Some days, it seems that everyone in the plastics industry is talking about private equity, and with good reason: Much of the continuing consolidation in the industry is being driven by private equity buyers.
``Who are these guys?'' I've heard executives ask. ``And why are they suddenly interested in plastics companies anyway?'' Good questions, because private equity groups are here to stay and will likely continue to own more and more companies in the sector. Understanding how private equity ``ticks'' can have a big-dollar impact for owners and managers of businesses.
White hats or black?
Neither, really. Private equity buyers are neither heroes nor villains, neither good nor bad. Their main focus is to make money.
For an industry that thrives on consolidation, a private equity buyer might seem like a strange bedfellow, since a private equity firm often resembles a cottage industry. The typical private equity firm is a relatively small group of bankers or entrepreneurs backed by a team of number crunchers. Each group reflects the individuals that founded it.
The money that private equity firms have to invest comes from pension funds and institutions looking for a bit more return than they would get from public markets. This money is not ``funny'' - not the ``flash in the pan'' of fool's gold. In fact, once funds are committed to the private equity firm, the firm usually has seven years to spend these funds. This fact goes unheard against the common view that private equity is a here today, may be gone tomorrow phenomenon.
So what do these guys actually do?
First, private equity finds deals to invest in. A flow of deals keeps the industry going.
Second, they typically apply more leverage than most family-owned private companies would be comfortable with. Successful private equity groups buy companies - that's their business - and, for this reason, they are important customers of lenders. This relationship helps to ensure some pretty creative structures and often favorable pricing. Private equity groups heavily rely on strong lending relationships for their existence. Oddly enough, lenders take comfort from this pressure.
Third, they focus on making each investment as cash-generative and as profitable as possible, thereby providing a strong incentive for management to deliver - often with a degree of risk. Sometimes the return comes from streamlining a business and cutting costs and capital spending. But just as often it comes from driving growth and expansion.
In a few years, it's typically time for the private equity firm to sell the portfolio company. If all goes well, the leverage effect of using debt allows investors to make strong returns. We often see one private equity group selling a business to another private equity group. While selling a good business might not seem like ``good business,'' that's the rule of the private equity game.
Many private equity investors are interested in plastics companies for a number of reasons.
Perhaps most importantly, many plastics businesses are fairly stable, although it might not feel like that most days. Unlike investors in public markets who tend to look for the next shooting star, private equity firms typically prefer solid companies that deliver slow, steady growth and predictable cash flow. If a company with those attributes also has a solid management team, the attraction by private equity is even stronger.
The high capital requirements of the plastics industry have a good news/bad news quality for private equity investors. The goods news is, the barriers to entry are typically high, so it's less likely that new competitors will appear unexpectedly. The bad news is that it can take a lot of money to stay in the plastics business. Growth that comes with a large capital price tag can be difficult for private equity to manage when cash is needed to pay down debt.
But for private equity - like everyone else - the biggest challenge in plastics is resin price fluctuations. No one is immune from sharp rises or an ``act of God'' like Hurricane Katrina, but businesses without the pricing power to pass through resin prices will be less attractive to private equity.
So, what's next?
Some executives seem to think that private equity's interest in the plastics industry is a fad. Others, including myself, think nothing could be further from the truth. Regardless, it's in the best interest of any business owner to understand the basic motives and means of private equity investors.
Public and private plastics companies of all sizes looking to grow through acquisition will be competing with private equity. Examples include acquisitive platform companies - like Berry, Ampac, and Myers Industries (assuming the announced transaction closes). Acquisitive growth has been a large component of the strategy of many companies. Unless firms understand the strategies and tactics required to compete with private equity, the level of growth available via acquisitions may disappear.
Successful consolidators work it out, but the rules have most definitely changed. Competing with private equity buyers for deals often requires companies to place a strong emphasis on long-term strategy and relationships in the sector, speedy closes and creative structuring - or very high valuation metrics. An example is Rexam's announced agreement with Owens-Illinois' plastic packaging business.
Right now, the number and size of deals in the plastics industry are just increasing, with no likely slowdown in sight. For sellers, a basic knowledge of private equity, and a little crash course for management in speaking the language of private equity, can make a real difference in driving the value of your business.
Will Frame is a managing director in Chicago with Deloitte & Touche Corporate Finance LLC.