the way, when the commodity prices turn and go the other way, none of these companies go and tell the customer, “Well, the price is going down, so you can, you know, reduce what you pay us.” But on the other hand, if you don’t have the ability to pass it through, and you see a sudden swing in what is a major portion of your cost structure, and you’re in a levered cap structure, which most of these deals as LBOs tend to be, you could be in a world of trouble.

Charlton: Absolutely, and you have to be on top of your data. And you know, sometimes the system of some of these companies we buy, at least in the lower middle market, don’t have the visibility they need to into these types of cost down to the level you need to get them down to, so it just…again, it’s one more hurdle that these small owners have to face, you know, with these commodity prices. It creates a lot of stress.

Steven Menaker, RSM:
You know, Anand, you mentioned sectors. But when you look at what sectors are doing well—clearly the oil and drilling, heavy machinery; we’ve seen Caterpillar—large corporate heavy-­‐equipment manufacturers have done very well as a result of the worldwide economy, and there are some sectors that are struggling, whether it be housing… So you just have to find that right space, and it has to have the opportunity for growth. If there’s not that growth, it doesn’t matter, really, what they’re doing or what they’re making; it’s going be a tough sell.

Philip: And the other thing as far as evaluations are concerned is that many of these manufacturing industries tend to be cyclical. And as a result, in a downturn you’re going to see their multiples artificially look inflated, because their earnings are at a cyclical low, which actually

might be the best time to be getting into them as opposed to when it’s the other way around. So you need to be quite careful of that dichotomy.

Snow: Let’s talk about the motivations of sellers—I mean whether it’s an individual seller, the founder of the company, or a corporate seller. Why are they seeking liquidity event, why are they seeking to divest the vision, and sort of what is unique about the current environment, maybe, compared to previous cycles?

Philip: I would say, in the current environment you’ve got, as I mentioned, these companies tend to be cyclical, and you’ve got an entire industry that went through the greatest financial crisis since the Great Depression, so they saw how bad it could get. And if you live through that and you came out with your equity intact, and now you’re starting to see an upswing, this might be a good time to get out—especially if you’ve been a business owner and had your company for 20 or 30 years and are looking to succession issues, this might be a good time to lock in what is a good run of the business. Now, we have certainly seen a dichotomy in terms of good business as “bad business.” Good businesses, again, are ones that made it through the recession relatively well and can command very attractive multiples. You’re finding those are very hot properties, and a lot of people are chasing them. The companies that didn’t do so well need to create a story around why they’re going to be different in the future, and those are the kinds of opportunities you can get at a much better valuation. The question there is understanding whether you’re truly going to be able to change the business model, or you’re just waiting for the next cycle to catch you.

Menaker:      We’ve seen clearly a trend of companies that have been purchased by private equity. Their funds are aging out, they want to dispose of it, and so they’re onto the next opportunity. So it’s created more companies that are into the mix that are trying to sell and create value, and someone looking that believes they can take that strong foundation and take it to another level. But again, I think it likely requires some additional investment. You can’t just buy the company and hope that it gets bigger, especially if it’s been nurtured through a private equity experience already where there’s a much stronger focus on cost controls, business planning, focus on what’s going to drive that value.

Snow: Potentially it sounds—now this is common in the middle market in general, which is succession issues and sort of company founders at a point where they don’t quite know what to do with the business or

they want to get out of it. Sounds like it is particularly true of the manufacturing sector. Are there a lot of founders out there that, you know, are looking for an opportunity to completely sell and go to the beach? I mean, how many of these founders want to stay on and, you know, participate with the private equity firm in the next stage of growth?

Charlton: I’d say the majority of our deals, management is always rolling some piece of equity. You know, the lenders who finance some of the deals we do, they like to see that while they like to have skin in the game, and, you know, it gets the entrepreneur, the seller, to buy into the growth story and get the—

Snow: Are you less interested in buying the company that’s just a 100 percent sale and the owner’s leaving?

Charlton: Well, it depends if you’re going to back management or replace management, and we’ve done both those deals. I’d say about 80 percent of the deals we do, we back management, and then there’s an orderly transition that’s agreed upon up front, which puts a little bit of risk in the deal, because you’re taking the seller out who used to be the person who’s kind of controlling the company. And you’ve got to recruit the right type of person in behind that person and get the right team in place to help grow the company but, you know, I think, aligns the interest of private equity with the seller to get that second bite of the apple. And in many times it’s worked out that it’s been bigger than the purchase price, and we’re happy and they’re happy.

Menaker: It’s just about making sure that there’s a management team in place—that if it’s just one individual that you’re buying and that person gets tired or something happens to them, there’s less value. So I think ultimately, I would think, Anand, you’d want to have a team that’s strong to begin with.

Philip: Absolutely. You’d want to have a very deep bench. Sometimes in middle-­‐market companies, we’re typically doing acquisitions between $100 million in size up to a billion in size, roughly speaking. But in many of these opportunities the team is very good at the top, but it drops off very quickly after that. And so part of what we try to do is complement the bench by bringing in a board that has at least three independent members, which would make the company stocks compliant from that perspective, even if we don’t have any intention at that point to take the company public. We want to position it to be able to do those types of things, and one of the goals is to have at least one of those members be in a position to step in on an interim basis and run the company if we need to do it.

In addition, we’ve got an affiliates network which consists of 40-­‐odd individuals, the majority of whom are executive, C-­‐level executives of former portfolio companies who’ve been successful with us, and they help us in a number of ways. They could help us with due diligence, manufacturing opportunities. They could be when we go in and meet with a company, walking the plant floor with us, and they will also, as I mentioned, to some extent be involved with the company post-­‐ close. And a subset of those individuals will be on the board of the company with us. So we try to complement the team in that manner. But you’re absolutely right, because one of the things we’ve found with entrepreneurs who have had businesses for a very long time is they could have a head of sales or VP of sales, but the entrepreneur who built the company still probably has the best relationships with the major customers, not the VP of sales. So we need to see through the management team and understand all those dynamics before you allow someone to take 100 percent of their proceeds and go to the beach as you mentioned, David, because that may not be in the best interest of what your customer thinks.

Charlton: And you hope those entrepreneurs can adapt. But many times they can’t adapt. They can’t adapt to even a 100-­‐day plan, because they never operated their business with a 100-­‐day plan, or three-­‐to-­‐five-­‐ year low-­‐ They didn’t operate on a budget, so many of these times they just can’t adapt. And then that’s the time where you have to bring somebody in.

Menaker: It’s really… That’s an opportunity for long -­‐range planning that many companies don’t even go through, that they run the business, they deal with this crisis, they go on to the next. But I think an opportunity where there’s  a  new  buyer  or investor  forces you to look  at  the business—peel back the onion, so to speak—and look at what can we do better. And I think the resources you just spoke to really can make a difference, and that’s where we’ve seen opportunities where they create more value. And that’s a win-­‐win for everybody.

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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