Strategic Vs. Financial Buying/Selling of a Custom Coater

Custom powder coaters face two primary alternatives when considering the sale of their business to third parties: the sale of 100 percent of their business to a strategic buyer or the sale of 60 to 80 percent of their business to a private equity firm. This decision can be complex. Thus, before beginning the process of selling, owners should gain in-depth knowledge of the value these business relationships can offer and whether a strategic purchaser or a financial partner is a better option.

First, know how each type of buyer operates and which one will enable your business to meet its objectives. Let’s examine the options:

• Strategic buyers are companies already in similar lines of business and which are focused on enhancing their existing business model and the financial return to their shareholders from the purchase of another company. Strategic buyers may also include the portfolio companies of private equity firms that are functioning as acquisition platforms. A strategic buyer may be upstream in the custom powder coaters supply chain (manufacturers of powder coating equipment, powder, and other consumable supplies), downstream (metal fabricators with in-house or outsourced powder coating), or metal finishing companies that provide competitive or complementary finishing services (other custom powder coaters, galvanizers, painters, platers, etc.).
• Private equity firms are companies that may have experience in the same or similar supply chain, but are not currently in the same line of business of the target company. Their primary focus will be looking at the company as a standalone investment with the potential for internal growth of revenue, earnings, and free cash flow. A secondary focus will be on achieving external growth by converting the company into an acquisition platform.

In many private companies, the owners’ objectives may diverge from one another. Reconciling those differences is critical to a successful relationship with any buyer. What are the financial and ownership objectives of prospective buyers? How do these compare to the owners’ definition of success? Aligning or reconciling these objectives is imperative. Performing due diligence on prospective buyers is every bit as important as the buy-side due diligence on the target company. In any transaction, there will inevitably be organizational changes and dislocations that occur post-closing. The owners should have a planning team created to identify and develop solutions to these issues, along with the buyer.

Strategic buyers are often ready to pay top dollar for an acquisition. Several factors are involved, including the potential to realize operating synergies and their willingness to receive lower returns on investment (ROI) than private equity firms. Strategic buyers may also offer a higher price in exchange for their stock, but that comes with both upside potential and downside risk. Private equity firms typically offer a lower initial purchase price, but with the prospect of higher, long-term gain based upon the future sale of any retained ownership.

While strategic buyers will usually acquire 100 percent of the target company for cash or some combination of cash and stock, private equity firms are able to offer all cash deal structures with the flexibility to meet the divergent needs of the ownership group.

One of the most important issues in deal structuring is financial leverage. Private equity firms tend to use higher levels of debt in the capital structure of acquisitions than strategic buyers. The effect may sometimes be to over-leverage a business, thereby reducing the reinvestment of operating cash flow into the business to fund growth. Owners must analyze the debt load in comparison to projected operating cash flows to realistically assess whether the capital structure fulfills operating requirements.

The strategic buyer’s industry expertise can often reduce the length and complexity of the due diligence process. Since financial buyers frequently do not have the same industry expertise, they may bring in consultants to perform part of the due diligence, thus drawing out diligence and delaying closing. Regardless of the type of buyer, it is still important that owners educate prospective buyers on the numerous benefits of powder coating, including its efficacy as a coating medium, its environmental superiority to other finishing techniques, and the custom design capability of powder coating finishes.

Owners should carefully review the investment criteria of prospective buyers, particularly private equity firms. Is this transaction consistent with their stated industry preferences and experience? Will they be able to add value based upon previous experience? Is this transaction consistent with their stated target company size? Is the proposed transaction structure similar to previous transactions in their portfolio? Is the proposed transaction consistent with previous transactions, e.g., if the buyer specializes in acquiring businesses with solid fundamentals, what are the implications if this transaction is a turn around? Does the private equity firm have sufficient “dry powder” to make incremental investments in the business, as needed? Previous acquisitions made by the firm will also indicate its strength in the follow-on investment stage.

The owners of a custom coater need a realistic assessment of what actually happened with the PE firm’s prior transactions. Every transaction includes a lot of “happy talk.” The objective is to get a complete picture, which is only achievable through careful due diligence and analysis. Uncovering issues with disruptive potential before the transaction closes is the paramount objective of this process.

Aligning strategies and visions may be one of the most important criteria in selecting between strategic buyers or private equity firms. Despite the fact that strategic buyers, unlike some financial buyers, will already have their own plans, the company is tasked with clearly explaining its vision and strategy for success.

Minimizing workforce disruption and maintaining the culture of the business will most likely be achieved through a partnership with a private equity firm, as strategic buyers will look to obtain synergies by streamlining operations through reductions in staff and management. That’s not to say private equity firms are not also committed to operational efficiency, but there is more opportunity for the target company’s management to remain intact, taking a strong leadership role in the new organization.

Good strategic buyers understand the importance of figuring out the essential cultural attributes that originally led to profitability and innovation in the acquired company, with the goal of preserving those essentials after the purchase. Cultural or legacy attributes that inhibit integration and operational improvement will be quickly eliminated. Private equity firms will have a greater tendency to maintain the culture of acquired companies and preserve the legacy of the business.

The seller is in the position to make many of the initial decisions that will determine how the relationship proceeds. Strong negotiating skills and a willingness to compromise will be key during this stage.

It’s in the best interest of the buyers to tell sellers and management that they are a partner in achieving long-term financial and operating objectives. They promise to work on strategic decisions together and to let management run day-to-day operations. Normally, those are true statements, but due diligence will reveal the extent to which that will remain true post-closing.

Management should be prepared for the somewhat laborious phase following closing, when the focus is on achieving operational excellence and organic (or internal) growth. Growth through acquisition will only occur after the platform company achieves operational excellence.

History has shown that the leading exit strategy for a private equity firm is to sell to a strategic buyer. The second leading strategy is to sell to another private equity firm focused on larger companies. Therefore, even if the first transaction is completed with a financial buyer, the target company and the managers with retained equity interests are more likely than not going to sell their ownership in a subsequent transaction to a strategic buyer.

John D. (Jack) Kearney Sr. is the managing director of investment banking at Dumas Capital Partners, LLC in Dallas/Fort Worth. He specializes in providing corporate finance services to middle-market companies and can be reached at jackkearney@DumasPartners.com.