Private equity finding value in the specialty chemical sector

This article is from the February 2020 edition of SOCMA’s Specialty Insights, a semi-annual publication especially designed for the specialty and fine chemical value chain. See full edition here: https://www.socma.org/resource-center/specialty-insights/

Private equity investors can benefit specialty chemical companies with ambitions for growth and strategies for reaching goals.

Merger and acquisition (M&A) activity in the specialty chemical sector has been healthy in recent years due to the desire of many manufacturers to expand their capabilities from technology and geographical perspectives. In 2019, the level of activity remained high, but the pace was slightly lower than prior years and recent quarters, according to Bob Girton, a partner with Edgewater Capital Partners.

The slowdown is due in part to the fact that there isn’t a sufficient supply of specialty chemical companies available for sale, despite there being significant cash available for investment. “It is definitely a seller’s market today,” said Joe Beatty, Vice President and General Manager, FAR Chemical.

“Indeed, valuations remain robust, but there is some anecdotal evidence that more sales processes aren’t successful, driven by a combination of weaker financial performance and the pricing of businesses for perfection,” Girton notes.

Businesses trading for very robust valuations have high margins, a differentiated offering or capability, reasonably attractive growth prospects, and reduced economic cycle exposure (i.e., not focused on automotive, oil and gas, etc.). “Businesses that don’t meet these criteria are trading at much lower valuations,” Girton said. “In addition, there appears to be more of a focus on business stability (margins, cyclically, etc. vs. growth), a trend that is also playing out in the public market valuation.”

Specialty chemical companies are not appropriate investments for everyone
Private equity (PE) firms or others that acquire specialty chemical firms need to understand the nuances of the specific business, as well as the specialty chemical industry and marketplace, according to Beatty. They need to recognize the risk profile and how risks can be mitigated by the right people following the right processes.

“When chemical industry specialists are involved, it can be a real pleasure because they ask terrific questions,” Beatty said. “On the other hand, it can be awful to be acquired by a firm with a background in totally unrelated business areas and no knowledge or understanding of specialty chemicals. The learning curve is tremendously long before these firms can be true partners.”

“Edgewater Capital, for instance, has been focused on the specialty chemical market for more than 20 years and is drawn to companies offering unique value propositions to their customers. Sometimes that means traditional IP (patents), but more often it’s the technical knowledge of the team, the capabilities of the facility, and/or the understanding of their customer needs and applications,” said Girton.

“Edgewater searches for investments in companies that are enabling their customers’ end products with materials and solutions that contribute a small component cost but are critical to the performance of the application. If we get that thesis correct, there’s a high likelihood that our company will enjoy strong margins, an attractive growth profile, and recurring, sticky revenue, even if it takes some investment to unlock that potential,” Girton said.

The company narrative is important to buyers
One key for companies considering a sale is to have a real story to tell supported by historical performance. It needs to present a clear picture of what the company is currently, what it will be in the future and how it plans to get there, according to Beatty. “The story has to be realistic and have a beginning, middle and end that hold together so that buyers will have confidence in the management team and its ability to execute and perform,” he comments.

Additionally, owners of family run businesses often have higher expectations for buyers, in comparison to PE firms selling to other PE firms or publicly traded, strategic investors. “They want to know the potential plans for the business because the employees are like family. They don’t want to sell to buyers who are only interested in potential profits at the expense of jobs.”

When these companies are acquired by PE firms looking for growth, the buyers often prefer to keep the entrepreneurial company leaders
engaged with the company in some way. Such leaders, according to
Beatty, have historical knowledge and experience, as well as a vested interest in their firm, which are too valuable to lose.

It is, therefore, important when a business owner is contemplating strategic alternatives, including the potential exit of the business, to define what a successful sale should look like, according to Girton. The owners should determine if they want to stay involved in the business and maintain an equity position once the deal is complete. If the objective is full liquidity, they should consider what will be needed in terms of employees, technical knowledge and customer relationships once the owner(s) are no longer involved.

The quality of the buyers should be a primary consideration. “Because the private transaction market has become much more efficient and well covered, good businesses will very likely achieve strong valuations today. The more difficult challenge is assessing fit for softer qualities, such as who will be the best steward for the business, employees and customers, who fits best in terms of personality and culture, and who will be able to deliver the tools and skills needed to drive the organization to its next level of success,” Girton said.

Advisors bring maximum value
“It is important to hire a talented investment banking and M&A legal advisor with experience in the specialty chemical space that understands clearly the owners’ expectations, objectives, and plans for the business,” Girton says. Beatty agrees: “The credibility of the investment banker is paramount in this whole process. The right people know the market inside and out, have extensive relationships, and can open doors,” he said.

When Edgewater considers an investment target, fundamental to their investment thesis is to understand what drives the customers’ needs and assess alternative solutions (more simply, is the value proposition differentiated and compelling)? “We want to be aware of the reasons, in as detailed, technical manner as possible, why customers choose a provider and establish a well-informed opinion on the overall direction of the relevant market and future needs. Through this, we generate a roadmap supported by those customer needs which is then linked to investment in the people, facility, and infrastructure or capabilities to fix identified company challenges and enable substantial, outsized growth,” explains Girton.

These types of investments can be beneficial for specialty chemical firms that lack internal resources but are looking to move to the next level. In addition to financial capital, PE investors often provide intangible assistance in the form of process discipline, geographic integration, as well as access to industry consultants with expertise in everything from market intelligence to manufacturing, according to Beatty.

Building value most important part of the equation
PE firms are generally not constrained by political considerations, unlike in the case of large, publicly traded strategic investors. “There is bureaucracy in these larger firms combined with the constant worry about quarterly earnings,” Beatty said. “Private equity, on the other hand, doesn’t care about politics within the company and doesn’t have a short-term focus on earning. They care about building the value of the enterprise and making decisions quickly that are focused on helping the company achieve its objective within the specified timeline.”

Edgewater has historically invested in orphaned divisions within large corporations and businesses run by owner-operators contemplating leadership or succession planning. Frequently, the later continue as our equity partners once the deal is close. “In both cases,” he said, “our job is to be the catalyst of change, unlock the unique capabilities that our organizations provide, and clarify focus and priorities on ambitious growth.”

Equally important, Edgewater is focused on enabling and empowering the people working for the companies it invests in. “At the end of the day, ALL of Edgewater’s investments are technical service businesses, and our people are what differentiate us from the competition. This means we need to support our teams by investing in people, facilities/infrastructure, and technology. Our job is not to ‘run’ these businesses, but to support and enhance the already wonderful things they do and the value these organizations bring to our customers,” Girton said.

In the current competitive M&A environment, Edgewater also seeks acquisition opportunities that provide quicker and, in some cases, clearer paths to enhancing its platform investments. Examples of M&A decision drivers, according to Girton, are opportunities for product diversity, commercial channel access, additive technology that enhances the value to its customers, increased scale/depth of the organization, and those that augment the team. “In these cases, Edgewater will act aggressively, both in terms of value and process, to distinguish ourselves from other potential suitors,” he said.

Alignment of expectations and transparency key to success
“The foundation of those values (alignment of expectations and transparency) is grounded in agreement on the ultimate objective and the critical factors/priorities to get there. Along the way, things will come up, and we will need to adapt together. That said, the longer we wait to face challenges, especially if they are fundamental to the investment thesis, the more difficult they will be to overcome,” Girton comments.

Typically, PE firms will maintain investments in specialty chemical companies for five to seven years. Edgewater builds its investment case around five years as it drives the target returns for Edgewater’s investors. That said, we’ve held investments for both shorter and much longer periods though, according to Girton. “The decision to exit is driven by when we think we’ve reached our targeted business objectives,” he says. “In practice, Edgewater’s strategic plans are typically only three years, because longer periods do not provide sufficient line of sight to specific actions needed to drive the business forward today,” he adds.

For more information on commercial trends and SOCMA’s ChemSectors, contact Paul Hirsh at phirsh@socma.org.

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