Private Equity Challenges Amid the Supply Chain Crunch
The effects of the global supply chain bottlenecks have been felt from the Port of Vancouver to the Port of Halifax and everywhere in between. Just about every business has been impacted in some form, but particularly the ones that depend on international trade. It’s also created a challenge for private equity firms looking to deploy capital and grow their portfolio companies.
Increased shipping costs and transport delays have led to tighter margins. There’s also the uncertainty regarding how long the situation will last. The end result is it’s difficult for private equity investors to determine an accurate valuation for a potential acquisition. Nonetheless, there are steps sponsors can take to be comfortable with making transactions in this environment.
Noise in the Numbers
The supply chain woes, which started in the early stages of the COVID-19 pandemic, have greatly accelerated over the past six months as global economies have reopened more broadly and demand has surged. With shipping costs skyrocketing, products delayed getting to market and no definitive resolution in sight, the situation has created a lot of “noise in the numbers.” That is, the current environment has made it difficult to gauge a company’s true financial position, whether it’s liquidity, cash flow, or EBITDA. What’s really giving private equity sponsors pause is the difficulty in projecting future returns as past and current performance may not be indicators of future profitability.
We’ve heard from one client that a shipping container that cost $4,000 to carry goods from Asia to North America a year ago now costs $20,000. Given that this particular customer ships less than $100,000 worth of goods in that container, it’s easy to see how much this dislocation impacts the company’s bottom line. We are seeing companies attempt to pass increased transport costs to the consumer, but no company can expect to fully offset a 5x increase in its shipping costs. Businesses may even need to reevaluate their own product lines and distribution channels, weighing the cost with the opportunity. Changing their operations could mean a dramatic difference in future profitability and may even require time to invest in new facilities or acquire new customers, which could result in a near-term dip in their numbers.
Focus On Resiliency
So how should private equity sponsors respond? It’s a matter of going back to the fundamentals and investing in business models, competitive positioning, and leadership teams. One way to assess a company’s underlying strength is to see how they reacted to the early days of the pandemic or during the start of the U.S.-China tariff skirmishes in 2018. The companies that demonstrated flexibility and developed innovative solutions in response to those challenges are likely to respond similarly to the current supply chain crisis.
During the pandemic, the management teams of our borrowers, backed by the private equity investors they’re working with, showed how quickly they were able to adapt to COVID-19. These teams were quick to react, including cutting costs, restructuring, and taking advantage of various government relief programs. These management teams took every possible action to preserve liquidity and make sure their companies would have the flexibility to ride through the uncertainty to come.
Because of the noise in the numbers, the response and the creativity of management teams in times of uncertainty weighs even heavier in a private equity firm’s due diligence process. That’s why patience is the key to completing a deal.
If a potential acquisition target is going through a challenging situation, private equity firms — to use a basketball analogy — can opt to hang around the rim if the company has a strong business model and management team. In other words, they’ll keep the due diligence process going, giving the sponsor more time to see how the company responds to the challenge. However, if there is pressure from a timing perspective for a sponsor to purchase a potential acquisition target, or if the target still has strong fundamentals and is something the sponsor would like to acquire at this time, sponsors can get creative by structuring the purchase price with a meaningful earnout over a two-to-three-year period based on the target achieving certain profitability thresholds.
Being patient and disciplined also involves getting as much information as possible. That means leveraging your partners and expanding your sources of information to get a better understanding of what’s happening on a macro level. You may want to talk to banks, accounting firms, industry trade associations, or even other private equity firms. The goal — as with each due-diligence process — is to help you grow more comfortable with a potential acquisition, especially as the supply chain situation evolves.
Andrew Gouw is Managing Director & Regional Market Leader, BMO Sponsor Finance.