Article written by Kay Cruse of Strategex and Anthony Bahr, and provided courtesy of Axial

On November 1, Strategex and Axial brought together a diverse group of private equity investors, family offices, lenders, and advisors in Cleveland for a manufacturing-focused event. Over lunch, the group discussed today’s most prevalent topics in manufacturing, and the direction in which they see the industry heading in the short term. Here are the top-five takeaways from this conversation.

1. An economic contraction is coming, but the short-term outlook is strong.
While the group unanimously agreed the next recession is matter of “When?”, not “If?”, the consensus was that leading indicators are overwhelming positive and the economic expansion — now in its ninth year — is expected to continue through 2019 and potentially 2020. However, acquirers are beginning to place more value on targets which have the ability to weather a downtown. For example, targets with a healthy aftermarket business, which tend to be countercyclical, are increasingly attractive to buyers.   

2. The labor supply is the dominant challenge in manufacturing today.
A near-record low unemployment rate, increasing minimum wages, more restrictive immigration policies, and an aversion to manufacturing jobs among younger cohorts are just some of the factors which have resulted in a severe shortage of qualified candidates. Furthermore, the ability to retain productive employees is becoming more difficult as fewer see manufacturing as a viable long-term career. In response, manufacturing firms are investing heavily in the employee experience, flex benefits (tuition reimbursement, gym memberships, paid parental leave, etc.), and workplace culture.

3. Industry 4.0 is on the horizon, but implementation will be slow.
Deal professionals see the advent of “Industry 4.0” as a potential solution to the labor and talent delimma, but the timeline for implementation is unclear. One component of 4.0, the utilization of computerization and robotics, is starting to take hold, but most don’t see a complete overhaul of traditional manufacturing taking place anytime soon.

4. Increasing interest rates are both a threat and an opportunity.
Many manufacturers are experiencing growing pains such as severe backorders, over-utilized facilities and equipment, and obsolete information technology infrastructure. Recent interest rate hikes have deterred some from borrowing to finance capital expenditures and capacity building, putting their ability to sustain growth at risk.

On the other hand, many lenders have seen a spike in originations as borrowers attempt to lock in rates given the expectation they will only increase in the short term. On the private equity front, the increasing aversion to debt has led to an increased demand for growth equity investments.

5. The lack of stability is the new norm, and agility is essential for success.
Above all, markets seek stability, but current socio-economic conditions are anything but stable. Volatility is everywhere, including tariffs, regulations, trade agreements, tax policy, and fluctuations in government spending (particularly infrastructure spending). Those involved in running manufacturing businesses, however, have come to accept volatility as business as usual. Rather than deferring action in hopes of tides turning, and rather than proactively embracing change to get ahead of the curve, managers agree nimble planning and rapid execution is key to succeeding in this new reality.

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According to BizBuySell.com, the Internet’s largest business-for-sale marketplace, all statistical data regarding the Business Transaction Market Place continues an upward trend.

The number of closed transactions reported through the 3^rd quarter of 2018 has increased by 8% over the first 3 quarters of 2017!

More importantly for Business Owners, sales prices continue to increase as well.  BizBuySell.com also reported that sale prices of businesses sold in the third quarter of 2018 reached new highs.  Median Sales prices on transactions reported in the 3^rd quarter increased 10.7% from the same period last year!  The record sale prices are directly related to stronger business financials which also hit new levels in Q3. With buyers able to offset increasing prices by acquiring healthier businesses, the result is a well-balanced market.

The market place is also seeing good diversity across the various industry segments is indicated by the chart below.

BizBuySell’s 2018 Buyer-Seller Confidence Index supports the idea of an equally beneficial market to both buyers and sellers. In fact, buyers are slightly more confident in today’s business-for-sale market than last year. While seller confidence remains unchanged compared to 2017, 60 percent of owners said they are confident they would receive an acceptable sales price if they exited today.

“The foundation of small business is about taking advantage of opportunity,” said Bob House, president of BizBuySell.com and BizQuest.com. “To be in a place where both buyers and sellers are able to capitalize without the other party losing out is fantastic and a testament to the strong will of entrepreneurs.”

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If you’re wondering what your business might be worth to an acquirer, there is a simple calculation you can use.  Let’s call it “The Build vs. Buy Equation”.

At some point, every acquirer does the math and calculates how much it would cost to re-create what you’ve built. If an acquirer figures they could buy your business for less than they would spend on both the hard and soft costs of re-deploying their employees to build a competitive product, then they will be inclined to acquire yours. If they think it would be less costly to create it themselves, they are likely to choose to compete instead.

The key to ensuring that what you have is difficult to replicate is focusing on a single product or service and building on your competitive point of differentiation. When you create a product that is unique and pour all of your resources into continuing to differentiate it from the pack, you can dictate terms, because re-creating your business becomes harder the more you focus on one thing.

The worst strategy is to offer a wide range of services and products only loosely differentiated from others on the market. Any acquirer will rightly assume they can set up shop to compete with you by simply undercutting your prices for a period of time and driving you out of business.

C-Labs Focuses On Building An Irresistible Product

Chris Muench started C-Labs in 2008 to go after the burgeoning opportunities presented by the Internet-of-Things (IOT). He began by writing custom software applications that allowed one machine to talk to another. In 2014, he got the industrial giant TRUMPF International to acquire 30% of C-Labs, which gave him the cash to transform his service offering into a single product.

By the end of 2016, Muench’s product was showing early signs of gaining traction but C-Labs was running out of money.

In the end, TRUMPF acquired C-Labs in a seven-figure deal that could stretch to eight figures if Muench is successful in hitting his future targets. Why would a large, sophisticated company like TRUMPF acquire an early-stage business like C-Labs? Because they knew that re-creating Muench’s technology would cost much more than simply writing a seven-figure check to buy it outright.

In other words, TRUMPF used The Build vs. Buy Equation and realized that buying C-Labs was cheaper than trying to reproduce it.

Selling too many undifferentiated products or services is a recipe for building a business that—if it is sellable at all—will trade at a discount to its industry peers. By contrast, the trick to getting a premium for your business is having a product or service that is irresistible to an acquirer, yet difficult for them to replicate.

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Article written by Danielle Fugazy | May 17, 2018 and provided courtesy of Axial.net

The M&A market as a whole remains white hot and the lower middle market is no exception. Sellers are undoubtedly benefiting from today’s strong market conditions. “The market is as robust as it’s ever been. We are seeing high valuations. Average purchase price multiples are at at an all-time high in mid seven times EBITDA,” says Graeme Frazier, president of Private Capital Research LLC and a founder of GF Data, a data provider that tracks companies with enterprise values of  $10 million to $250 million. “Even rising interest rates are not quelling demand.”

There are multiple factors leading to the frenzied deal pace in the lower middle market. First, there’s a tremendous amount of capital in the market. The abundance of dry powder has been well documented over the years. Second, the lending markets are feeding the frenzy. According to GF Data, debt multiples have reached a total of 4.2 times EBITDA and on the senior side they have inched up to 3.4 times EBITDA in the lower middle market. “It’s not a record, but there is sustained strength in the lending market for sure,” says Frazier.

Robin Engleson, a managing partner with Sapphire Financial, which provides debt and equity to middle and lower middle market companies, says it’s the combination of both the dry powder and equity available fueling activity. “You have an abundance of debt, and buyers are willing to over equitize these transactions today. Today, lower middle market companies that have a reasonable story have a good shot of getting the highest valuations they could ever get,” she says.

Additionally, some of the frothiness in the lower middle market can be attributed to larger buyout firms and strategic acquirers—perhaps priced out of their own markets—coming down market to find good deals. One of the main reasons private equity firms look down market is to average out their cost of capital. After buying a platform company at a high valuation they more frequently move down market to find add-on opportunities at a better price to average down their costs. According to Pitchbook, as of Q2 2018 roughly half of all buyouts globally and more than two-thirds of all buyouts in the U.S. are add-ons. In the first quarter alone add-ons accounted for 70 percent of all buyout activity.

“You are seeing a lot of traditional middle market sponsors compete in the lower middle market.  Valuations are high for good middle market platform companies and so they’ve entered the lower middle market to find a company that can serve as a buy-and-build platform,” says Dan Lipson, a partner with Rotunda Capital, a Washington, DC-based private equity firm. “With more resources dedicated towards business development, either through internal staff or external buyside firms, traditional middle market sponsors feel comfortable they can deploy an adequate amount of equity capital through an add-on acquisition strategy even when starting with a lower middle market platform. It’s given growth to companies like Axial and the role of the business development professional.”

Moving  away from financial engineering and organic growth, it’s clear that the buy and build strategy have become one of the most common value creation tactics today. According to Pitchbook, it’s most frequently used in sectors that are highly fragmented like healthcare and education.

As a result of the strong market dynamics at play even less attractive deals are starting to get more attention. “The higher quality deals get done at a premium. Even deals that aren’t above average are starting to get bid up. The quality premium is narrowing. This is when things can start to get ugly. During a downturn your higher quality assets will weather the storm. Assets that are of lesser quality will have difficulty,” warns Frazier. “We see the IRRs they are modeling and unless they are able to grow these assets fast, it’s going to be challenge to make the return on capital with the high valuations that were paid or make it through lean times.”

Waiting for things to turn

Many typical lower middle market investors continue to wait on the sidelines for valuations to come down. “It’s a competitive market. Everyone’s look-to-bid and bid-to-close ratio is lower. We look at a lot of attractive companies, but we constantly push ourselves to remain disciplined. Unfortunately that means we are sometimes passing on companies in auction simply because we know the market clearing price is beyond what we’re willing pay,” says Lipson. “It’s not an easy market to be a buyer. When you’re paying full value, you have to have to be very focused and confident that you can execute your value creation strategy.”

Jeff Kadlic, a founder of Evolution Capital Partners, a lower middle market private equity firm, agrees that it is hard to compete in today’s market. “The larger funds are just so well capitalized that they don’t even need financing contingencies to close acquisitions in the lower end of the market, so it’s an attractive offer as a seller. The valuations for growth have become eye popping,” he says.

Hunter Street Partners, a firm that provides opportunistic debt and equity to the lower middle market, is looking to target areas where they feel there are pockets of dislocation. “We are looking for good companies with stressed balance sheets. There is not a lot of distress yet, but frothiness leads to dislocation. Although tough to predict when dislocations will increase, we are positioned to further take advantage of them as they occur,” says Neal Johnson, CEO and founder of the firm.

Despite feeling like the market is at the top or close to it, market professionals don’t see anything on the horizon that will change market conditions anytime soon. “There’s no sign of a slow down. We are seeing a lack of good target companies, but there’s nothing to make us believe that demand for lower middle market companies will slow. It’s certainly a compelling market to be a seller,” says Frazier.

Frazier also suggests that the growth of the private lending industry in the lower middle market could be a red flag, but says even that is only fueling demand. “After traditional banks had their wings clipped finance companies came in to fill the void. The underwriting standards can become relaxed, just like they did in the last cycle, but still we have no reason to believe things won’t continue as they are. There’s no fundamental reason for them to stop.”

Sapphire’s Engleson says she is seeing creative lending structures put in place to help boost returns from lower middle market companies. “As soon as lower middle market companies reach a certain threshold, their valuation multiples go up. This has always been true, but the increase is more significant now. Buyers are entertaining the purchase of smaller and smaller companies as combining them and bringing them to that next level today can mean increasing their value from five to six times EBITDA to 10 times EBITDA. This scenario is happening a lot more frequently. It’s a great time to be a seller.”

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By Nora Zhou Author, Axial

2017 saw a lot of activity in the middle market restaurant and food franchise industry. We spoke with two experts from BBVA Compass about market forces impacting the space and expectations for 2018.  “Refranchising [editor’s note: the sale by brand owner of corporate-owned units to franchisees] by the big franchisors has been a primary driver of M&A activity in the restaurant sector for the past seven or eight years,” said James Short, Director of Food Franchise Finance at BBVA Compass. “Jack In The Box Corp was probably the first that did it. Taco Bell, Burger King, Wendy’s, many different large brands have sold company stores to franchisees.”

By doing this, franchisors have created what’s dubbed as an “asset-light” model. Short said, “They are able to cut out of a lot of expenses, and their capital expenditures go down substantially because they’re no longer running the restaurants.  This almost always results in improved cash flow margins for the franchisor”

An inflow of private equity investors into the space has also boosted M&A volume in the space, said Kevin Fretz, Senior Vice President at BBVA Compass. He said private equity investors often find better returns within the restaurant sector because there is a perceived risk premium relative to similar-sized general industry companies. Short noted that an average private equity group seeks to make approximately a 20% equity return in the restaurant sector. The larger private equity firms tend to acquire the entire brand and hold on their books for their prescribed investment horizon, often five to seven years, Fretz added. Family offices are also an active group in the food and franchise sector. According to Fretz, unlike larger PE firms, family offices often hold such assets longer. And instead of acquiring a brand, they frequently acquire mid-sized franchisees, often driven by investment size limitations.

Speaking of what incentivizes family offices to invest in this sector, “The answer is often the same as for the larger firms,” Fretz said. “They’ve got a pool of money they have to invest, and the investors expect a certain return, and the commercial & industrial market generally isn’t generating those returns for a similar-sized investment, so they look to that next higher riskhigher reward sector, and find food franchise.”

One thing family office and PE investors have in common is that they both are often targeting large, national brands and they are focusing on the ability to scale, said Short.

“I think most [PE firms and family offices] are looking to acquire, at a minimum, 20 units at a time versus trying to do one-offs. They’re looking to pick up a whole market and gain some economy to scale,” said Short.

Due to confidentiality, Fretz and Short weren’t able to share specifics of deals done by family offices, but they said JAB Holding’s $7.5bn acquisition of Panera Bread in April 2017 was one of the most notable deals of the year. JAB Holdings is a German private equity investor and also the owner of Caribou Coffee and Peet’s Coffee & Tea.

In terms of the predictions for 2018, Short said that the M&A deals that may happen in 2018 will likely be more geared toward franchisee to franchisee, versus a refranchising event, and the overall M&A level will likely moderate somewhat, due to expected multiple incremental interest rate hikes.

“There were three interest rate increases in 2017 by the Fed and we’re expecting three or four in 2018. So as the cost to capital continues to increase, it’s very likely that lending is going to slow down a bit,” Short said. “In addition, a lot of brands are wrapping up their refranchising efforts. Burger King is completely done, Wendy’s is basically done refranchising, and most of these large brands are now at their desired ratio of company-run stores to franchise stores.”

Fretz added that a higher cost of debt will not only slow down the rate of capital expenditures, it will also likely suppress purchase multiples, “because it will not be possible to layer as much debt against a given amount of equity and maintain a certain WACC, or the debt-to-equity equation will shift because that cost to capital will be higher. This  equation should ultimately drive a commensurate decrease in purchase multiples absent more investable equity for a given transaction”

Short noted that the multiples on the acquisition of an entire brand have generally ranged between 6 times and 20 times, while the multiples for acquisitions between franchisees generally range from 4.5 times to 8 times, dependent on concept and size of operator. As for the difference in numbers, Fretz explained that “as a franchisee you are somewhat constrained as to what efficiencies can possibly be squeezed out of that operation from a cash flow margin perspective. You’re ultimately bound by the limitations of the brand itself. Whereas, if you own the brand, I think your opportunity for growth and improvements in efficiencies is perceived as almost limitless.”

Both Fretz and Short think 2018 will be another busy year for the food franchise sector with continued robust transaction volume, although likely focused more within franchisees and local and regional-size brands, and likely at multiples somewhat moderated from what have been seen the past couple years for reasons mentioned previously.

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By Kay Cruse Strategex | January 31, 2018

In due diligence for earnings and legal issues, best practice dictates the use of a highly qualified, third-party assessment.  So, why not take the same path when it comes to validating the qualitative elements that support the earnings history?

More importantly, if you had the opportunity to provide an assessment of future earnings in the same diligence exercise, how much more value could that provide to your deal assessment?

QofE looks at past financial performance.  Many times, we’re asked if there’s a way to document future earnings potential.  The short answer:  absolutely there is.

With few exceptions, in a third-party-assisted, detailed customer due diligence initiative, we are able to not only identify the potential for future spendbut importantly how customers believe the company ranks as their preferred supplier.  By extrapolating rank and future spend and comparing it to the target’s company’s share of wallet at the customer – something that QofE can’t find – one can build a pretty detailed picture of the future financials of a potential acquisition.

Coupled with how the company compares competitively – do they lead or lag competition – you’re on your way to identify future earnings, and also create a reasonable roadmap of potential hurdles that the newly acquired company will have.

What additional value does a third party bring?

Firstly, a professional research-interviewer is able to have an engaging and non-threatening conversation about the target company without ever having to mention that a deal is pending.   They can dig into key questions, such as:

• What are the company’s top strengths?
• What are its top areas of improvement?
• Why does the customer buy from the company?
• How does the company perform across a wide variety of customer-valued measures?
• What would the customer most like to see the company provide or innovate to solve underserved or unmet customer or market needs?

As important as the interviews themselves are, the most important element of a third-party’s customer diligence is the ability to pull together a complete analysis of both qualitative and quantitative findings.  This enables you to construct a strategy that is more fact-based and unencumbered by conjecture and preconceived theses.

In short, the value of third-party research is to have thorough conversations where there is no preconceived agenda. This helps you build a deep and clear understanding of what the company needs to do in order to have a more satisfied and loyal customer and what actions need to be taken to expand on growth and opportunity.

Who wins in this approach? Everyone: the target company learns from the Voice of the Customer what they need to do to accelerate growth and opportunity; the acquirer begins to have an intimate and detailed understanding of not only the target company but also of its customers in order to prioritize a 100-day integration strategy upon close; and lastly, the customer whose voice was heard and whose needs will be met.  We have found this approach often takes the sting and fear of a shift in ownership off the table.  It’s a great way to turn the page on a new beginning for both the acquired and the acquirer.

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By Karen Sibayan | January 13, 2016 – courtesy of www.axial.net

During negotiations in an M&A deal, buyers and sellers look closely at several factors in order to agree on a price that properly captures a company’s value.

One of the closely examined metrics in this process is EBITDA, which stands for earnings before interest, taxes, depreciation, and amortization.  EBITDA is used as a way to measure company performance. EBITDA indicates whether a business is profitable by revealing the amount of its normal operational earnings.

EBITDA has many uses in addition to the M&A sales process. For traders, analysts, portfolio managers, and others, it is an indicator of whether companies are properly valued. It is also a gauge for lenders to know if companies will be able to pay their future debt obligations. However, while EBITDA provides a valuable snapshot of a point in time in a firm’s cycle, it does not necessarily provide a complete picture of a business’ true value or performance.

What is EBITDA? If you’re considering selling your company, understanding how EBITDA is calculated can help you present your company’s financials in a way that makes your firm’s post-sale cash flow attractive to buyers.

Investors use EBITDA to measure the enterprise value of the company.

“In a sale process, generally what a buyer pays for a company is a multiple of EBITDA,” says James Cassel, chairman of Cassel Salpeter & Co. (an Axial member).

Is EBITDA the Same as Cash Flow?

Many think of EBITDA as synonymous to a company’s cash flow, but is this really the case?

Adams Price, a managing director at The Forbes M&A Group (an Axial member) says that EBITDA serves as “a proxy for pre-tax operational cash flow. It gives a sense of what cash flows might be expected to come out of the business after an M&A transaction.” Since a company’s depreciation, amortization, debt, and tax profile can change as a result of a deal, EBITDA removes those components from the picture. EBITDA is also a more standardized way for buyers to compare companies within their respective sectors.

What EBITDA effectively does, according to Cassel, is take the earnings of a company while not accounting for capital expenditures (capex) and the interest on a company’s debt.

EBITDA removes the factors that distort a company’s profit from the equation. This is why even though EBITDA is not precisely cash flow, it can be considered the best proxy.

Read more about Why EBITDA Is Not Cash Flow here.

How is EBITDA Calculated?

What goes into calculating EBITDA? Kenneth Eades, a professor of business administration at the Darden School of Business, explains how EBITDA is calculated to arrive at this standardized number. “The metric starts with EBIT,” a company’s profit before interest and taxes, “which is a nice number because it indicates how much profit a company produces before it pays debt holders and the government,” Eades says.

After taking EBIT and adding back the depreciation and amortization expenses for the period, we get EBITDA. EBITDA has the benefit of being a number that is not affected by how much debt a company carries. However, “this comparison is ideally used within the same industry because the depreciation and amortization part of EBITDA will differ across industries,” Eades says.

Depreciation expense is created when the cost of a long-term asset is divided and reported as an expense over a period of time. For instance, companies that are in capital intensive industries often have a lot of equipment on the books that creates a significant depreciation expense. When this depreciation expense is added to EBIT, the resulting figure is significantly larger. By contrast, other industries will have little or no depreciation to add back, which means the two figures will be approximately the same value.

While depreciation relates to “real” assets such as equipment, amortization involves adding back expenses tied with intangible assets such as intellectual property or patents. An amortization expense is created when a cost of a patent, for instance, is divided over the length of the patent’s life.

There are differences in companies’ multiples and earnings. When buying the assets of a company, the transactions are mostly on a cash-free and debt-free basis, with the debt being paid off at closing. In terms of cash flow, buyers look at non-cash items such as depreciation. From these, many private equity firms come up with a range of multiples of EBITDA depending on the industry and business characteristics.

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BizBuySell.com, the Internet’s largest business-for-sale marketplace, reported today that the number of annual small business transactions continue to ascend to new highs during the 1^st quarter of 2017!

Noted statistics from the report are:

• Average revenue for businesses sold increased by 8.4% over same period in 2016.
• Average Net Income reported by businesses sold increased by 6.6% over same period in 2016.
• Average sales price for transactions reported increased by 7.7% over same period in 2016.
• Total number of transactions increased by 29% over same period in 2016
• The Dallas / Fort Worth metro area reported the 9^th highest number of transactions out of the top 67 markets in the US.

The breakdown of business transactions by broad categories are as follows:

• Service 36%
• Retail – Other 29%
• Retail – Restaurant 22%
• Manufacturing 4%
• Other 8%

The top 5 individual categories for total transactions are as follows:

• Restaurants
• Health/Medical/Dental
• Convenience Store
• Dry Cleaning / Laundry
• Beauty Related

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