2021 was a big year for mergers and acquisitions in distribution. Although 2022 seems primed for another bull year, NAW Fellow Brent Grover, who has offered insight and expert counsel on hundreds of deals, believes that distribution M&A has hit a peak in value and will soon begin to decline.
Grover himself worked in the distribution industry for more than 20 years at his family business. He and his brother sold it to a private equity company about 20 years ago. Since then, he’s been consulting, helping companies increase their value and work on exit strategies. He is an advisor with Pease & Associates, and is an investor in and advisory board member for Supply Chain Equity Partners, a private equity firm focused on the distribution industry.
Here’s his take on what’s coming for M&A in 2022 and beyond.
DSG: About how many deals have you been a part of?
Brent Grover: Since I started doing consulting work, I’ve been involved in a lot of sales transactions. As an advisory board member at Supply Chain Equity Partners, we look at 100-200 deals per year. We don’t buy them all, but we buy two or three and sell two or three every year, so there’s a lot of activity.
DSG: What do you see happening with M&A this year?
Grover: The market last year, in 2021, was on fire. It was a bull run for wholesale distribution companies. The real point of interest to distributors was who those buyers were and what those deals looked like. The fact is that more than half of the purchases in 2021 were by private equity funds. Fewer than half of the deals, around 40%, were strategic buyers. Looking back at 2021, I don’t think it can get any better. COVID affected all of this because it was an accelerator for acquisition activity and is still an accelerator for digital.
The private equity funds still have a lot of what they call “dry powder.” Billions of additional dollars were invested in private equity funds last year, and those companies are paid to deploy that money. The strategic buyers out there in wholesale distribution have very deep pockets right now.
The cash flow has been fantastic. Before, most of these distributors had never had this much cash. One of the reasons is that a lot of receivables at inventories returned to cash during the 2020 period when business wasn’t so good. Ironically for distributors, when business isn’t good, cash usually is because their current assets revert to cash. Government money also came in and forgave loans which added a lot of funds.
So the question is, how long will it last? Are we on the downward slope? I would say yes. How long will it take to get to the bottom of the hill? Everybody’s guess is different on that, but looking ahead to the rest of 2022, I don’t think this is sustainable.
DSG: You don’t think it’s sustainable as far as the prices people are getting, but what about the number of deals?
Grover: I don’t think that’s sustainable either. One of the things that sparked activity last year was privately-owned companies. To be clear, when I talk about M&A in distribution, I’m talking about privately-owned sellers. Most of them are family-owned businesses.
DSG: How do you think rising taxes will affect M&A? Would you say that fear of taxes going up was driving deal flow?
Grover: I definitely think so. The standard long-term capital gains rate that people were accustomed to was 20%. But, it could be 39% or more for people who live in high-tax states. Those sellers will also get hit with state income tax, in some cases over 10%, which is not deductible from federal tax.
Starting last May, a lot of people called and asked, “Can I get this business sold this year?” One of the questions was also when the changed taxes would be in effect. All kinds of things were up in the air. That’s without even mentioning estate tax, which wouldn’t kick in until 22 million for some families in the past, but is now going to kick in around 11 million.
DSG: Let’s talk about the macro and microeconomic factors affecting acquisitions in distribution.
Grover: The nominal growth this past year was 11.7%, and I think there’s a lot of premature celebration going on. I would rather compare it to before COVID to see how we’re doing and consider what 2020 and 2021 would have been like under more normal circumstances. So 11.7% doesn’t blow me out of my chair.
Wholesale distribution’s overall growth rate in 2021 was 7.5%. That’s the biggest I’ve ever seen, and I’ve been in the business for 40 years. So, why is that? How much of it was inflation? How much is a premature celebration? I think we’re looking at something that is not sustainable.
DSG: If I own a distribution company and am interested in selling, should I sell now? It appears that in your view, valuations are not going to get higher for the next few years.
Grover: I don’t believe they will. If I had a company to sell, I would be actively working on it, or I would’ve already sold it. You can’t underestimate the fact that it takes a while for a well-managed sale to happen. It doesn’t happen overnight. People sometimes ask, “Can I do it in six months?” You can, and it gets done in six months all the time if the ball’s already on the tee. But, if you’re just starting out and you’re looking for buyers, I’d say nine months to a year.
We’re on a rollercoaster. I think we’re at the top of the hill, and we won’t go further up. How long will it take to start going down, and how rapidly will it decline? I think there are a lot of risks in waiting.
DSG: Many distributors made more money this year because they adjusted their inventory values to counteract inflation. How do you see pandemic supply chain issues and the resulting commodity price changes and inflation affecting M&A activity in 2022?
Grover: The answer to that question has a lot to do with distributors who have pricing power and don’t have much to fear from raising the prices of their products. We don’t have any control over copper and steel, but copper is really important to you if you’re an electrical distributor. If you’re in packaging, plastic resin is important to you. So, if you have pricing power, you can pass that on to your customers.
This gets into the Distribution Strategy Group’s area of expertise. You know who has pricing power and a truly distinctive value proposition. That’s not easily copied and is highly valued by customers. The skill of your salespeople is also important. Many have never sold in an inflationary environment before. Some managers don’t know what it’s all about either. If you aren’t diligent about keeping up with price increases, you’re going to go backward.
Retail sales have been strong, making everyone feel good, but we’re not in the retail sales business. Look at the Purchasing Managers Index (PMI) – it’s slipping. The cost of a 40-foot container was $7,000 a year ago, and now it’s $19,000. There’s a shortage of truck drivers, and they have 10-hour day limitations. I don’t believe these things are going to go away quickly.
DSG: What factors do you look for as a buyer, and how can you prepare as a seller?
Grover: It’s like selling your house. If you have a leaky basement, it doesn’t matter how great the rest of your house is. You’ve got to know the basics. Do you have a system that works? What’s your digital strategy? Do you have a strategic plan? What about your management team? Are they all over 70? How am I going to come up with a story for buyers about why your company would be a good investment for them if it wasn’t a good investment for you?
So, why would someone want to buy your company? Ask what’s your value proposition and is it distinctive? What do your customers value about your company, and can you demonstrate that with information?
We’ll look at a three-year trend on each of your sales territories and their customers and look at sales, profit margin and other things that drive profitability. Buyers today are smarter than ever, and when you sell to a private equity company, they’re going to do a market study and do a quality of earnings analysis on your business.
What people want is EBITDA, which is a proxy for cash flow. They want EBITDA and growth. If the adjusted EBITDA of the company isn’t at least $2 million, most financial or strategic buyers won’t even look at it. If doing a deal is significant, and you’re not getting a lot of upside from it, you’re not moving the needle very much. The point is that I could be using my people and my time to make other deals that would be more meaningful to my company.
DSG: Where does a sell-side banker bring value to the process? Do buyers appreciate their participation?
Grover: Before I blow the horn of advisors like me, I would say that you need to have an attorney who’s accustomed to doing transaction work of a similar size and scope. There are a lot of attorneys out there who do deals, but that’s not what they do every day. So I think you ought to find a firm who can help you out or another lawyer at the firm you’re already using.
The accountant is also very important. The lawyer keeps you out of trouble as far as risk, but the accountant helps you get as many after-tax proceeds as you can. So you need a skilled accountant who’s really a financial advisor.
So then, what role does the sell-side advisor take? You need someone who can help you find the best buyer. When you have someone who has expressed an interest in your business, we need to vet them. Sometimes the buyer you already know is the best but may not pay as much as somebody else. A good advisor can help you find the best possible situation.
Watch our interview with Grover: