Fueled by historically low interest rates, private equity investment in the molding industry is at record highs. We have seen numerous high-profile buyouts in the last two to three years. So far in 2017, the following noteworthy companies have all been acquired or recapitalized in private equity sponsored transactions: R&D Molders, Xcentric Mold, Richardson Molding, Dutchland Plastics, Plastic Components and Pexco (among others).
Molding Business Services Inc. is currently tracking more than 165 molders that have private equity ownership. Is all this outside investment a good thing for the average molder or processor? Is it a good thing for the industry?
Here are some benefits:
Liquidity. Private equity has significantly boosted liquidity and capital investment in an otherwise mature industry. This is especially true for molders and processors with $20 million or more in revenue and healthy profits. Globalization and offshoring had the effect of reducing outside investment — and hence liquidity — from the turn of the millennium through emergence from the Great Recession. Today, owners looking to exit have more options than at any point in the last 17 years. Company shareholders are the largest beneficiaries of the additional liquidity due to increased transaction multiples and higher valuations.
Professional management and outside board of directors. Private equity investors seek to replace (over time) the owner/operator model that has dominated the industry since the 1950s. Most often, PE investors install a model that utilizes professional management and an outside board of directors. While the owner/operator model has its merits, the typical PE management model can lead to increased focus, solid strategic direction, higher ROI, and — most importantly — better execution. An independent and outside BOD allows for more ideas, more discourse and best practices since companies can draw on a much larger base of knowledge and experience. The new management style and oversight is designed to enhance productivity, grow profits and drive shareholder value. The companies, shareholders, and the industry all benefit from this aspect of private equity investment.
Management and employee incentives. Private equity investors generally do a good job aligning interests among the shareholders, the management team and the employees. Typically, this is done via bonus programs and/or equity incentives. Having all stakeholders on the same page helps the company set and achieve goals that drive shareholder value. This can help the company, shareholders and higher-level managers.
Building shareholder value (the right way). The focuses of private equity investing are building and enhancing shareholder value. There are many PE groups that do this well while doing it the right way. Strategic investments in human capital, equipment and processes — combined with focus and execution — can lead to huge gains in shareholder value. This is in stark contrast to shareholder returns that are generated largely by financial engineering. The "right" kind of value creation is very good for the company, the shareholders, the management team, the employees and the industry.
Private equity ownership also involves some common risks:
Leverage. Almost every single private equity buyout or recapitalization utilizes debt capital — in most cases more debt than a family-owned molding company would be comfortable using. Leverage generally enhances shareholder returns but also carries risk. Right now, we are in a period of sustained — albeit slow — growth and low interest rates. This makes higher debt burdens feasible. But an uptick in interest rates combined with a downtick in the economy and the loss of a major customer could easily spell doom for any plastics processor carrying too much debt. While leverage over the short term is probably good for shareholders, generally speaking it increases risk to the company, the managers, the employees, and the industry.
Goodbye owner/operators. Departure from the owner/operator model can have benefits, such as the ones described in the above section, but it can also have significant drawbacks. The ultimate owners of a PE recapitalized molding company are a blend of insurance companies, pension funds, high net worth individuals and other hands-off stakeholders. While these people and entities are great sources of capital, none of them will sign personal guarantees on the debt and you will never find them at the plant at 2 a.m. troubleshooting a job or sorting parts for a critical order. MBS has seen this time and time again: When it comes to customer service and quality, there is seldom a replacement for the owner/operator model in the custom injection molding industry.
Crowding-out. Prior to the recent influx of private equity capital in the molding space, most M&A transactions at the lower end of the middle market were strategic in nature (e.g., a molder acquiring another molder or a thermoformer acquiring a blow molder). MBS has found that strategic acquirers are generally more risk-averse than buyers in the private equity community. Strategics are less likely to use the same high degree of leverage in an M&A deal. Generally speaking, this explains why more deals are being won today by private equity buyers and less by strategic buyers. MBS considers this a negative for the industry because major productivity gains, technology advancements and long-term investments — which are all good for the industry — are more prevalent after strategic M&A deals vs. private equity backed transactions.
Investment horizon. Private equity in the lower middle market traditionally has an investment horizon of three to seven years for a newly acquired platform company. Some argue that the limited investment horizon discourages certain capital expenditures, which can hurt productivity gains and profits over the long-term. Other data shows that capital expenditures increase during private equity ownership. At MBS, we believe the biggest risk posed by the typical hold period involves increased uncertainty among the employee base as well as the customers, while a second ownership change looms on the horizon. If a key employee or key customer decides to jump ship as a result of an imminent sale, the company, the shareholders and the remaining employees could be adversely impacted.
In conclusion, we feel it best to embrace the benefits while being mindful of the potential risks. When we are advising a client in a sell-side process, MBS strives to bring a healthy cross-section of strategic and private equity buyers to the table. For our sell-side clients that gravitate to the private equity model, we stress the importance of proper due diligence. After all, not all private equity buyers are the same. There are subtle and major differences that can make or break the long-term success of a private equity sponsored transaction.
Andrew Munson is a partner at Florence, Mass.-based Molding Business Services Inc.