Manufacturing Private Equity: Strong and Gaining Steam in Q4 2015

If 2015 has seen an overarching theme in the mid-market private equity space, it’s probably best described as “eagerness for activity.” The markets are lush with new PE capital. Nowhere is this truer than in manufacturing, which has stabilized since 2009-10, when the seeming consensus was that U.S. manufacturing was a relic from a bygone era.

The private equity community showed strong support for manufacturers in 2013, pushed valuations to new heights in 2014, and maintained its upward momentum in the first half of 2015. PE continues to demonstrate faith in manufacturing companies as the final quarter of 2015 unfolds.

Even in the face of a strong dollar, the manufacturing industry continues to show signs of strength — although some are concerned about jumping into a saturated market and getting burned by sky-high valuations.

Eagerness for Activity

CohnReznick, the tenth-largest public accounting firm in the country, estimated that more than 1,650 mid-market private equity deals took place in 2014, a record high flow. More than 1,030 of these deals, or roughly 62%, occurred in the industrial manufacturing and wholesale distribution sectors.

PE activity is particularly centered on middle market companies. According to Pitchbook, approximately 83% of total buyout activity took place with mid-market firms, up considerably from the historical 70% share. As noted by Jeremy Swan, principal in Venture Capital Practice, “even big name private equity brands like the Carlyle Group and Berkshire Partners are devoting more capital and energy to the middle market.”

Investors and manufacturers are seeing valuations climb across the board. According to Preqin Buyout Deals Analyst, the average PE-backed buyout deal among North American industrial manufacturers grew from less than $350 million in 2013 to greater than $500 million in 2014. Deals exceeding $1 billion more than doubled in the same timeframe. This represents the highest average value since before the financial crisis and the second highest of the century.

The markets are bloated with cash right now. A research report by RR Donnelley found that PE general partners only returned $232.5 billion in 2014 and that capital called by PE investors was also down. This represents a 21^st century high for total net cash flow in the segment.

Shifting Fundamentals in Manufacturing

Global pressures on manufacturing are emphatically different in late 2015 than they were five or ten years ago. There’s plenty of evidence to support the notion that the United States is experiencing a renaissance in the manufacturing industry.

In 1973, manufacturing accounted for 25% of U.S. GDP. The 1980s and 1990s saw a huge concentration of manufacturing product transfer to China, Mexico, and other low-cost environments. By 2013, manufacturing only accounted for 12% of GDP and only 8.8% of total employment — a precipitous decline. The sector was particularly hard hit during the recession. Nearly 280,000 jobs were lost in the auto manufacturing industry alone between 2007 and 2009.

Yet reports of manufacturing’s death have been greatly exaggerated. Manufacturing employers added 869,000 jobs between March 2010 and April 2015, according to the Economics and Statistics Administration. Drivers of industry growth include plunging oil prices, lower costs for raw materials and transportation, rising labor costs in Asia and Latin America, and added efficiency from American manufacturers.

The June 2015 report from the U.S. Department of Commerce stated that 76% of manufacturing job gains have been in three durable goods sub-sectors: machinery, fabricated metals, and transportation equipment. This isn’t necessarily correlating to interest from PE investors, though. According to the Federal Reserve Board, the dominant PE manufacturing subsectors are aerospace and defense, food and beverage, and chemicals.

Factors Fueling Mid-Market Deals

As important as the return of strong manufacturing fundamentals has been for various economic sectors, the real movements behind robust manufacturing private equity activity are more systematic. The entire private equity field is feasting on a strong sales cycle. Company owners are living through positive asset inflation. The scars of 2008-9 are still present: Owners recognize the risk of holding onto their business in the longer term and want to get out while they are ahead.

Investors and fund managers understand how competitive and aggressive the markets are trending. This puts a lot of pressure on PE firms to deploy capital and put assets to work. According to the Wall Street Journal, there is also a record amount of cash sitting on corporate balance sheets earning next to nothing.

This phenomenon is apparent when you consider the nature of PE-backed exits in 2014 and early 2015. Across the country, smaller firms are leveraging M&A deals and low financing rates to turbocharge growth. Tales abound of lower mid-market firms (enterprise value around $20 – $50 million or so) that got burned during the recession. These firms scaled back costs and labor during lean times, but preserved physical capital. Many were looking for assistance to take advantage of rising markets. There continues to be significant room for growth or value-add services for such firms. These are exactly the types of manufacturing companies that PE and M&A professionals are working with heading into 2016.

Manufacturing Multiples

Mid-market companies with lower CapEx, relatively high cash generation, and a steady performance even through the recent recession are likely to have the most attractive multiples for PE investors.

Private equity likes lower multiples, but that’s a bit of a rarity across the sector. Preqin estimates that multiples can rise as high as 15 times EBITDA, though it’s more likely that multiples will reach 4x or 5x in the upper middle market and 2.5x to 3x in the lower end. Either way, there is a squeeze on multiple arbitrage opportunities.

One area that where investors are likely to see smaller multiples is in machining (perhaps with a few hotspot exceptions, such as when Boeing built a huge new plant in South Carolina). Depreciation and technological advancement force machining companies to devote serious CapEx to continued operations. Very few companies can readily do this, which means that multiples on the aggregate can lag behind.

Secondary Factors for Manufacturing Private Equity Participants to Consider

Numbers can’t capture every element of the modern manufacturing/private equity dynamic. The middle market in particular has its own eccentricities, such as succession planning issues or shifting or uncertain business models. These considerations are critical for those trying to unload capital before the investment fund period closes.