Driving Growth In Manufacturing

U.S. manufacturing is undergoing a renaissance, and private equity firms have taken notice. In this fascinating discussion, Donald Charlton of Argosy Private Equity, Anand Philip of Castle Harlan, and Steven Menaker of RSM compare notes on ways that private equity firms are driving growth in their manufacturing portfolio companies and taking advantage of new opportunities in this long-overlooked space.

Privcap: What are some of the biggest drivers of change in the manufacturing space, and what do those changes mean for private equity investors?

Anand Philip: Castle Harlan has been an investor in the industrial sector, and manufacturing broadly, for a very long time. On an almost a weekly basis we’re walking plant floors of portfolio companies we own and companies we’re looking to acquire.

One of the big changes we’ve seen over the last 15 years is in relative cost positions. Fifteen years ago, manufacturing wages in China, for example, were significantly lower than what they were in the United States. They were 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. You throw in the hidden costs of offshoring—which are, for example, a longer lead time, tying up your inventory costs as your products flow across the ocean—and effectively the U.S. is much more competitive relative to China today.

We’re seeing a resurgence of manufacturing in the United States. We’ve seen reports that 10 percent to 30 percent of jobs that have gone away could come back to the U.S.

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?

Donald Charlton: A lot of the companies that we’re looking at are in the lower middle market. These are companies that have enterprise value from, say, $15 million up to $50 million. Many of them have gone through the recession of ’08 and ’09 and really had to cut costs.

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 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.

Can we expect to see more private equity deals in the manufacturing space in the near future?

Steven Menaker: I think with this renaissance of manufacturing—you’ve seen the politicians speaking about it—companies are 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 on to it as his medal of honor. And so I think that transactions are becoming a little bit more active and a little bit more aggressive.

What do these manufacturing companies 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. A situation that I’ve seen is that you have 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 bring to the mix.

Is everyone in agreement on that?

Philip: 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 make actionable decisions based on it—those types of things are going to be critical going forward. We see companies all the time that have information that they don’t use, and part of what we do is try 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 full cost structure, they absolutely don’t understand how the business works. And if you can help analyze the business in those matters, 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.

Are there other areas where private equity can make a difference?

Charlton: They say one of the most undermanaged resources in all business is pricing. A lot of times a company spends so much time and resources and team members focused on cost control, but 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 for hundreds of companies. And I think it really opens the owners’ eyes. They can see, just like you said, that some customers may be actually costing you money, and you have to fire them.

The way to implement a price increase may not be across the board but stratifying all your products and figuring out where you can gain the most ground. Many times they think their customer is going to leave when, in actuality, rarely do they leave.

What is the mood like now in U.S. manufacturing? Compared to 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. We continue to be the largest manufacturing country in the world. We’re the largest economy in the world. So we shouldn’t discount that. We’re the most productive of any employment force in the world. We absolutely sell more, so we just have to find that opportunity to grow. Without that push to growth, it’s really going to be impossible to get there.

What are some of the biggest challenges that could derail that growth?

Charlton: We see that a lot of owners struggle with finding talent because manufacturing technology has increased. 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.

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. At certain levels, you’re absolutely right—it’s very hard to find the talent. Say 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.

What is driving deal flow in manufacturing, given the many changes around the world that are affecting the space?

Charlton: One area I’ve been looking at recently is machining. There’s a plethora of machining companies out there, and some people say the U.S. is going through a renaissance and machining is undervalued. The owners are getting up in age and have no succession plan.

But machining is tough. The multiples are fairly low unless you’re in a hot area. Like, the South Carolina area is a very hot area right now; Boeing just built a big manufacturing plant there. So the companies down there that have invested in technology to compete in machining are commanding higher multiples. But ones that rely on the old way to do things trade at a much lower multiple.

Menaker: When you look at what sectors are doing well—clearly oil and drilling and heavy machinery. Large corporate heavy-equipment manufacturers like Caterpillar have done very well as a result of the worldwide economy. But there are some sectors that are struggling, like 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.

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

Philip: 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. If you lived 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 businesses and bad businesses. Good businesses 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 if you’re just waiting for the next cycle to catch you.

Are there a lot of founders out there who are looking for an opportunity to completely sell and go to the beach? How many of these founders want to stay on and participate with the private equity firm in the next stage of growth?

Charlton: The majority of our deals, management is always rolling some piece of equity. 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 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.

Philip: Absolutely. You’d want to have a very deep bench. Sometimes in middle-market companies—we’re typically doing acquisitions between $100 million up to a billion, roughly speaking—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.

In addition, we’ve got an affiliates network which consists of 40-odd individuals, the majority of whom are C-level executives of former portfolio companies. They could help us with due diligence in manufacturing opportunities. They could be walking the plant floor with us when we meet with a company. And to some extent they could be involved with the company post-close.

One of the things we’ve found with entrepreneurs who have had businesses for a very long time is that they still have 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 we allow someone to take 100 percent of their proceeds and go to the beach.

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. They didn’t operate on a budget, so many times they just can’t adapt. And that’s the time when you have to bring somebody in.