Reprinted from Modern Distribution Management

Five years ago just a handful of reported acquisitions involved private equity investment, and consolidation overall was moving at a snail’s pace. At that time, many financial buyers expected e-commerce could marginalize the role of storefront distributors. They also saw integrated supply as a threat to the viability of many distribution companies.

"The sector was long undervalued," says James Miller, a managing director and head of the distribution practice at Brown Gibbons Lang & Company, an investment banking firm with offices in Cleveland and Chicago.

But fast forward to 2006, and interest from private equity has picked up to a sprint. Financial buyers played a role in at least 35 distribution transactions in 2005, Miller says. Private equity groups snatched up more than $20 billion in revenues in reported distribution deals between December 2004 and December 2005. That’s more than the total reported revenues acquired by private equity groups from 2000 through 2004.

What’s driving the trend? Part of it is an across-the-board increase in M&A. Private equity groups in particular have an unprecedented chunk of cash to play with – the capital raised in 2005 was 300% higher than that raised in 2004, Miller says. More than 150 funds have more than $1 billion under management each. "They’re raising capital faster than they are spending it," he says.

In fact, more than $100 billion worth of unspent private equity is available, which represents more than $400 billion in buying power with leverage. Those in the financial industry say the spending spree is unlikely to subside anytime soon.

Why Distribution?
Private equity firms are economic buyers looking for a high rate of return on their investments. They usually buy companies, build them up, and then sell them after several years, either to a strategic buyer, another financial buyer, or through an IPO.

For these financial buyers, the stock of distribution companies is rising. In 1999, fewer than three dozen private equity groups had a stated interest in acquiring distribution companies. Now more than 80 are looking for investments in the sector, Miller says.

When it became clear that integrated supply and e-commerce weren’t having the forecast effect, private equity groups took another look at the sector. Big deals such as Clayton, Dubilier & Rice’s 2004 investment in Rexel Inc., the $9 billion global electrical distributor, also helped to validate wholesale distribution companies. CD&R invested about $4.4 billion in the company.

Numerous other firms made successful investments in distribution companies in diverse sectors, seeming to confirm the channel’s potential. Among them: WESCO, whose sale in 1998 to another private equity firm resulted in 6X CD&R’s initial investment. It was later taken public by The Cypress Group. Beacon Roofing Supply’s IPO resulted in a 9.5X return on Code Hennessy & Simmons LLC initial investment.

"Distributors have what we consider a very attractive spread of risk," says David Novak, a partner with Clayton, Dubilier & Rice Inc. Novak was the lead financial partner responsible for the acquisition of Rexel.

Investing in a good wholesaler-distributor is like investing in a portfolio, Miller says, because distributors serve many different end-users and manufacturers. Business is usually not dependent on just a few key relationships.

Despite many investors’ earlier worries that e-commerce would challenge traditional distribution channels, Novak says there is little threat that technology will disrupt wholesaler-distributors’ functions. Instead, technology is increasingly making it easier for distributors to cut waste and work more efficiently. This is also attractive to investors.

What’s more, wholesaler-distributors are taking on more responsibilities. These include sales, marketing and other value-added services, which again increase companies’ viability, Miller says. When a manufacturer or an end user outsources these services to a distributor, it’s difficult to take them back in-house.

After the economic downturn of 2002, many companies implemented leaner practices and cost-cutting initiatives that have improved margins, says Mark Doran, a partner with Freeman Spogli & Co. In addition, higher commodity prices have helped propel revenues. Freeman Spogli owned Century Maintenance Supply before it sold the MRO distributor to Hughes Supply in 2002.

"The deal flow seems to have picked up more in industrial than in other sectors," Doran says. But financial buyers say that they have seen increased activity in sectors across-the-board and in almost every size of distribution company.

Financial buyers may be more inclined to look at sectors of distribution that aren’t cyclical. "It’s tougher to sell companies in cyclical markets," Miller says, such as industrial, electrical and electronic component distributors. "Many distribution sectors are coming off cyclical low points so it may be perceived as a good entry period," says Jonathan Seiffer, partner at Leonard Green & Partners LP. Leonard Green invested in White Cap Construction Supply and sold it to The Home Depot in 2004.

Going Up
As interest from financial buyers has increased, so have valuations.

Valuations of all acquired companies – not just wholesaler-distributors – averaged 8X EBITDA in 2005. When you break it down by size of company, those with greater than $500 million in revenues saw an average 8.5X EBITDA in 2005; $250 million-$500 million saw 8X; and the average multiple for companies with less than $250 million in sales was 7.3X, according to Standard & Poor’s.

In 2001, the average for large companies was 6.3X, while that of the smallest companies was 5.4X. Those in the middle haven’t changed significantly, up from 7.8X EBITDA in 2001, though 2002-2004 had valuation multiples that fell to 7X EBITDA.

The highly liquid debt markets are facilitating private equity funds’ ability to pay premium prices. Average total debt/EBITDA advance rates to fund leverage buyouts have risen from a low of 3.6X in 2001 to 5.2X in 2005. "It’s not that difficult to get to a 7X purchase price multiple when you can borrow 5X, especially when you are under pressure to deploy your equity capital," Miller says.

On the higher end, Home Depot recently announced it would buy Hughes for nearly 12X EBITDA, or about $3.4 billion, a premium price that resulted from competition for Hughes from an unnamed financial buyer. CD&R paid 10X EBITDA for Rexel.

The valuation gap between strategic and financial acquirers is disappearing. Strategic acquirers used to outbid financial buyers. Now, private equity investors have closed the gap and many times even outbid strategic buyers, Miller says.

"It’s definitely increased seller expectations," says Peter Gotsch, partner with Code Hennessy & Simmons LLC.

Seiffer of Leonard Green agrees. "But ultimately I would be surprised if there are a significant number of transactions at these valuation levels unless meaningful synergies are available to buyers," he says.

Rising valuation multiples may also be forcing financial buyers with extensive experience in the industry to be more strategic in nature, CD&R’s Novak says. Over the past 10 years CD&R has bid for some of the top electrical distributors globally, including its investments in Rexel and WESCO. At one point, CD&R also entered talks to buy electrical distributor Hagemeyer NV, but those plans fell through after the company’s lenders decided to pursue a financial restructuring instead. The firm also has invested in foodservice distributors: Alliant Exchange, which it sold in November 2001 for a $1.3 billion gain, and Brakes, a UK-based distributor acquired in 2002 for $989 million.

Rick Cravey, of Cravey, Green & Wahlen, says he expects valuations to stay high, at least for the next 12-24 months. His firm focuses on companies at the lower end of the market – at least to the vast majority of financial buyers – with values of $25 million to $200 million. One of the company’s largest purchases was of $300 million industrial electronics distributor Carlton-Bates, which was sold to WESCO in September.

What Buyers Want
While some firms do look for turnaround opportunities (for which you likely won’t get a premium), most have standards and thresholds they want distributors to meet before they invest. The top concern for most is capable and stable management, at both corporate and branch levels. Other factors:

• Stable cash flows: Investors need to secure debt at closing as well as be able to pay down debt.

• IT systems: Technology supports growth, which is the goal of all financial buyers when they invest in your company.

• Training programs: "If the people aren’t good, the distribution business won’t be good," says CHS’ Gotsch. There should be a system in place for replenishing and improving the work force, including the recruitment of college graduates.

• Value-added services: Taking on additional services makes a company more viable by making it irreplaceable in the supply chain and giving it the ability to capture more market share.

• Defensible market position: Investors will be looking for opportunities to garner more market share and grow the company. Gotsch says it is more important to have a significant share of a product market or a local market than to have a broad footprint in several markets. High market shares are hard to duplicate, he says.

• Diverse customer base: Investors don’t want a company that has a majority of its sales concentrated in a few large customers. They prefer a mix of small and large customers and suppliers, Cravey says.