Winning private equity

Private equity firms have been active in the automotive industry for years, to mixed reviews. Their objective is straightforward – deploy capital from high net worth individuals and institutions by taking equity ownership in a company for five to seven years and managing it for strong returns. The ways they achieve this can be seen as constructive or exploitative depending on the beholder, since some of the methods of maximizing cash flow (e.g. shrinking staff, cutting research and development) emphasize short-term gain versus long-term growth.

The approaches vary by firm, but we at IRN believe that private equity investors have been good for the auto industry in providing funding and imposing rigor on companies that could benefit from it.

Because their expertise is more strongly in finance than manufacturing, private equity firms often seek assistance from experts in evaluating an investment. IRN has participated in many due-diligence engagements to provide an objective third-party assessment of how an automotive supplier is positioned and whether it can meet the equity firm’s expectations. The priorities and concerns of equity firms can vary, and their final decision is occasionally surprising.

In one case, IRN was retained to review a maker of complex, injection-molded automotive components. The company had two new products – one already commercialized and another in development – that were expected to accelerate sales growth and profitability. From our perspective, the supplier was a solid choice for investment, a decent company with room for improvement and upside potential. As is usually the case, the offering memorandum was positively glowing, but stripping away the hyperbole still left a company with a good story to tell.

After four weeks of IRN research, our client decided not to pursue the deal, much to the disappointment of the target company. The private equity firm’s investment committee could not get comfortable for reasons that reflected preferences and a lack of experience with the auto industry. Their concerns included:

The company’s management bench was not deep enough. Some equity firms bring in new managers, but that was not the philosophy of this firm.

The message is that succession planning matters. The company was not able to accurately forecast its business. During the period of due diligence, the supplier reported monthly results that were significantly more positive than its forecast had been. Not being familiar with the dynamics of the automotive industry, this particular equity firm was convinced there was a business management problem.

They decided that the company was a chugger, one that would plug along with positive results but not be a breakout success. This firm’s objectives required finding some blockbusters.

It is certainly disappointing for a successful automotive supplier to learn that it is not going to make the grade despite having a good report card. When money is needed to fund growth or buy out existing owners, it is difficult to be at the mercy of equity firms that may perceive things differently.

Future revenue stream and bottom line performance are always key factors for private equity firms, so suppliers should focus on solidifying customer relationships and future orders, seek ways to grow a little faster than the market, and continue to look for a match.

IRN Inc.
www.think-irn.com

About the author: Melissa Anderson, vice president of automotive research group IRN Inc., has consulted with automakers and suppliers extensively since 1986. She can be reached at melissa@think-irn.com.