This article appeared on June 2nd 2008 in the ICIS Business News supplement published for the annual FECC congress. It highlights important strategic issues influencing distributors and suppliers. Prior to its publication, the content of the article was reviewed by several industry experts. It should not be considered as a legal opinion, but as expressing the views of an industry expert.
A number of chemical distributors are facing now the strategic, financial and legal challenges which were already foreseen last year. Additionally, they have to define new principles of cooperation with their commodity and specialty chemical suppliers based on applicable competition laws. “On the right track” aims at clarifying these issues by covering the following topics: Fragmentation or consolidation of the chemical manufacturing and distribution sectors, latest trends in distributor M&A activities and new legal and commercial rules for commodity and specialty chemicals.
1. Industry fragmentation or consolidation?
Early March 2008, at the Brazilian Chemical Distributors Association congress in Bahia, Dr Pedro Wongtschowski President of the leading Brazilian chemical manufacturer “Ultrapar” factually demonstrated the growing fragmentation of the chemical manufacturing industry. While in 1970, the top ten producers had a global market share of 16%, in 2006 their market share declined to 11%. Over the same period, the top thirty producers market share had gone from 29% to 20% and the top fifty producers saw their global share decline from 36% to 25%. (Table 1: Chemical industry fragmentation).
TABLE 1
The increasing fragmentation of the chemical manufacturing industry is the result of the globalization, the emergence of new producers in Asia and the Middle East, as well as the leading producers’ focus on core competencies and key processes. It is symptomatic that several of the past top ten chemical industry leaders like Hoechst, ICI, Montedison, Rhone Poulenc, Veba disappeared from the scene.
By contrast, the top ten European distributors increased their market share from 29% to 34% between 1998 and 2006. (Table 2: top ten European distributors’ growing share). Similarly, between 1999 and 2006, the top ten North American distributors saw their joint market share increasing from 34% to 44%. While the revenues of the top ten distributors are based on published figures, the overall distributor or producer market sizes are based on estimates. However, these contradictory trends are evident and we can therefore state that while the chemical industry is increasingly fragmenting, the distributor sector is consolidating to such an extent that suppliers and customers have often a limited choice of available distributor options on the European and North American markets.
TABLE 2
These developments, although barely realized so far are likely to impact future distributor M&A strategies. One of the main justifications for the consolidation of the distributor scene was founded on the wrong perception that the chemical industry was consolidating. Other reasons for the distributor consolidation are known such as the producers’ drive for doing more businesses with fewer distributors, succession issues in family owned companies and the corporate and private equity owned distributors’ strategy to pursue “Buy & Build” growth strategies.
2. The end of the “Buy and Build” M&A strategy?
The main industry consolidation engine behind the “Buy & Build” strategy were the investments made in chemical distribution in the nineties by renowned public companies, like Ashland, Internatio-Muller, Stinnes, Veba and Vopak and in the last years by private equity firms like 3i, AXA Equity, ABN Equity, Bain, BC Partners, CVC, Permira.
The following example highlights the money game behind the distributor industry consolidation. When a private distributor achieves sales of 100 Millions Euros, he may typically get a 5 Millions Euros EBITDA which, depending on his company equity structure and debt levels, can allow him to invest 3X EBITDA or up to 15 Million Euros on the basis of a 50/50 debt equity ratio. A corporate or conglomerate owned distributor obtaining the same result can double this leveraged financing to around 6X EBITDA or up to 30 Million Euros as he offers as risk guarantee a wider asset and equity base than what a private distributor may put forward. Before the credit market turmoil, private equity owned distributors were able to mobilize up to seven to nine times the previously generated EBITDA. Private equity sponsors mostly focus on the acquired company’s cash generation potential to raise debts. The possibility to obtain loans based on creative financing instruments and the possibility to transfer debts to the next buyers without paying back the debt principals supported the recent expansion of the “Buy & Build” model. Consolidation in chemical distribution was mostly driven by external sources of leveraged financing, initially by public conglomerates and lately by private equity. Without these "external" leveraged investments, the distributor sector consolidation would have been much less spectacular.
This example makes clear the structural advantage corporate and private equity owned distributors enjoyed so far. During the period 2000 to 2007, eighty per cent of the distributor M&A or over 150 transactions were globally completed by private equity owned distributors. Two aspects facilitated their inroads into distribution, namely the boundless availability of funds for financing new acquisitions and the possibility to trade companies as secondary or tertiary placements. While private equity owns a relatively small number of distributors, they now control the industry leaders in Europe and America, namely Brenntag, Univar, IMCD and Azelis as well as some smaller companies such as Quaron, Solvadis, Safic Alcan, Warwick, Unipex or Banner/Surfachem.
During the last years, several leading private companies avoided to get involved in pricey M&A activities and focused their efforts to achieve ambitious organic growth programs. Leading distributors like Algol, Quimidroga, Caldic, Helm, Eigenmann & Veronelli, Barentz or Norkem grew organically their revenues without resorting to M&A activities. They show solid results and balance sheets with low indebtedness. For instance, Iberian distributor Quimidroga became in 2007 a 600 Millions EUR distributor whose sales and profits grew organically more than 20% over the last two years.
Several factors may act now as private equity investment decelerators, namely the credit crunch, more difficult to manage and less profitable exit opportunities and more restrictive M&A procedures. Competition authorities are now likely to be more attentive to market share issues to avert some distributors’ market dominance and the formation of oligopolies. EU competition authorities are likely to use the concept of pertinent market to approve new transactions. To circumvent this restriction, private equity owned distributors are seeking to expand on the emerging markets of Asia, the Middle East and South America or are acquiring smaller European niche players. This is illustrated by Azelis’ recent acquisitions in India and Turkey matched by IMCD expansion in South Africa and Turkey and the other small size acquisitions which took place so far in 2008. These aspects will impact the number and scope of new distributor M&A activities in Europe and in North America and are likely to reduce significantly the recently observed M&A multiples in line with what is happening for specialty chemical manufacturing acquisitions.
3. New competition rules for commodity and specialty chemicals
Distributors and suppliers often paid limited attention to competition laws. They tended to overlook the importance of these legal issues which paradoxically concern all the commercial aspects in which they are involved, such as information exchange with suppliers, distribution contracts, exclusivity, antitrust, merger policy, market share and market dominance. As these topics are fairly complex and distributors have limited legal in-house resources, they tended to mostly rely on their suppliers to put them in the picture. However, few suppliers have specialist legal resources capable of mastering these topics and the information provided to distributors was often contradictory and in hindsight even inadequate.
It is important to underline that competition laws are evolving under the influence of new jurisprudence, consumer protection, business economics and competition agency regulations rather than being cast as a defined set of rules, like those written in the French Code de Commerce (1). They are not meant to protect producers or distributors but to look after the customers’ welfare.
In practice, competition rules differentiate the distribution of commodity or bulk industrial chemicals based on producers’ sales to several competing channels and multi-sourcing for distributors from the distribution of specialty chemicals. The latter is broadly based on sales to a selected network of specialized channels covering specific markets or industries. The ensuing legal principles often reflect commercial practices already in place in the industry.
Producers and distributors (Table 3) are expected to fulfill reciprocal obligations when they are involved in the sale of commodity or bulk chemicals. Producers should apply the principle of fair pricing and avoid price discrimination among channels to markets. They should also serve distributors fulfilling product stewardship compliance criteria and offering modern logistic and environmental protection capabilities. It is now generally admitted that they should not ship directly to their distributors’ customers since they are not supposed to know which customers are served by them and at what prices. (2)
TABLE 3
Distributors may exchange information with their commodity suppliers based on market trends, technical and service issues but should avoid giving away information about prices and customers. They should organize delivery pick ups at their suppliers’ sites when these shipments are delivered directly to their customers and keep sufficient stocks to meet their customers’ demand. Finally, they should have antitrust compliance programs as well as proper governance policies in place.
For specialty chemicals (Table 4), the main legal and commercial difference derives from the concept of supply exclusivity which creates specific mutual obligations for both producers and distributors. The exclusivity dimension is commonly found in other consumer and industrial sectors. Producers wishing eventually to sell exclusively to a selected network of specialized distributors must fulfill a list of demanding obligations. Firstly, they should commit to work with a single channel to serve a given specialty market or industry on a defined territory. They select their distributors according to a defined set of criteria such as market development skills and industry expertise. Producers should publish a distributor policy and define the type of transactions and customers they will serve directly and those who will be managed by their distributors. Producers and distributors relationships are described in contracts whose terms are in conformity with new competition laws. Producers must technically train their distributors’ staff and abstain from selling to distributors’ competitors active on the same markets. Producers should also audit their distributors’ ability to comply with REACH and Health, Environment and Safety (HSE) principles.
TABLE 4
Similarly, selected specialty distributors should have enough resources to develop and serve defined target markets. They are expected to provide their suppliers with a range of information on market trends, technical developments, competitive technical activities, product performance and quality issues, as well as some information on customer data. Distributors should defend their suppliers’ brands and refrain from promoting specialty sales outside a defined territory or industry. They should abstain from offering similar competitive chemicals to their customers and should align their marketing resources with their suppliers’ strategies. Exclusivity rules implementation entails a range of mutual obligations for both suppliers and distributors.
These obligations should be well defined and contractually agreed between the partners, keeping in mind the customers’ interests. They can sometimes be difficult to implement when distributors offer specialty chemicals from one source on an exclusivity basis in one country and compete with their supplier in another EU country or when they import competitive unbranded Asian chemicals for specific applications. Due to the increasing specialty and fine chemicals “commoditization” largely influenced by Asian producers, it seems more difficult to strictly apply mutually beneficial exclusivity terms. It is easier to be aware of these principles than putting them in practice. In case of doubt, it is always prudent to take advice from competent competition law experts.
Distributors are at a crossroad: the chemical industry is fragmenting while distribution is consolidating, the dynamic financial forces behind the “Buy & Build” strategies are temporarily decelerating and new legal and commercial rules create demanding mutual obligations for distributors and producers. These identified developments encompass the most recent strategic, legal and financial challenges faced by the chemical distribution industry. Distributors will successfully overcome these challenges by working closely with their suppliers and by defining with them new partnership principles in conformity with modern legal and ethical principles.
Marc Fermont
DistriConsult Senior Partner
(1) Professor Giorgio Monti: “EC Competition Law” Cambridge University Press 2007
(2) Dr Thomas Wesserly. Freshfield Bruckhaus Deringer. FECC presentation Brussels. November 2007