Greenhill & Co. Managing Director Newton Sears works with distributors to provide expert insight for better decision-making regarding acquisition opportunities, recapitalizations, valuations and other restructuring activities.
Greenhill & Co. is an advisory-focused investment bank dedicated to mergers and acquisitions (M&A), restructurings, financings and capital raising.
In this discussion, Ian Heller and Jonathan Bein, Ph.D., talk with Sears about the state of the M&A market in distribution and how both buyers and sellers can prepare.
Jonathan Bein: Tell us a little about your firm.
Newton Sears: We advise companies, owners and investors on buying and selling businesses and help them think through the optimal way to capitalize on their business. For example, if a company is evaluating an acquisition or wants to think through the preparation of selling itself, or alternatively wants to evaluate a financing structure for its business like a big dividend recap, then we have a lot of expertise to lend. Our sole focus has resulted in us being true specialists in the practice of M&A and helping businesses and owners maximize value, and that focus and expertise has allowed us to differentiate ourselves in the advisory market.
If I were to make an analogy to the distribution industry, the SKU we sell is the advice provided during a sale or acquisition. But like many value-add distributors, we wrap a lot of other ancillary advice around the sale or acquisition of a company, or in the case of distribution, the design or installation advice around that SKU. Ultimately, the relationship with the customer is geared toward helping them maximize their outcomes and create value no matter what.
We work on the sell side with sellers, on the buy side with acquirers, and with company types ranging from family-owned to large multinational, publicly traded companies. Our ability to provide advice cuts across all types of businesses and situations.
Ian Heller: You advised the distribution solutions group acquisition of Hisco on the Hisco side, correct?
Sears: That’s right. We worked with the team at Hisco from start to finish on that transaction. The Hisco transaction is an example of the fun that we have working with these management teams, owners and investors, and ultimately being side-by-side with them to achieve excellent outcomes.
Bein: Can you contrast what you do in the investment banking world with what the private equity world does?
Sears: The most significant difference is that we are not investing in businesses. We are not lending money or investing equity into the businesses that we work. We do not take ownership stakes in companies. We focus on transactions and when a seller or a buyer needs advice on how to best execute that transaction.
Bein: When you describe it as a consultative model, are you also essentially helping to market the company when you’re on that sell side?
Sears: Without a doubt. Whether it’s with a buyer or a seller, we constantly stay in touch with our contacts in the industry to keep them up to speed on updates they should know about. We help them think about their business: What are their strategic priorities, and how do mergers and acquisitions fit into that? But yes, when we’re working with a seller, we are 100% helping them market their business and preparing for various topics and nuances that will inevitably come up in a transaction.
Heller: How is industrial distribution viewed in the capital markets?
Sears: Distribution is a massive global market, and here in North America, very large, as well. The role of the wholesaler has a long history and has matured over time to a point in which they’re a critical part of the existence of their vendor and customer partners. That long history means that the industry itself is very familiar to the world of capital providers, or what I’ll call the capital markets and the individuals and institutions who are allocating equity and debt capital to different business enterprises. The capital markets know and appreciate the importance of the distribution industry.
Why is that important? In the equity capital markets, that means a lot of public and private equity capital has been allocated to the industry. As it relates to private companies, if you’re an operator or owner of a distribution business, then there’s a high likelihood that private equity capital would be interested in investing in your business.
The distribution business is tried and true, so much so that the lending world doesn’t have to learn it from scratch. If you’re an owner-operator of a distribution business, then attracting equity or debt capital is remarkably viable.
Bein: What is your perspective on the state of mergers and acquisitions in industrial distribution?
Sears: The M&A market is a nuanced topic, but in my personal point of view, transaction volume is down, however, the best businesses can and will transact in this market and not at a discount. Transaction volumes are down for a variety of reasons, whether it’s the relatively rapid increase in the broader cost of capital or of some of the fiscal and monetary policies enacted in the past 12 months. In distribution specifically, many businesses are operating and performing at historically high levels and sometimes buyers want to get a feel for what a more normalized environment looks like in terms of performance. But setting that aside, my takeaway is that the best businesses can and will transact in this market.
High-quality businesses that elect to pursue a sale are still receiving robust interest from buyers and are by no means taking a valuation haircut. How do you judge high-quality? In my experience most operators and owners have a good feel for whether they’re winning in the market, if they’re creating value through their strategic initiatives and what their perceived strengths and weaknesses would be in the eyes of a buyer. We’re always happy to assist an owner in thinking through those topics before they explore a transaction. In general, if the operator can check these boxes and also feels confident about the near-term business outlook, then they should be confident about taking their business into the M&A market.
On the side of transaction volume being down, if your business is lacking its peers, or the market you’re selling into is a little soft, then you’re almost a hundred percent not going to explore a transaction. But that should be viewed as an opportunity to look inward and lean into strategic initiatives that would enhance the profile of your business for a seller.
For example, if you believe that your pricing model could be more dynamic and want to test out different approaches then it’s advantageous to do that when you are not trying to sell the business. To play that out, let’s assume that the pricing initiatives have gone well, and that gross margin has improved 300 basis points one year later.
If those pricing initiatives were being explored in the midst of a sale, or just before a sale, then the very best the seller can expect is to receive a fraction of the value of those improvements from a buyer; the improvements are not well developed enough for a buyer to give full credit.
Now let’s assume that the business is being sold one year following the successful pricing initiative; you as the seller can expect to receive a MULTIPLE of the value created from the pricing initiative. The benefits of that strategic action are reflected in the historical performance of your business and are much easier for a buyer to give credit for.
That’s all to say that a quiet M&A market shouldn’t be viewed as a definite negative from the operator’s perspective. They should view it as a time to lean into some of their strategic initiatives and be ready for when they do want to test the market.
Heller: Concerning mid-sized distributors, how small of a deal will your company advise on?
Sears: It always depends. I can’t give a hard, fast rule. On average, when we’re selling businesses, the value of the business is anywhere from $150 million to $200 million on the low end, and then no limit on the upper end from there. That’s been our usual low-end threshold though.
Heller: When you are evaluating deals, what are the key operating metrics you focus on? Do you look for key investments in technologies, inventory management and KPIs? What makes you walk away?
Sears: Regarding what buyers are focusing on, I like to bifurcate that question between what an operating company is looking at and what a private equity investor might be looking at. If you’re across the table from an operating company, the first lens that will be applied is always strategic. Does the target company enhance the strategic path I want my own company to pursue? Maybe it’s white space in terms of a vendor relationship, a regional presence, or a market or customer. These are the types of criteria that strategic acquirers are evaluating and have been developed well ahead of any deal setting.
The next lens is the concept of accretion and dilution. Is this target business going to be accretive to my operations and financial profile? And if not, how can I price the acquisition to make it more accretive? As it relates to the accretion or dilution topic here are some of the questions that an operating business will want to address:
- Does this target business enhance my own company’s profitability?
- Does combining with this target allow me to outgrow the market?
- Is there a marketing or ecommerce capability at the target that would meaningfully enhance my own business?
- Is there a legitimate cross-sell opportunity?
The financial investor is likely assessing the target business as a platform investment. And for starters, an easy way for a financial investor to earn a compelling return on the investment is to grow earnings at a higher rate than their own cost of capital. So if the cost of capital for the private equity fund is 15%, they ask:
How can I grow earnings faster than that while I own the business?
A very actionable way to do that is through acquisition. That’s why you’re used to seeing a lot of private equity investors use an acquisition playbook once they’ve acquired the platform.
Acquisitions aren’t the only way to grow. Maybe the target has a unique organic growth angle. So, they’ll ask: What are the steps to increasing earnings? And then a follow-up question would be: who would be interested in acquiring this business once I need to monetize my investment?
Bein: You just completed a significant transaction involving an employee stock ownership plan (ESOP). Can you talk about ESOPs in general?
Sears: At a very high level, an ESOP transaction shouldn’t be all that different from a non-ESOP transaction, but there will be some nuances. The principal nuance is having the trustee bank for the ESOP involved and ultimately needing them to sign off on the acquisition. In that respect, it’s not dissimilar from when a public company is sold. When a public company is sold, all or most of the investors and shareholders must sign up for the sale. In the context of an ESOP, the trustee is speaking on behalf of the ESOP participants and will need to sign off on the transaction.
I think there will also be qualitative factors to keep in mind. If you’re acquiring an ESOP, you’ll want to ensure the employee-owner ethos that has been a tailwind to the company culture is maintained. You can’t just set up another ESOP, but there are tools you can put in place, whether it’s stock option programs or things like that to keep that employee-owner ethos moving forward. Culturally, the qualitative benefits are significant and something that a buyer doesn’t want to lose.
Heller: At what point should a company who is thinking of hiring you get in touch?
Sears: It’s never too early for us to interact with a potential buyer or seller. If we have created rapport or a relationship before the transaction setting, that’s always helpful. That’s what we are doing when we’re not executing transactions. We are getting to know buyers and sellers and ensuring we understand what’s important to them, solving for the most important criteria and ultimately, trying to find a win-win situation in a transaction.