Written by: Dillon Zwick
Edited by: Jon Nash
In the early 1980s, the junk bond king Michael Milken and his investment banking firm Drexel Burnham Lambert ran into a difficult problem: they were too successful. They were so good at selling junk bonds that they ran out of junk bonds to sell. To solve this problem, they realized a company could be purchased using its own assets as collateral, which would create more junk bonds for them to sell. Even better, it would push the company’s existing credit into junk territory, which they could also then sell. This is how the leveraged buyout (LBO) was born.
Drexel Burnham Lambert would play financier to the corporate raiders like Carl Icahn, who dominated the 1980s and 1990s. Buying up companies, slashing and burning corporate excess, and then selling for a hefty profit.
By the 2000s, the corporate raider strategy had run its course. Its demise was due to a variety of factors. Too many players duplicating the same strategy drove up costs and eliminated all potential profits. In addition to market saturation and no remaining viable targets, corporate culture also changed as companies unilaterally cut costs to make themselves more profitable and less appealing to the raiders. From the ashes of one strategy, another was born.
From 2000 until last year, many private equity (PE) shops took over the leveraged buyout space. Many utilized a platform roll-up strategy that is heavily driven by inorganic growth. The strategy is simple: buy up many different companies in a particular market, merge their back-office departments, cut excess capacity, let the profits flow to the bottom line, and then sell after a short holding period.
Although some players in that space have been very successful, since 2008 most PE firms have failed to beat the S&P 500 and have provided suboptimal returns. As the legendary Peter Drucker would say, “Culture eats strategy for breakfast”. Roll-ups gave way to pile-ups and integrating the cultures of multiple disparate companies simultaneously often ended disastrously.
In 2017, the Tax Cut and Jobs Act created the carried interest tax deduction that set the industry ablaze. As of January 2022, there is now $1.81 Trillion of dry powder in the private equity sector. There has never been more money allocated to investment activities in all of human history than there is today. The result is now complete market saturation, or as the industry would say, there is too much money chasing too few deals.
Just as the corporate raider gave way to the roll-up, the roll-up is coming to an end in favor of what’s to come.
So, what is to come?
By the end of this year, the Fed is likely to raise interest rates to 3.5%. With the US economy at full employment and all major inflationary drivers (energy, shelter, food) still pointing up and to the right, the Fed is likely to blow past neutral and continue to increase in 2023. One consequence of this is that corporate valuations will decline. A company trading at 12-15x EBITDA today will likely only fetch 8x or less in the near future.
Even markets that possess high buyer demand and abundant capital can still catch investors offside. In the housing market, Zillow paid above-market prices on houses hoping to quickly flip, but they got too far ahead of the market and ultimately lost $880M on the venture.
Private Equity firms that loaded up on acquisitions in the past few years will be stuck with the companies on their books. They will be faced with either holding for the long term or booking a loss. Even worse, much of the LBO market is financed on variable rate debt, making current portfolios sensitive to rising interest rates.
During the roll-up era, investors were dissuaded from putting money into their companies and undertaking deep operational restructurings to optimize performance. They were unlikely to hold the companies long enough to see the results of such efforts and those added costs would have actually been harmful to short-term valuations. If the past decade was dominated by financial engineering, then the 2020s will be the decade of the operator.
The new era of M&A activity will be that of the corporate overhaul. The best use of dry powder will be devoted to enhancing corporate performance, optimizing supply chains, investing in the business, and generating organic growth. The corporate overhaul playbook is as follows:
Regionalize Business Operations
It’s no longer feasible to have supply chains that wrap around the world. Companies will need to move operations to the same trading block as the customer. If a company’s operations are in the Regional Comprehensive Economic Partnership trade block, but are serving US customers, then it is time to reshore operations into the US, Mexico, Canada (USMC) trade block.
Manufacturing lead times have never been longer and have shown no signs of improving. As interest rates and cost of capital rise, they will eat away at any savings offshoring may have provided. Meanwhile, the cost savings of offshoring dwindles by the day.
Cash Conversion Cycle
A company today sourcing goods from China is faced with the following situation. Suppliers want 15% cash down for a quote, another 35% for a PO, and the remaining 50% FOB, with a projected cycle time from PO to delivery in the US close to 90+ days. If that same good was sourced in the USMC trade block, the terms would be 50% cash down for the PO and 50% 30-60+days after delivery. Even more significant, the cycle time would likely only be 30 days.
The amount of time it takes from the day payment leaves the company’s bank account to the day they get cash back on the sale of their product differs substantially in those two scenarios. In the first situation, the cash conversion cycle is 90-120 days. In the second scenario, it’s anywhere from -30 to 0. As interest rates rise, the interest expense in overseas operations will become less tenable.
In 2000 at the height of offshoring, it was 34.6 times cheaper to hire a Chinese employee than a US worker. This has been reduced to 4.5 times cheaper and continues to approach parity. China’s working-age population peaked in 2012 and now their demographic decline has produced major labor shortages, with 70% of companies struggling to find workers.
Some companies, particularly retailers, have attempted to respond to supply chain issues by abandoning lean manufacturing principles and overloading inventories that are now facing large markdowns. The problem isn’t lean manufacturing. The problem is extended supply chains in a time of global turbulence that is likely to worsen as the world contends with geopolitical instability, climate crisis, and demographic decline. The solution is to apply the principles of lean manufacturing to the supply chain – eliminate waste, reduce cycle time, and increase reliability.
As companies near-shore, they need to automate as many jobs as possible. The US working-age population peaked in 2019 and has declined ever since. The continued loss of workers, combined with increased demand for labor generated from caring for an aging population, foreign direct investment, and reshoring, will drive up labor costs for the next several decades.
Luckily, the price of industrial robots has decreased more than 50% since the 90s, and there is a lot of room to grow with current technologies. Robot density is around 1% in the US, far below the 8.3% obtained in Singapore. But the US is starting to catch up. One emerging success story is the largest meat packing facility in the US under construction in South Dakota. It is utilizing the latest technology and will be able to operate with 20% fewer employees than traditional plants. Nationwide, robot orders are up 40% in the first quarter of 2022.
Invest In Organic Growth
Inorganic growth has been increasingly rare as two decades of roll-up strategy has depleted most of the market of opportunities. As firms switch to holding their investments long-term, they will need to invest in organic growth models.
However, there is an inherent barrier to switching from a roll-up mentality to an overhaul strategy. Overhaul requires investors to shift from taking money out of the company to pouring money in. Companies that seize this opportunity early will be able to run circles around their competition for years until they catch up, as it takes years to restructure and reshore operations. Investor hesitancy is the opportunity to seize here.
Prepare For The Worst (Cut Costs and Risk)
The ESG (Environmental, Social, Governance) movement gets a bad wrap for being a rebranding of the triple bottom line rhetoric that started in the 1970s. As the saying goes, doing good for people, the planet, and profits often gets interpreted as virtue signaling over what is best for one’s business. This seems to have been borne out as many companies that prioritized people and the planet often ended in bankruptcy.
Long term, a sustainable business is a profitable business. And, a profitable business is one that doesn’t go belly up from mishandling the challenges of our generation. ESG is now better understood as effective risk management for the current crisis of climate change, demographic decline, and failing democratic institutions.
Since the 1980s, we’ve witnessed a 500% increase in natural disasters driven by climate change. Last year, climate-related disasters cost the US economy $145B, a 50% increase from 2020. As the climate crisis unfolds, businesses will face critical and unfamiliar issues. This year alone, businesses will have to contend with:
- Extreme heat waves. Texas just experienced the hottest May on record by a staggering 5.5° above average. The heat is increasing energy consumption and straining the already unreliable Texas power grid.
- Across the US, power grid operators are warning of rolling blackouts this summer.
- Fire marshals in Texas are warning of historic wildfires like those not seen since 2011.
- Conditions in the Gulf of Mexico are similar to those in 2005 that brought about the devastation of hurricane Katrina.
The baby formula facility at the heart of the recent shortage is now offline again due to severe thunderstorms that caused the plant to flood, and will take several weeks to come back online. While Tesla’s plant in Germany has experienced several delays due to being built in a region with insufficient water resources. The facility can’t expand past phase 1 development without additional water projects constructed in the region.
Companies will need to stress test their operations and ensure the viability of their disaster recovery/business continuity plans to ensure they have water, power, and resilient supply chains to continue operations in the face of environmental disruption.
Employee quit rates are at all-time highs. While each year, the US working-age population shrinks, it will be increasingly paramount for businesses to train and retain talent.
Turnover can cost a business 1.5-2x an employee’s annual salary. Incurring costs of recruitment, training, loss of productivity, loss of institutional knowledge, harm to employee morale, increases in errors and defects, and a slippery slope of more turnover.
The cost of turnover and retention rates will become standard KPIs that companies will have to manage going forward.
In 2021, a record 46% of tech IPOs have a dual-class shareholder structure that often gives founders super-voting rights and ensures that the CEO can’t be fired. When boards of directors can no longer fire the CEOs who report to them, CEOs become unresponsive to board guidance. Removing those guardrails has led to some spectacular abuses of power in recent years, most notably WeWork & Uber. Each instance cost shareholders tens of billions in value. Corporate governance that provides for true checks and balances is the tool to ensure underperforming CEOs don’t take out the entire business with them.
Companies that actively manage risk through an ESG strategy have been shown to benefit from operating cost reductions, higher employee retention rates, greater access to capital, and better financing terms.
While the working-age population grew, GDP growth was almost self-assured through an ever-expanding production and consumption base, a phenomenon known as the demographic dividend. In that environment, businesses won by producing the most amount of goods for the most amount of people. Now that we have entered a period of retrenching, the game’s fundamental rules have changed. The new winners will be those companies producing the best goods and services using the least resources – time, money, and people. If this sounds like the early 90’s, well dig those fanny packs out of the attic and get to work.