The perennial problem facing small and medium sized businesses which reach a certain age or size is, what to do next? Companies in the UK engineering sector have recently faced a tough time if they opt for flotation. The strength of sterling has squeezed margins for firms which trade abroad, and this has affected stock market attitudes to growth potential in the engineering sector.
Although mergers and acquisitions are boosting activity on the London Stock Exchange, the number of new listings is down. Companies valued at less than £50m are considered too small to merit much attention. In this climate, some manufacturing and engineering companies are shunning the stock exchange, and others are choosing to quit, to seek funds for expansion through other routes.
If they opt for venture capital, they may find that here too, the performance targets are tough. ‘It is critical that companies show growth. Growth must be aggressive, because of the high cost of the equity,’ Chris Key, a partner in the corporate finance division of accountant Robson Rhodes in Birmingham explains.
Another option has emerged in the 1990s, via the US. It is a financing technique called leveraged build-up (LBU) which enables a company to achieve critical mass through bolting acquisitions on to a core business over time.
It is not to be confused with an LBO the leveraged buyout. ‘An LBO involves buying a company and financing it with a mixture of debt and equity. Cash is generated over a period of five to seven years,’ Marek Gumienny, a director of investor and deal arranger Candover explains. ‘Whereas an LBO involves buying one business then exiting, an LBU involves buying lots of businesses starting small and becoming big.’
Candover provides funds either through a £140m trust, or via investments in limited partnerships which it manages. Gumienny says for LBUs, the strategy is to ‘extract synergies’ between businesses purchased, bringing together aspects of potentially shared operations like headquarters and marketing.
Candover has had particular experience of LBUs in the aerospace sector, where it has financed Cork Industries. ‘Build-ups involve lots of research,’ Gumienny says. ‘You have to find an industry due for consolidation.’ At the moment, the engineering sector is particularly attractive to investors using the LBU route, and Candover is among those looking for new opportunities.
LBUs differ from other methods of expansion in the way they are financed. Funding involves a mixture of equity and debt, often initially in a ratio of 50/50.
‘It is no secret that small and medium sized companies are unloved because they have no liquidity,’ says Nicholas Field-Johnson, Robson Rhodes’ head of corporate finance. ‘In the engineering sector, the scale of operations is ripe to make debt financing the attractive route to go.’
This has a lot to do with interest rates. Four or five years ago, using debt to fund acquisitions would have been considered high risk. But now, it is a cheaper source of finance than equity. ‘Of course, we would not advocate 100% levels of debt,’ Field-Johnson says, ‘but the five-year interest rate trend looks favourable, and that is not going to go away overnight.’
The automotive component market is widely seen as a prime candidate for the LBU treatment. ‘You have to be conservative,’ Field-Johnson warns, advising a maximum debt/equity ratio of 50/50. He also points out that a critical performance indicator is not profit but cashflow, as the business expands.
LBUs are gaining popularity ‘in response to market circumstances,’ according to Dick Munton, a director at venture capitalist house Cinven. ‘Businesses are being more professionally sold, at auction, for example,’ he points out, while more innovative ways to finance purchases are being devised. Building up a group through acquisition may not be a new idea. But the involvement of private equity houses which take an ownership stake and use leverage to finance acquisitions is new, Munton argues.
Munton is on the board of Vector Industries, which has expanded in the 1990s through leveraged build-ups. The first six companies were acquired in 1994, followed by another five in 1995 and 16 in 1996. The group is now worth more than £200m.
Ian Fisher, deputy chairman of Vector, explains the strategy.’We formed a private holding company through leveraged build-up. A relatively stable economy enabled us to use more debt capital. Stock market conditions have made it possible to buy public companies relatively cheaply. We then manage change in the private sector, where we do not have institutional shareholders breathing down our necks.’
Fisher is also involved in Rubicon Partners, which acts as management in buy-ins and buyouts. In the case of LBUs like Vector, Fisher says the value emerges from giving time and attention to companies ‘unloved in their former family’.
Motivating management, through giving shareholdings, for example, is also important. ‘The managing directors of all the companies we have acquired say it has been the most productive period in their careers,’ he says.
Vector has made some acquisitions in the automotive components sector. ‘As you progress, there are two options,’ Fisher explains. One is to streamline, buying businesses to find synergies, raising equity from shareholders. The other is Rubicon’s route, ‘to take on a reasonable amount of debt and sell off businesses, once enhanced, to pay off the debt’.
He stresses the timing of exits is crucial. ‘You have to sell only when you are ready. The key is to think about each business as a long-term hold. When it comes to selling it, you get a better price.’
There seems to be some difference in perception of LBUs outside London. According to Paul Trainer, regional director of venture capital group 3i in Birmingham, ‘the idea has been around a long time’.
He concedes: ‘It is true that in the engineering sector in the West Midlands it is very difficult to raise money.’ But there is a great incentive for automotive companies to expand, to become a tier one instead of a tier two supplier, he adds.
‘There is a mad scramble for position between thousands of companies globally,’ he says.
‘Since groups like Rover have signalled that they want to do business with five or six suppliers rather than several thousand, a lot of automotive companies are looking for acquisitions to become major suppliers.’
Again, one strategy is to look for synergies, Trainer agrees, adding that in the West Midlands there is still a lot of scope for this.
The other is for companies to position themselves as a genuine tier one supplier.
For example, if they make, say, suspension components they buy a company that makes drivetrains and become a chassis supplier.
There is a lot of interest in West Midlands companies from overseas buyers, particularly from US companies wanting a foothold in Europe. ‘It is a classic route for them to get on to tier one,’ Trainer says.
He reckons it is immaterial whether the financing is through an LBU, or not. ‘The important thing is that if a company is not quoted, the management are shareholders and can have greater control over the business,’ Trainer argues.
There is an advantage to expansion through a leveraged route, he concedes. This involves different pricing. Rather than looking at current values and dividing the cake among shareholders, incentives can be given for a group to reach growth targets over a longer time period.