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By Andy Zaleski and Jerry Dentinger
March 22, 2012
In a recent study by BDO USA LLP, 70 percent of private equity (PE) fund managers expect to close 2-3 deals in 2012. And 28 percent of those private equity professionals see the greatest opportunities for new investments in the next 12 months in the manufacturing sector. This is welcome news for a manufacturing industry in need of capital for future expansion and innovative growth.
Private equity - with its significant amount of dry powder to be put to work - is continuously looking for investment opportunities in Michigan and around the Great Lakes region. Manufacturers in Michigan and across the Rust Belt, could equally benefit from increased access to capital from PE funds to secure growth opportunities through mergers and acquisitions (M&As), and to build inventories.
PE Investments to Support Growth Through M&As
M&A interest will remain very high for the manufacturing sector as the economy continues to improve. This interest is driven by manufacturer’s general optimism around their perceived prospects for 2012: U.S. manufacturing plants expect revenues to increase by 10 percent (median), supported by a 5.7 percent (median) anticipated increase in workforce sizes. Yet many of these same manufacturers have identified emerging skills shortages among their workers - 39 percent of manufacturers report that they do not have the skilled leadership and talent to drive continuous operations improvement. This issue is compounded by the fact that the vast majority of manufacturers don’t have business systems and equipment in place to support strategic initiatives. For example, only 18 percent of U.S. manufacturers have state-of-the-art business systems and equipment in place to provide long-term support for world-class customer-focused innovation. And only 11 percent have business systems and equipment to provide long-term support for world-class supply-chain management. These same manufacturers face higher expectations for designing and delivering new products or next generation products. Given these apparently daunting challenges, many manufacturers of all sizes would welcome the right financial or strategic partner to assist in providing the capital and management support to help take their companies to the next stage of growth and profitability.
Capital Infusion from PE Funds to Build Inventories
Those manufacturers who weathered the recession have generally returned to profitability and are running at higher productivity levels but not yet at full capacity. Inventories of manufactured durable goods rose for the 25th consecutive month in January 2012, according to the U.S. Census Bureau. The ability for companies to build their inventories to match demand will require access to alternative forms of capital such as from PE funds, as debt markets continue to be luke warm, particularly for middle market companies.
Challenges for Middle Market Manufacturers
Interestingly, since the recovery started, most investments have been concentrated at the lower end of the middle market in the $50 million to $100 million range and the volume of deals below expectations.
There are two main reasons for this being the case:
Risk adversity – Private equity investors remain risk adverse as they look to put capital to work in light of challenges they still face with their existing portfolio companies in this sector. They cannot afford an underperforming asset at a time when limited partner investors are watching very closely. In many cases, private equity investors have limited themselves to add-on acquisitions as they continue to hold and work to add value to their portfolio companies through product and market extension strategies.
Valuation expectations – While it is true that economic conditions have improved in Michigan and the Great Lakes region, growth rates have been modest. The return to profitability in most cases has been due to cost cutting first and top line growth more recently. In addition, price increases have not fully kept up with increased input costs therefore overall growth rates have been subdued. Therefore, there is a shortage of companies that have come to market that present the growth opportunities to justify the valuation multiples being generated through the auction process. In addition, strategic buyers, also with record levels of cash to invest, have out-bid private equity buyers. While financial returns clearly drive investment decisions, sometimes other strategic issues like capacity constraints, competitors and industry position or market access drive strategic buyers to pay higher prices than financial buyers can justify.
An increase in private equity activity in the manufacturing industry hinges on one major driver: the economy recovering at a faster pace. As the economy improves, Michigan and Great Lakes region manufacturers will be in a better position to attract private equity investment in order to meet growth objectives. At the same time, private equity funds will be looking for larger middle-market deals as they put their dry powder to work.
Andy Zaleski is a tax partner at BDO USA, LLP in Detroit, and Jerry Dentinger is managing director Transaction Advisory Services at BDO USA, LLP in Chicago. BDO USA LLP is a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. More information at www.bdo.com.
