Manufacturing M&A: The Art of Anticipating Problems

Manufacturing business owners understand better than most the importance of anticipating problems. Mechanical issues, raw material sourcing, labor shortages… not having a contingency plan for the inevitable malfunction in any of those categories can be the difference between profitability and insolvency. The events that have unfolded so far in 2022, have made those anticipatory skills infinitely more important.

Earlier this week, we sat down with 5 manufacturing-focused deal professionals to discuss the state of M&A in manufacturing. Topics of discussion included things like the ripple effects of the war in the Ukraine on global trade, sustained supply chain congestion, and how those events are impacting manufacturing operations and M&A activity in the Lower Middle Market.

Thank you to the following Axial members who participated in the discussion:

• David Fowles, Vice President, Mangrove Equity Partners
• Jessica Ginsberg, Managing Director, LFM Capital
• Fran Korosec, Director, Align Business Advisory Services
• Terry Hannafin, Partner, Carter Morse & Goodrich 
• Justin Smith, Director of Business Development, LongWater Opportunities

Video

Introductions: 00:00 – 03:48

Russian Invasion of Ukraine and the Impact on the Lower Middle Market: 3:48 – 10:55

• Jessica Ginsberg, LFM Capital: At the moment, it’s too soon to tell what the impact of the war will be on deal flow. LFM capital is generally US focused and so they are not experiencing any impact in their portfolios yet. 
• Terry Hannafin, Carter Morse & Goodrich: Like Jessica said, the lower middle markets react at a much slower rate to macroeconomic news than the public markets do. In terms of discussing strategies with their clients, Carter Morse & Goodrich focuses on three topics. The readiness of the ownership group, the company, and the markets. The impact of the Russian invasion may impact some of those conversations but at this point it is too soon to tell. 
• Peter Lehrman, Axial: In terms of the timeline of selling a company, will the war impact when your firm will advise a company to go to market?
• Terry Hannafin: They usually take it case by case, the invasion would have to specifically impact that company. 
• Jessica Ginsberg: Similarly, LFM Capital tracks their metrics very closely in terms of how many NDA’s they sign and data on general deal flow, and it feels as if things are flowing normally despite the macro news. 
• Fran Korosec, Align Business Advisory Services: For Align, it is business as usual as well. They predict that unless a business is shipping or receiving their products directly to or from Russia or Ukraine, the impact of the invasion on the US lower middle market will not be very large, especially if that company was able to survive Covid.
• Peter Lehrman: How might the news impact your portfolio companies going to market?
• Justin Smith, LongWater Opportunities: Currently, LongWater is in build and acquisition mode at the same time and fortunately don’t have any supply chain issues due to the invasion. LongWater also has not dealt with companies in the oil and gas industry due to ESG concerns, however businesses in that industry will most likely be impacted even in the lower middle market.

Impact of Supply Chain Issues on the Lower Middle Market: 10:55 – 23:18

• Peter Lehrman: How have the supply chain issues impacted portfolio companies?
• David Fowles, Mangrove Equity Partners: Mangrove currently holds four portfolio companies, three being niche manufacturing businesses. Those three businesses are still being affected by supply chain issues in Asia and have seen rising prices, which must be partially pushed onto the customer. 
• Fran Korosec: Align’s clients have also completely changed the way they buy materials. More frequent buying cycles have transformed to purchasing in bulk. There has also been an erosion of gross margins due to increases in material prices and many companies are trying their best to pass those prices on to their customers in order to protect their margins. 
• Terry Hannafin: Carter Morse & Goodrich is seeing the same thing, with firms spending more time on planning and lead times than they did in the past. They have also begun to implement dual sourcing to find additional sources of inventory. 
• Jessica Ginsberg: On the bright side, although issues still exist, LFM Capital is seeing improvements in the supply chain. For example, increases in steel prices affected their portfolio companies, but they are seeing vast improvements. It is important to use real time data to react to these types of issues and so LFM Capital invested a lot of resources into analytics. 
• Fran Korosec: Another issue that has arisen is the supply and cost of skilled labor. Skills such as tool programming and machine operators have always been scarce but this have been exasperated. 
• Peter Lehrman: What exactly is causing this decrease in skilled labor?
• Fran Korosec: We have not been training and investing in these types of jobs in the last 20 years and so people are retiring and leaving the workforce. 
• David Fowles: Several of Mangrove’s portfolio companies are very engineer heavy and the average age of the employees is increasing. Not only that, but it is becoming increasingly difficult to keep those employees on.
• Jessica Ginsberg: Exactly. It’s both difficult to find skilled labor but also difficult to maintain talent. LFM is having to become increasingly creative in order to keep employees on, for example offering raises every month for the employees that stay on. 
• Terry Hannafin: How do the issues of employee retention factor into your acquisition strategies?
• Justin Smith: When LongWater speaks with bankers and brokers oftentimes the advisors cannot answer questions regarding labor problems. A business may be thriving, but has issues with their labor. LongWater takes this as an opportunity to automate. 

Lower Middle Market Automation: 23:18 – 35:41

• Peter Lehrman: Are there any examples of automation being implemented in the lower middle market businesses to combat the skilled labor shortage. 
• Justin Smith: Automation occurred in one of LongWater’s portfolio companies called Lewis Cabinets. The automation lowered lead times and improved shipping times. 
• Peter Lehrman: How big of a business was that? 
• Justin Smith: $6 Million in EBITDA.
• Fran Korosec: One of the businesses Fran works with added automation to their canning line during Covid, which has now added private label canning as a new dimension to the business. 
• Jessica Ginsberg: LFM also just bought a business called SureKap, who’s primary product is an automated bottle capper. Although machines exist for almost anything you can imagine, many lower middle market businesses are still doing things like bottling containers by hand, so there is still a lot of room for automation. They also bought a company called Eckhart through the Axial platform that manufactures lift-assist tools. Due to Covid, many firms have chosen to implement automation to combat the inability for people to work in-person and so companies like Eckhart saw tremendous growth due to this push for automation. 
• David Fowles: With all this automation, the key is doing it in chunks rather than automating all at once. This can help a firm grow steadily and not fall flat due to the rapidity of some automation processes. 
• Peter Lehrman: How is automation used in generational family owned businesses? Sometimes automation can be a sensitive topic in companies like these. 
• Terry Hannafin: There is a lot of conservatism in family owned businesses. Automation requires capital and a certain skill set and so an outside consultant will usually be brought in to make sure things run smoothly. 
• Jessica Ginsberg: How you pitch automation to a family owned business is also important. Many of them think that automation will result in a complete firing of all employees in their factory, when in reality there still needs to be people to run the machines. Therefore, education needs to be involved in the process. 

Pricing of Deals in the Manufacturing Industry: 35:41 – 51:00

• Peter Lehrman: How is pricing of deals changing in the lower middle market? 
• Fran Korosec: One of the businesses that Fran advised was able to pass along the increased prices of materials onto their customers. However, some aspects of the business, such as installation, could not be passed along, so businesses are having to become more and more creative in their pricing, both of their products and of their deals. 
• Terry Hannafin: Some businesses experienced a Covid bump rather than a decline and so now the question for those companies is whether or not their increase in business will continue and if their market share truly has changed. Carter Morse & Goodrich often advises their firms to wait for a period of time before entering the market because it can pay to prove that your increased business is sustainable rather than simply promising investors that it will continue. 
• Jessica Ginsberg: For LFM Capital, all pricing of deals is done on a deal-by-deal basis so it varies to a large extent. One trend she has seen is that earnouts and seller notes are becoming important factors in deals again. 
• David Fowles: Mangrove is seeing similar trends in that their due diligence process is increasing over time because they have to take an even deeper look at businesses than ever before due to changes in the markets. 
• Peter Lehrman: Pricing seems to be different deal by deal, but is there any fundamental change in diligence that will be maintained in the future? 
• Jessica Ginsberg: LFM’s diligence processes have not fundamentally changed. They are still working with outside sourced diligence providers. What LFM has taken away from recent events is that not all downturns are created equal. For example, pre-Covid, LFM would always ask for ‘07 – ’09 data to see how a business performed during a downturn. Now, it is just as important to look at ‘19 – ’21 data, yet they can not be accurately compared because the downturns were so different in nature. 
• Terry Hannafin: Carter Morse & Goodrich hasn’t seen any new lines of diligence, but they have certainly begun to go deeper into their existing diligence. 

Competition in the Deal Market: 48:56 – 01:00:25

• Peter Lehrman: Competition has increased in the lower middle market, what are some of the trends in the market regarding competition and buyer diversity?
• Terry Hannafin: A lot of lower middle market businesses recovered pretty quickly. However, there is still some hesitation from the sellers even with a large increase in buyer interest, which has driven up valuation numbers. Carter Morse & Goodrich focus mainly on tailoring their clients to specific buyers to achieve the best outcome. 
• Fran Korosec: Align takes the same approach to selling, by detailing what their owners hope to gain through a transaction and then coming up with a tailored list of buyers. Align is still seeing large numbers of strategic and financial buyers with the only difference being the length of time it takes for due diligence. 
• David Fowles: The market is very competitive and there is a lot of dry powder as well. Mangrove has tried to adjust to this by moving slightly up market and adjusting their financial criteria when searching for deals. Even with these adjustments, Mangrove has seen higher multiples as well. 
• Jessica Ginsberg: LFM is finding it harder and harder to win deals, and oftentimes it comes down to fit and culture rather than pure financials. LFM aims to be extremely flexible to suit the goals of owners. 
• Terry Hannafin: Exactly. Often a deal doesn’t come down to the last dollar and is more of a puzzle to try and find the perfect fit for that specific deal. 

Closing Remarks/Summary: 01:00:25 – 01:01:13

• Peter Lehrman: So many things have changed in the lower middle market but the one thing that has stayed the same is that it’s not always the top offer that wins a deal. Buyer and seller fit is a crucial factor that often outweighs the monetary details of a deal.