Get an insider’s look at how private equity (PE) firms evaluate distribution companies, from people and processes to market opportunities. John Schweig, Chairman of the Board at BlackHawk Industrial and Operating Partner at private equity firm Snow Phipps, joined us for a recent Wholesale Change episode.
Schweig was a partner at Bain and Company, held a variety of roles at Grainger including Senior Vice President of Business Development and International and Chief Strategy Officer. He received an MBA from Harvard Business School and a B.A. in Mathematics and Economics from Colgate University.
In his current position, he brings his operating experience, network and judgment to inform and balance the financial insight at Snow Phipps, enabling operating teams to take their businesses to new levels.
Distribution Strategy Group: We hear about all the venture capital folks who are going after tech companies. Why do private equity firms like distribution?
John Schweig: Distributors convert almost all of their profit into cash flow. Private equity firms finance their purchases with a decent amount of debt. So great cash flow helps cover the interest payments and helps bring the debt down. Banks and other lenders love to lend to distribution, because the assets behind it are receivables and inventory. It’s a whole lot less risky to put a million dollars against inventory and receivables than against some completely purpose-built piece of machinery that is enormous and could never really be sold in the event that the business started to head south.
Also, there are industries that get side-swiped by technical advancements and products, or by a service innovation. It can happen in distribution, but if a new widget comes out that displaces the old widget distributors can usually just pivot to the new solution. They’re a little bit less at risk than other kinds of business. Private equity firms like that.
Finally, distribution has relatively low barriers to entry. It’s not that hard to set up shop as a small distributor, which makes for a pretty fragmented sector of the economy. A lot of the distribution-specific markets are ripe for consolidation.
DSG: Why are private equity firms eager to be involved in consolidation?
Schweig: It’s remarkably simple and remarkably powerful. Large companies sell for higher multiples than small companies do. Let’s say I own a large distribution business as a private equity company, and I paid 10 times EBITDA for it. I can potentially go out and buy another three, four, five smaller distributors at a lower multiple. If I do a really good job of integrating them and hopefully get some synergies, I’m hoping I can someday sell that larger combined EBITDA for 10 times or even more. And if the owners of the businesses I acquired to get there choose to put some of their proceeds into the combined business, they can participate in that upside.
DSG: You might be buying those add-on companies at a six or a seven or an eight-times multiple on EBITDA. Is that a rough range?
Schweig: Yes, but it really does depend on size and other factors. It the business growing or not? Does it help us expand our product line? Does it fill an important geography that we’re missing? Does it have great people who can add to our team?
DSG: In the private equity world, there’s the concept of a platform business. Take us through what that is about, platform versus add-on or bolt-on, and how that might inform how distributors think about their own business.
Schweig: A platform business is one that we think is set up well to be the initial investment in an industry for us, upon which we can acquire and integrate other businesses down the line. They’re more valuable because they’re typically bigger, but also because they’re the mechanism through which this is all going to happen.
To be a platform business, you need to have some size, and it depends on the market you’re in and the aspirations of the private equity firm as to how big that might need to be. But we’d be looking for a seasoned, scalable executive team that we think could perform well if the business grew 50%, 100%, 200%, because that’s what we’re hoping to do. We’re looking for folks that hopefully have had at least some experience in acquiring and integrating businesses.
DSG: So, the talent of the management team is actually part of the consideration set when you’re looking at a distributor, because you don’t want to replace the management team. You want one that can scale with the business. Is that correct?
Schweig: Yes. Generally speaking, the last thing private equity firms want to do is buy a business and then have to change out the executives. That is slow and expensive, and there’s no guarantee you’re going to go find a better person or group of people than what was there. We would much prefer to find and pay up for great talent.
If private equity has a reputation for changing out management teams, it’s only because the private equity community has figured out that you can get great results with great talent. If there is a need to add talent or (hopefully not up front) change out one or two people, we will certainly do so. I think it’s a real misnomer that it’s standard operating procedure. If anything, it’s the opposite. If you own a distribution business and you’re thinking of selling, you can look at the track record of various private equity firms and find out whether that’s something they routinely do or not.
DSG: What is it about the business that makes it a platform, aside from scale?
Schweig: Ability to scale is the overriding concern. That touches talent, processes and systems. If you’ve got an ERP that does a great job, but it would start creaking at the hull if you were 50% larger, that’s not insurmountable but it’s not as attractive. If you have processes that are built around doing things very differently for each of your customers, that’s hard to scale.
Future acquisitions could be in other locations. If you already have more than one location, that means your company and your people are familiar with operating in a multi-site environment, and that’s all the more helpful. If you aspire to be a platform, you may have some work to do–maybe you’ve got some holes in the talent side of the house, maybe your system needs work to scale, etc.
DSG: Do you model, at a financial level, the benefit of purchasing in the new entity before you make the acquisition?
Schweig: We certainly evaluate how well we think a platform buys, but it’s a double-edged sword. If they buy well, we may not be able to add as much value, but bolt-on acquisitions will benefit. We absolutely look at purchasing when we’re looking at bolt-on businesses. We will compare cost of goods and see where we think we might get some leverage.
DSG: There are factors you look at in terms of the customer base, the supplier base, the services and technology. Can you run us through that matrix?
Schweig: Sure, let’s discuss each factor. Competitive position: if you are a market leader in a pretty well-defined niche and that niche is big enough for you to still have runway, private equity loves that. It makes you a more obvious platform, plus you either do or could have a cost advantage over your competitors because of your larger scale. That means you can invest more in talent, in systems, in additional acquisitions, whatever it is to actually help you gain more and more share.
Red flags would be a niche that is so tightly defined that there’s not much room to grow, or one in which you already have 80% share or more of the market. That’s good for you, but there’s now not very far to go. If that is you, consider branching out into some close adjacencies. Those could be products, customer segments you don’t sell to today or maybe new geographies. You want a potential buyer to see that there’s more runway.
Customer base: generally speaking, we want to see stability in the customer base. The red is a huge percentage of the business all wrapped up in just two or three accounts.
If that’s you, find ways to diversify a bit. Obviously, I don’t recommend getting rid of the large customers, but find ways to attract new ones.
Secondly, we like to see an established track record of acquiring and growing new customers. Red flags would be declining sales per customer, declining new customer acquisition, etc.
If that’s you, no doubt you’re already working on it. I’m not sure there’s a magic wand other than sales and marketing talent and talking to customers and prospects about what’s holding them back.
DSG: Are there some warning signs you look for on the vendor side?
Schweig: What we like is stability on the vendor side. Losing a large vendor soon after the acquisition is hard to come back from. A potential red flag is one or two suppliers that represent a huge portion of your business. A mitigating factor there would be if you are one of their absolute largest distributors. That would suggest a more stable relationship and possibly some pricing power.
A strong warning sign, and this happens in some distribution industries, is when suppliers have too much control over the end-customer. They own the customer and set the price, then “reward” you for servicing the account. It feels more like a commission than it does distribution. That can work if your competition is limited, but it’s a situation where you don’t really control your own fate. If this is you, are there ways you can diversify a bit so that it doesn’t constitute the entire business?
DSG: What about products and pricing?
Schweig: You earn better margins when you have a higher share of the products you’re selling than your competitors do. If you are a $100,000 distributor of a brand and you’ve got folks in your market that are selling $2 million, I don’t think you’re setting price. The worst situation is a distributor with relatively low share of fairly generic products. That’s a recipe for low margins and low turns. Nirvana would be if you have a private label that people in the marketplace actually know and like. That’s a recipe for high margins and high turns.
If you’re selling mostly me-too products, that’s when value-added services start to come in as a way to protect yourself and help with your margins. Especially in the world of Amazon and other internet-only competitors, you need value-added services that would be difficult or unattractive for them to offer. That’s a level of protection that is really important to private equity. Value-added services can also provide a level of protection against companies that aren’t necessarily internet-based but are simply much larger than you. Say that you are a $20 million distributor. There are probably a number of customized and/or complex things you could do that it might be hard for a multi-billion company to offer without having their whole world spin apart.
To the extent that the services are wrapped around the products themselves, that is particularly valuable. Think about things where they don’t really get the service, other than in and around the product. Things like kitting, calibration, testing, installation–these are things that happen actually with the product itself. These services can form great levels of protection. Useful, but less valuable, are services the customer isn’t paying for and can unbundle on you. Maybe you have fabulous technical assistance that your customers love, but they buy most of their stuff from your competitors. You have this expensive thing you do, and it’s not actually causing customers to buy from you.
I’ve looked at an awful lot of businesses over the last handful of years. A distributor that has what we feel is a really defensible set of value-added services that protects them can be worth one or two times more in their multiple.
When you think about your value-added service, be honest with yourself. If you say, “Oh, our folks know a lot about the product,” that’s great, but is it enough? Are your value-added services nothing more than a list of what you do and what you’re proud of? Or are they things that actually make it hard for your customers to get that service when they buy from Amazon or Staples or some other huge entity?
Hear from Schweig in this episode of Wholesale Change: