PE Investors Can Find Hidden Treasure in the Lower Middle Market - Part 2

In essence there is too much money chasing too few deals. In that article, I suggested that there are opportunities in the lower middle market that PE firms may be overlooking: for example, companies that adopt disruptive technologies to improve their production and distribution processes. What follows are additional guidelines for PE to find attractive investments.

Look for Opportunities in Shrinking Industries

As investors bid up the prices for fast growing companies with industry-leading products and strong competitive advantages, they are ignoring opportunities of less glamorous businesses in more mature industries. These companies have a very different risk profile:

• Their technologies and processes are time-tested and proven
• Their markets are well-known
• Their customers’ needs and purchasing behavior is well-understood

Companies in the “old economy” are available at much lower valuation multiples because their growth rates are lower and fewer investors are interested. Many may be spin-outs of larger public companies, being cast aside because their growth rates are low and they are seen as a drag on PE multiples and stock prices.

Obviously, not every company in a mature market is an attractive investment opportunity. Investors should be looking for businesses that have:

• A strong connection with their customers
• Well-developed production, distribution and service capability
• A well-established brand and reputation in a local or regional market

These strengths can make them attractive platform investments or add-on acquisitions in a roll-up strategy.

Even when an industry is shrinking and other capital is fleeing, there may be promising opportunities for clever investors to generate substantial profits by buying distressed assets and re-deploying them in innovative ways. For example, the commercial printing industry is going through a rationalization broadly linked to the development of the internet. Customers no longer publish voluminous quantities of expensive 4-color glossy product catalogs and marketing collaterals—they can be produced and updated much more easily and cheaply on their easy-to-access, always available web sites. Yet, most middle market companies still buy large format special sale banners, business cards, and even shipping labels, sourced from an efficient supplier with the correct specialized equipment, who will also stay attentive to their delivery needs.

As a result, innovative companies have identified opportunities in an industry that others ignore.   Because of transportation costs and the need for responsive turnarounds, commercial printing remains a local or regional business. By understanding and accepting the inevitable need to downsize the overall industry and rationalize its capacity, innovators can acquire and roll-up a number of local commercial printers, consolidate production and eliminate redundant costs. Each acquired company brings a book of loyal clients who can still be sold and serviced locally, while printing and distribution are performed regionally. With lower costs and greater volume than any of the formerly independent printers, the parent company can invest in more efficient technologies to widen its competitive advantage over the remaining independent printers and establish a strong regional or national brand.

Target Vulnerable, Complacent Incumbents

The overwhelming majority of lower middle market companies are closely held or family owned and operated. This ownership structure can cause some special challenges and compromises that often cap a business’s growth and profitability at levels well below full potential.

Conflicting Stakeholder Interests 

In some cases, the owners of the company have very different financial needs, risk tolerance and investment time horizon. In one family-owned manufacturing company the goals of the 40 year old CEO were very different than those of his grandmother, the largest shareholder and widow of the founder. Their conflicting needs and perspectives make it difficult to create strategic alignment among the owners and other stakeholders.

Reluctance to Invest 

The CEO’s vision and growth strategy will require additional investment, but some family members depend on dividends as their only source of income. While the CEO sees that industry trends present both the need and opportunity to consolidate the industry, and to acquire or merge with related companies over the next 10 years or so, some owners in prior generations have a much shorter time horizon and much lower risk tolerance. As a result, they are reluctant to reinvest more capital in the business and are even more reluctant to borrow money to fund investments.   They worry about lower dividends due to reinvestment or debt repayment, and they are especially reluctant to pledge assets as collateral.

Vulnerable to Hungrier Competitors

Some owners’ main objective is steady predictable income, providing a comfortable lifestyle, avoiding the investment and added risk that growth requires. Nothing wrong with that of course—but it makes the business vulnerable to newer, hungrier, well-financed market entrants, such as those PE investors look to acquire.

Stuck in Their Ways

Sometimes the challenge is not lack of owner alignment, but lack of strategic vision and leadership. Owner-entrepreneurs may be more capable and comfortable working with their tools than working on the company’s strategy. As one company president told me “my definition of strategy is doing tomorrow what you did today, just doing it a little better.”

Lack of New Product Development

Complacent companies without strategic vision fail to develop new products and customers, adopt new technologies and invest in developing and retaining their key people. The business often lacks clear, well defined systems and processes. Verbal direction by the hands-on owner-entrepreneur seems to work just fine. These businesses can be successful and profitable in the short term, despite the lack of investment in future success.

If the owner-entrepreneur wants to take some cash out of the business by selling some of his equity, a complacent company can become an attractive investment opportunity for the capital provider. However, aggressively growing the value of the business will require transforming many aspects of the company—investing in more efficient production technologies, adopting software-enabled production control and resource planning processes and upgrading the capabilities of the management team by internal development and new hires. Changes of this magnitude cannot succeed without the buy-in and active support of the owner-entrepreneur. But, because old habits are hard to change, savvy investors will insist on majority control and a planned program to replace the owner with new leadership in an orderly transition.

Manage Risks in Transforming a Complacent Company

The major risks that are involved in transforming a complacent company are organizational, operational and financial. To manage these risks, potential investors should:

• Engage people with deep industry experience and a network of industry relationships from the earliest stages of their investment process. Screening out companies that do not have a strong set of stable customer relationships and those that are unlikely to adopt the value-creation transformation plan avoids spending time and due diligence fees on prospects that have little chance of success.
• Once you get to an LOI, the due diligence team should include people who know the industry. They can use their operating experience and industry contacts to assess the management team and understand the company’s growth potential—both are essential to assessing and managing the key risks.
• Including experienced industry executives on the board, with a special role of understanding and influencing the required organizational, operational and technology changes is very valuable. If necessary, they can step in as an interim executive without missing a beat.

An experienced industry executive can also help the investors and management build a realistic 3-5 year value creation plan for the business. The plan will be built on the cash flow provided by strong, loyal customer relationships. But, key elements of the plan will be using new capital to make the transformative investments in people, process and technology that the complacent management has avoided. Making these investments pay off will require revenue growth to achieve the scale of operations that justify the investment and take advantage of higher speed processes and operations management software more commonly found in larger, more mature companies.

PE firms face new and growing challenges to their ability to deliver attractive returns on their investors’ capital. Financial engineering and traditional roll-up strategies alone are unlikely to be enough. Leading firms know that they need to find investment opportunities that others overlook and adopt an aggressive transformation plan to rapidly grow the value of a company, while managing the inevitable risks of doing so. We have discussed three types of lower middle market companies that are often overlooked as investment opportunities: technology users, good companies in shrinking industries, and complacent family-owned and closely held companies. In all three categories, including operating executives with relevant industry experience throughout the investment cycle is an important way to reduce risks and increase the investor’s odds of success.       

About the Author

Bill Heermann is a partner in the Colorado practice of Newport Board Group. Bill has deep expertise in building and running industrial manufacturing and construction companies. To learn more about Bill’s background and to contact him click here. 

Connect with Bill on Linkedin