Trends in Manufacturing Transactional Activity: Is it the 1980s again?
By Dennis & David Kebrdle
Posted: 11th June 2018 08:54Our practice at Chikol Equities, Inc. “Chikol” began in the early 1980s when we completed the first of about 15 leveraged transactions, mostly in the manufacturing and distribution space with our last exit occurring in 1999. We didn’t have sufficient equity to work with, so our transactions relied upon about 95% debt, which was a combination of senior secured and mezzanine. Back then, we were paying in the teens for senior financing, with mezzanine carrying a higher current rate of return along with the usual “equity kicker”. The prices being paid reflected the “value & cost” of funds being used in the marketplace. The expensive cost of debt is a dramatic contrast to the last four to five years where “funds cost” has been in the low single digits to borrow, while prices escalated dramatically. Buyers have been paying multiples unheard of only a few years ago. This has been a great run for sellers, and in the PE world, companies have been sold multiple times with each transaction bringing good returns and fees.
Where we find the similarities to comment on is in the velocity of transactions and the level of activity taking place. In the 1980s and 1990s, PE firms moved into the lower to middle market at a rate that wasn’t there in the past. Family businesses started after the cycle of Depression and WWII were coming into maturity and the opportunity to sell was exciting. Instead of assets driving sales, EBITDA multiples brought value to cash flow rather than just real estate and equipment. It was a “boom” time for family businesses and several of the current larger operations are the result of that cycle. Many family businesses couldn’t borrow funds at reasonable rates to pass the business to the next generation, so in many cases a sale to PE firms with access to capital at favorable targeted return rates, based on enterprise value growth, became the path often chosen.
Where Chikol sees the similarities is that although funds are being lent at extremely low rates, the changes in the “rules” associated with bank lending has reduced the available funds again, but for different reasons. Whereas in the 1980s funds were just too expensive, today there is less availability so there is the same impact on sellers. Once again, the easiest path to sell a business is to outsiders who have access to funds that aren’t there for owners to use, and who can pay more than the insiders can! This has stimulated the rate of transactions again, much like it was in the 1980-90s, to the benefit of sellers.
What has this cycle done for our management support business, with the similarities of the need for improved operational processes and asset management, to justify the higher prices again? We find a great deal of similarities with the earlier period as we drive to reduce the amount of capital employed for each dollar of revenue generated. Where there was first a “go round” of the “lean” experience starting with the large manufacturers that moved down to every “tier” of supplier, the need has again returned.
The dollars being paid for a business is driving the demand for higher returns on capital employed today, rather than what the funds actually cost! Where it was a process of “cutting” costs to create profit back then, it is now enhancing velocity and improved volume per hour as a more necessary path. The targeted end result is the same, except that in this cycle the rates are not on a downward path but instead are climbing in a dramatic increase to the cost of funds.
Last time, we received the benefit of bank interest rates dropping from the 11%-17% to 6%-8% (before the recent cycle of 2-4% with no access), which reduced debt service by 50% on the interest portion of the monthly payments. Today we are faced with a doubling of debt service requirement with just a few % of increase. The recent Federal Reserve announcement of 1.25% basis point climb this year will mean a 25%-50% increase in required cash production from where we are today. So, investors that have paid based on the historic low cost of capital will be faced with substantial cost increases, surely mirroring what happened at the end of the last cycle brought on by inflation and the dollar movements.
In Summary: For those of us in the operational improvement and turnaround business, this cycle will again present opportunities to assist our investor and owner friends, to reduce the amount of borrowed funds tied up in the “process” of production and product sales. Reductions must be captured in the supply chain when the materials leave the vendor to accounts payable when we schedule them to be paid. Where the process has gotten lax, we’re seeing stock inventory levels rising to amounts we experienced in the 1980s. Producers lean on rich “stocking levels” as a hedge to ensure quick deliveries, but customers continue to often demand 60 day to 240 day payment terms, so the formula doesn’t work. Additionally, there is lack of investment by ownership in the next generation of equipment to reduce the production cycle costs (because it was less expensive today to maintain higher inventories and spend a few more hours of labour at stagnant wages). This dynamic demands a sophisticated approach for the savvy investor, who has access to funds beyond what was paid for the enterprise. They have to invest to bring greater cash flow than what was there when the place was bought, in order to cover the increased debt service, which will probably continue to increase in the years to come. The PE player with access to cash is in a better position than the individual owners, but they must move now to upgrade operations and get tighter control of capital employed for every dollar of sales being shipped.
If your firm has an investment that mirrors much of what we’ve noted in this short editorial, please feel free to contact us at (574)360-5279 or DennisKebrdle@Chikol.com and DavidKebrdle@chikol.com(574)-360-8755.
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Dennis & David Kebrdle are Managing Partners and Co-Founder of the firm and routinely speak about the industry at venues such as ACG, ABA and TMA conferences and as guest speakers at Notre Dame, IU & BG MBA programs.