Newsletter 13, July 2004 (No comments so far)
Changing rules
Will the recent spate of equity investors in chemical distribution change the rules?This article was published in the June 9th issue of European Chemical News and summarizes a presentation titled “Chemical Distribution: Will equity investors change the rules?” which was given on June 10th 2004 at the annual event of the Canadian Association of Chemical Distributors in La Malbaie near Quebec.
The chemical distribution sector has always been subject to continuous ownership changes. This is mainly because of succession or financial issues at privately owned small- and medium-size distributors. More recently, change has been accelerated by the exit of most of the diversified conglomerates previously involved in the sector.
There has been a fear that the sector could be faced with a shortage of buyers. During the last three years, Vopak, E.On, MG Technologies, Hays and Internatio Muller have sold their chemical distribution companies. These conglomerates played until recently an important role in the consolidation of the chemical distribution sector and in shaping its present competitive environment.
But, in recent times, several private equity investors have entered the chemical distributor arena and they now own seven leading European chemical distributors. It is worth asking what attracts them to invest in this competitive, diversified and complex sector and, maybe more importantly, what are their overall management and exit strategies.
In March 2004, DistriConsult conducted a comprehensive survey among the private equity investors involved in the sector and among the chemical distribution companies they already own. The main results indicate that private equity investors are motivated to invest in chemical distribution due to:
- Expectations of further industry consolidation;
- Significant growth opportunities;
- High returns on the equity invested;
- Cash flow optimisation; and
- Favourable exit prospects.
They perceive the investment risks to lie mostly with new environmental and legislative compliance rules, a tough competitive environment, industrial stagnation in western Europe, inability to meet credit deadlines and probable interest rate increases.
The managements of the acquired distribution companies indicate that their financial owners make a significant contribution to their companies by emphasising financial performance, supporting new acquisitions, giving them assistance to grow the business and instilling a strategic mind set.
All equity investors follow more or less a similar model in whichever sector they invest their owners’ funds. The private equity model, applied also in chemical distribution, is based on four leverages, namely equity, financial, management and tax optimisation. Equity leverage is based on limiting the equity invested, which tends to remain at or below 35% of the contracted debts; on attracting bank loans, and on avoiding additional equity capital increases.
Financial leverage is used to increase cash flows and to reduce debts, to grow the business and to reduce costs in order to make possible an onward sale of the company under positive terms. Management leverage aims at having a professional and high performing management team in place and to motivate it with stock options and minority equity ownership. Tax leverage is based on the creation of a holding structure, preferably registered in a favourable corporate tax haven, such as Luxembourg, where Azelis and Brenntag are now incorporated, for example.
The main question to ask is whether the private equity model, which is so far proven in most industry sectors, can be equally successful in chemical distribution? Based on the experience and observations of the performance of Albion Chemicals, Azelis, Epenhuysen Chemie and IMCD, we may say that the model is generally successful when it comes to managing medium-size distribution companies. All four companies now owned by private equity investors are performing better than when they were owned by a strategic owner.
The private equity investor model is notably different from the strategic investor model. Strategic or industrial investors emphasise synergies and internal value drivers. They tend to finance their investments with higher equity levels and rely less on bank loans. They also take a longer term approach.
Private equity investors emphasise financial performance and cash flow generation. They give a major importance to external criteria such as market share and average compounded growth rates, which are often speculative when it comes to chemical distribution.
They leverage their investments highly and tend to involve management financially in the equity. They tend to view their investments with a shorter time horizon of three to seven years and always buy a company with the goal to resell it profitably.
In many instances, private equity investors have unrealistic growth and returns expectations. They tend to underestimate the competitive trends and have a limited understanding of chemical pricing processes.
By highly leveraging their investments, they tend to reduce the net cash flows available to grow the business more. Unlike other industrial sectors, chemical distributors are dependent on their suppliers for new molecules, for the management of environmental issues and for gaining the benefits of extended outsourcing trends.
Producers favour distributors that have a competent management in place and a sound financial performance. In other industrial sectors, like the building industry or the MRO (maintenance, repair and operations) sector, industrial distributors are much less dependent on their suppliers.
Many speculative or optimistic statements were made about growth in the chemical distribution sector, which pegged growth in the undefined chemical distributor market at twice GDP. This intuitively estimated chemical growth rate overemphasised the chemical industry outsourcing trends and the external growth experienced by several acquisitive distributors.
The figures recently made available by the German Association of Chemical Distributors (VCH) indicate that the volumes managed by German chemical distributors from 1993 to 2003 increased from 4.8m tonne to 5.8m tonne, which gives a compound annual growth rate of 1.3%.
The VCH figures give a credible description of the historical chemical distribution organic growth rate, while taking into consideration that the demand for several chemicals, such as industrial solvents and acids, was stagnant or even declined during the last ten years.
Chemical distributors operate in a crowded and lively environment characterised by continuous consolidation and new entrants. Five of the top ten polymer distributors were not on the market 15 years ago, neither were IMCD and Azelis active in their present form.
Companies operating on the fine and speciality markets have a different profile to the companies involved in commodity chemicals. Nalco or GE Chemical Services are also offering chemicals and related services to water treatment and automotive end users, in competition with other suppliers to these industries.
In Germany, Penta Chemikalien, which has existed for 36 years as an alliance of independent distributors, recently strengthened its operations by adding some attributes common to holding companies, in addition to being an active solution and trading provider for its independent members. By investing into Penta as well as in each others’ companies, Penta Chemikalien members maintained the flexible structure of medium-size distributors required to serve the producers’ and customers’ multiple requirements.
Penta Chemikalien recently enlarged its international presence by extending membership to UK-based Tennants Distribution, France- and Benelux-based Epenhuysen Chemie, Switzerland’s Thommen and Italy’s Ilario Ormezanno. Similarly, the ECDA and Pluschem alliances are seeking to develop new service options for their commodity and speciality partners.
Furthermore, several privately owned chemical distributors such as Algol, Biesterfeld, Nordmann Rassmann and Caldic Chemie simplified their legal structure by adopting a holding organisation, which separates the owners’ strategic and financial involvement from their operationally focused business units.
This development brings to the diversified chemical distributors a clearer and more flexible role definition as well as improved efficiencies.
There are four possible exit strategies for equity investors owning chemical distributors, namely an initial public offering (IPO); a secondary placement or a sale to another private equity investor; a sale to a strategic investor, or bankruptcy, which is the least preferred option. Private equity investors in chemical distribution have so far tested their exit through a sale to other equity investors, such as Permira did when it sold Azelis last year to the management and to Elektra.
Vopak launched an IPO in 2002 by offering Univar shares to Vopak shareholders. This resulted in a reasonably successful partial flotation of the company, while Holland America Line (HAL) foundation still retained 44% of Univar. Univar share values have increased 40% since they were floated.
Several equity investors have been able to sell their distribution assets to strategic investors, as in the case of the sale of Unipex in France to Atrium Biotechnologies of Canada. Similarly, the 3i minority fund in the UK has taken several equity positions within several chemical distributors such as Tennants, Surfachem and Stanley Black, with a longer term perspective. It expects to cash in its investment when it sells the minority stakes to existing or new shareholders. For medium size distributors owned by equity investors, secondary placements, LMBOs and a sale to a new strategic investor offer a range of available options which reduce the equity investors’ exit risks.
The past experience of IPOs for chemical distributors has been rather dismal. Chemical distribution companies lack visibility, stock liquidity is reduced and chemical distribution shares are as cyclical as are other chemical shares. This recent history limits the access to financial markets for private equity investors and makes exit strategies for larger investments much more difficult. In reality, in the chemical industry in general and more specifically for large scale distributors, exit barriers are much higher than entry barriers.
This new chemical distribution industry environment provides a more predictable financial environment where all players involved in the sector obey the same rules, namely to earn their cash flows and pay their debts, before being able to make new investments and new acquisitions.