Small, privately owned businesses are attracting the attention of Wall Street. Here's a glimpse of what's behind the interest in the electrical market and what the acquirers are looking for.
Acquisitions are all the rage on Wall Street lately. Some analysts say there hasn't been this much activity in the mergers and acquisitions arena on Wall Street since the 1960s. A lot of those acquisitions are of small, family-run businesses. Although no one has come up with a solid total on the number of private companies sold in the last year, estimates generally come in at about 300,000, and the electrical industry has contributed its fair share to that total.
There are several factors driving the buying binge says Ed Lay, president and managing director of Distribution Resources, New York, N.Y. First of all, acquisitions are at an all-time high because the market is flooded with capital from both domestic and international markets. There are massive financial resources available. Compounding this is the fact that interest rates are low and continuing to fall. "We see venture-capital firms, investment groups, private investors, as well as other companies, forced to look around for ways to make their capital get an above-market rate of return," he says.
This bullish economy translates into an interest in small-cap or emerging-market companies-companies that are much higher risk, but also offer the potential for a much higher return. With so few national distributors, there's a lot of opportunity out there.
"There's so much money available and so much of an imperative to keep the funds rolling and keep investments moving that we're seeing companies investing in industries that they never, ever would have looked at before," says Lay. "Those dynamics-the availability of capital and trying to get a higher return on a traditional investment-are driving a lot of looks and interest in areas that never would have made it onto the radar before."
Lay, whose New York-based consulting firm works with manufacturers and distributors on strategic planning for performance improvement, thinks those dynamics of capital and a desire to secure a higher investment return are accelerating the natural consolidation of the electrical industry, an industry moving along its normal path to maturity. Currently, there are only a few publicly traded electrical distributors, among them Anixter International, Rosemont, Ill., W.W. Grainger, Lincolnshire, Ill., Hughes Supply, Orlando, Fla., and Noland Co., Newport News, Va. That could change soon because of people like Jonathan Ledecky.
Ledecky, a former Wall Street executive, first got into the consolidation game by buying up over 200 small office-supply distributors and blending them together into U.S. Office Products Co., Washington, D.C. He put together a similar venture in the flower wholesale business with U.S.A. Floral Products, Inc., also based in Washington, and is now building companies based on the same concept in the building maintenance and equipment leasing businesses.
Ledecky says pressures to consolidate come from within an industry as it matures. Efficiencies that are possible through consolidations are so compelling, particularly in Mom-and-Pop-shop, fragmented industries, that it's difficult for those industries not to consolidate because of the need to reach higher levels of productivity-to do more with less-to gain or keep a competitive edge. He says securing economies of scale is one way to achieve that edge.
When Ledecky put together his roll-ups in the office-supply and floral businesses, he went into the projects with the idea that bigger is better just because of the savings realized in the back-office functions. "You put a group of distributors together and you don't need 12 warehouses, 12 back-offices, 12 data-processing departments, 12 billing departments, 12 payable departments," he says. "There are enormous savings that you get by aggregating the volume of the distributors into one core, centralized unit."
This is the premise behind Ledecky's most recent consolidation endeavor, UniCapital Corp., Bay Harbor Island, Fla. Formed to consolidate equipment-leasing firms that work with companies wanting to lease things like aircraft, trucks, telecommunications equipment, computers or even vending machines, this roll-up not only reduces administration costs by consolidating the back-office operations of the companies, it also gives the individual leasing firms greater access to capital at a lower cost and makes available new services to their customers.
Consolidating services is a relatively new concept in the roll-up arena, but one Ledecky and others see as having great potential. Washington, D.C.-based Consolidation Capital Corp., another Ledecky roll-up venture, has entered into letters of intent to acquire seven electrical-contracting service firms (see "Contractor Consolidation," EW, March 1998, p. 24). Ledecky has plans for this enterprise to be a "multi-discipline service organization in the facilities management industry." He says this facilities management roll-up will include not only electrical maintenance services, but also such routine building maintenance services as janitorial services, fire protection and security systems equipment maintenance, pest control services, grounds maintenance, and parking facilities management, among others.
Ledecky sees the consolidation of electrical contractors and other service firms being driven by the rise of the mega-chains and the big-box retailers, like the Wal-Marts and the K-Marts-national companies with national marketing programs. "They're building national footprints of buildings across the country," he says. "They want consistency in service, consistency in customer contact or relations. They want quick response times. They want a central 1-800 number to call when there's an electrical or other problem. And so it's really a pull strategy where the customer is asking for these things, rather than a push strategy where you try to develop something and then convince the customer of its benefits. Here the customer benefit is quite clear to the end users, so they're the ones asking for it."
As an example, he recalls that at one point Wal-Mart was using almost 400 different electrical contractors. He says Wal-Mart wants to get that number down to about seven. "It's much cleaner for them to have fewer points of contact. It's much more efficient from an operations standpoint, an insurance standpoint and a liability standpoint to have players who can cover a large-scale universe of the country," he says.
Electrical distributors will not escape the consolidation of contractors unscathed. Ledecky predicts that the roll-up of electrical contracting firms will accelerate, and this in turn will fuel the roll-up of electrical distributorships. "In electrical contracting, the size and scope of the market for the expert services provided by electrical contractors has been expanded by the technology push to wire for Internet access, EDI and telecommunications, as well as the re-engineering of buildings, the upgrading of existing buildings and the construction of new buildings. All those demographics trends, which have been expanding in this economic cycle, make it a very attractive place to make an investment," he says. As a result, he says the electrical distributors will be rolling up as the contractors are rolling up because the contractors are putting themselves together in such a way as to extract better pricing from the distributors. "When one end of the business rolls up, typically the other end also rolls up," he says.
But there may be an even more compelling dynamic behind consolidation within the electrical industry. The electrical wholesale industry is still very much a family-owned and operated industry. Ledecky says the businesses in this industry have, historically, been passed down from generation to generation and are fairly illiquid in nature.
A lot of the activity in and around small and mid-size companies is a result of the age of those companies, what generation of family ownership the company is in, as well as the age of the company leadership. The majority of companies in the electrical distribution industry are privately owned, and many were started in the post-World War II boom. That puts the average age of businesses in this industry at around 40 or 50 years, with many owners looking at retirement.
It also means many distributorships are either in or approaching their third generation of ownership. "Very small or privately-owned companies very often can't make it into the third generation, so there is a generational aspect or time clock that you can't escape," Lay says. "Statistically, only 13% of businesses survive into the third generation, which means 87% of them don't. That means they either go out of business, or they're sold, or there's an asset sale-there's some event that takes place at that moment."
In most cases, the resolve and commitment of the existing leadership of a company determines what that event will be--getting out of the business, transferring it to a larger company, selling it to the employees and creating an employee stock ownership plan (ESOP) or trying to grow and take the company to the next level, according to Lay. "I think we'll see more activity in this area in the next five to ten years than we probably ever have before, just because of age-the sheer dynamics and statistical probability facing companies in that age bracket," he says. "Midsize and smaller electrical distributors are going to be in play, not because they're not profitable or no longer have a customer base, but because they're facing this third-generation transition. At 50 to60 years of age, a company is at that decision point."
With so many companies going through the same decision process at the same time, certain patterns emerge. If the decision is to sell, the process is generally a long one. In the Spring 1997 issue of the Boston Review, a publication of the Boston Federal Reserve Bank, John Campbell writes: "Matching buyers and sellers of small, private firms has always been difficult, particularly when individual players are involved. The search for a match can be long and serendipitous, and the negotiations emotional since sellers typically feel deep personal attachments to their firm. Buyers, on the other hand, rarely know exactly what they're getting and must hedge that substantial risk."
>From the company owner's standpoint, this is a time when he must decide if he is comfortable with a prospective buyer controlling the future of a business he has spent years nurturing and growing. And although many small-business owners sell their companies and walk away immediately or within a short period of time, many consolidators use the strategy of keeping a company's existing management in place. If a condition of the sale includes the former owner staying on as part of the management team, the seller must decide if he would be comfortable with the new owner being his boss.
Much of the value for an electrical wholesaler or any distribution-based company lies in its management, its key personnel and its customer relationships. These are the kinds of things that don't show up on the asset sheet or the valuation. But Lay says that's where the ongoing and future value of the company lies. "The more an electrical distributor structures his business to reflect those capabilities, values and strengths, and minimizes as many inherent structural or marketplace weaknesses that exist in the distribution industry, the more likelihood the seller's valuation of his company will be acknowledged by the buyer," he says.
Reaching an agreement on price is one of the major stumbling blocks that crop up during the acquisition process. When a business owner gets ready to put a price on his business, Ledecky says the seller very often looks at that business the way he would look at selling his house. "You always think your house is worth a lot more than the market ultimately determines that it's worth," he says. "You have that expectation of getting a high price. It's the same thing with a business. For most people it's like selling their baby. So in terms of selling their baby, one, there's a real reticence to sell their child. And second, if they're going to sell their child, they want to make sure they're getting every last dollar possible."
It's a hard sell even if the business owner is going to stay on and continue to manage the company. But Ledecky says it doesn't matter how much independence the owner is going to retain; it doesn't matter that the family name is not going to change over the door. "At the end of the day, it's the money that talks," he says. "Making sure the owner feels he's getting the full price for the business is very, very important."
The standard model for pricing private companies in the United States today is about six times the current adjusted operating income of the business. It's considered a proxy for the amount of pre-tax income that the entrepreneur or owner can take out of the business each year. So if the company is making a million dollars a year, a buyer would try to buy it for six million. Ledecky says the seller would more than likely take that offer because of what he likes to call "the seller's mentality." He explains:
"If you try to buy it for one or two times the operating profit, the person says, 'Well, I'm young, and I know I'm going to be here for at least a couple more years, so that's no advantage to me.'
Three times? 'No, not really. I'm still not looking to retire.'
Four times and the person starts to get interested. 'Wow, I'd have to work awfully hard to get that $4 million. It will take me four years to get that. There's no certainty the business will still be operating year after year in the same manner. Gosh, I've worked awfully hard. Maybe it's time to take out some profits. But I'm really not all that excited. I enjoy my business. I enjoy my life.'
Five times? 'Hmmm.... That's really interesting. I've put 20 years into this business. The thought of making five years' revenue in one year is awfully appealing and attractive.'
So when you say six times, the number becomes large enough to really make the entrepreneur think about selling his business. Six is largely the magic number for the sale of private companies in the United States today."
But Ledecky cautions that at the same time, the investor has to get a return on his investment, and if the acquirer is publicly held, the stock market needs to see a return on that investment in order to fuel the public company's growth and its access to capital. So the reverse is also true, that if the public company pays more than six times a company's operating income, then it's getting less than about a 16% return on investment. Divide 100% by six and you get 16.6%. Ledecky says that's sort of the threshold and the reason six times works.
The investor has to see that the company is getting a greater return than he would get by investing the money in a treasury bill or in other stock. "At that six-times level, there's comfort that the company buying these firms knows what it's doing," he says. "But that's been true historically; this is not a new phenomenon. It's just a comfortable number at which private, illiquid businesses seem to change hands."
So if you only get to multiply your company's value by six to set your asking price, you want to make sure that value figure is as high as possible. Being able to place a high value on a company means getting it in top shape, from the inside out.
"Pure and simple, you want the company's operational capabilities to be at their peak, when you begin seeking a buyer," says Ed Lay. "You want the company to be in a growth mode, not in a decline. If the owner has done his homework and done a good job, and by that I mean he has gotten the company to a relative market-leadership position, his ability to get a really solid value for his company in the event he decides to sell, will be greatly facilitated."
Lay also compares selling a business to selling a house: "If you've got a tremendous house in great shape, in a great location, everybody wants it. If it's not in great shape and not in a great location, you'll have to take what you can get, especially if you've got to sell it next week."
If someone is interested in a company in decline, "then there's bottom fishing going on," he says. "The acquirer is looking for a bargain, which means that any hope that the owner had of maximizing the return on his time, effort, and so on, will not be realized. The goal of any company in sell mode should be to maximize the return on its operation. The stronger the position you have in your market, the more opportunities you'll have, whether it's to grow the business or to sell it. There's no substitute for a strong balance sheet."
Companies with strong balance sheets are the only ones Jonathan Ledecky considers for acquisitions. The company must be profitable. "We don't purchase companies with turnaround issues or profitability issues," he says. "We're really trying to go for the premier player in each locale that we're in."
He says prospective acquisitions must also be companies with a leading local franchise. "By that I mean they have to have a reputation for excellence over time," he says. "Typically, the companies we buy are 30 to 50 years old. They've really withstood the test of time. They've been recession-proof or recession-resistant. They've been able to make money in good times and bad."
Finally, he says they must have capable, motivated management, and he believes in leaving that management intact. "That's because they're touching the customer," he says. "You leave the feet on the street, and you get a much better result. What you're really trying to change are the things that don't touch the customer--the back--office things.
"My experience in doing these roll-ups in other industries has been that the successful distributor knows what he knows and knows what he doesn't know. The successful distributor roll-ups are those where the functions that touch the customer remain untouched by the consolidator. The unsuccessful consolidators have tried to centralize that process, too. To be a successful distributor, you must maintain a high level of service and customer contact."
The service and customer contact required in distribution may explain why the hype about changes in this channel being a death knell for wholesalers is just that--hype. No matter where or how a customer buys products, he still needs the product delivered.
"There will always be a need for a point of distribution," says Brad Cohen, a senior analyst at Sands Brothers & Co., New York, N.Y. "And with the need for a point of distribution, you can be more efficient if you have a network of distributors. I think we will see consolidation, and there will be fewer distributors, but they'll be deeper and more efficient at the distribution level."
Consolidation may actually prove to have a very positive effect on the industry. Lay says he has observed that the industry has changed, but the programs and the rhetoric and the platforms of discussion really have not. So he views a lot of the changes being forced on the industry by consolidation as positive changes for the better.
For example, he says companies are being forced to be more efficient and use technology to drive down costs or they won't be able to compete. "Because there is more capital, we're seeing a real acceleration in the consolidation of the industry," he says. "It's being driven by the need to secure economies of scale and reach higher levels of productivity-to do more with less. The way to do that is through technology-inventory management systems, information management systems, EDI, VMI and all those acronyms we hear now." But all those things have got to be more than buzzwords, he says. They've actually got to be created and implemented.
Larger companies with bigger capital reserves, logically, are going to be the ones that will be more willing and able to make those kinds of technology investments, and they will be compelled to do so. "Otherwise, the whole concept of getting bigger from a geographic and location standpoint doesn't make a lot of sense," he says. "If there's an area for leadership to be provided, it's certainly in this area of larger companies that can afford to make those big investments in distribution technology, particularly on the logistics side.
"Consolidation does not have to be a bad thing. But it will only be positive if the players that remain, and who are larger as a result of acquisitions, follow through with the investments required to transform those good companies into superior-performance companies. And that will only come through continued building of service infrastructure."